Ocotober 2002

Pretax Plans for Small Businesses

By Theresa A. Cardello

Large corporations have reaped the benefits of pretax plans, also known as cafeteria plans, for years. They know how effective pretax plans can be for retaining and recruiting employees. Many small businesses, however, are unaware that they can pay for employee benefits before taxes, giving their employees an instant raise and saving the business owner significant taxes. This misconception hurts both small businesses and their employees.

What Is a Pretax Plan?

Rather than providing benefits directly to employees, a cafeteria plan allows employers to help employees pay for certain expenses, like health insurance, child- care, and out-of-pocket medical expenses, with pretax dollars, giving them more take-home pay.

A cafeteria plan is defined in IRC section 125(d) as “a written plan under which all participants are employees and the participants may choose among 2 or more benefits consisting of cash and qualified benefits.”

Employers like cafeteria plans because they save on their share of FICA (Social Security and Medicare) and federal unemployment (FUTA) taxes. Cafeteria plans also permit employee benefit plans designed for diverse needs, cushion the blow of premium increases, and increase employee awareness of the cost of benefits.

All cafeteria plans offer employees a choice between cash and certain qualified benefits. Choices can be offered through a salary-reduction premium payment plan, a salary-reduction flexible-spending arrangement, or a more elaborate flexible benefits plan.

Paying for healthcare premiums, child-care, dependent care, medical expenses, and commuting expenses with pretax dollars means that employees can take home more of their pay. Employers also pay less in Social Security, Medicare, and federal unemployment taxes. These savings often pay for the plan’s set-up and administration. Exhibits 1 and 2 contain more detailed examples.

IRC Section 125 Plans

Also known as premium-only plans (POP), IRC section 125 plans are the most common form of salary reduction plan. They reduce employee taxes as well as employer matching FICA taxes for group insurance (typically health) premiums. The plans’ primary objective is to permit employees to pay for their share of the cost of insurance premiums with pretax dollars (e.g., group health insurance premiums). Employees can save up to 35%, depending on their tax bracket, and employers can save approximately 8% on the matching Social Security (FICA) and unemployment taxes.

A POP can be used for several different premium payment arrangements. An employer might require its employees to pay for the entire premium, or the employer might pay a specific portion. As long as it is an eligible pretax benefit, whatever premium the employee is required to pay can be paid with pretax salary reduction dollars.

Flexible Spending Account

Many salary reduction plans go beyond the premium payment plan format and permit employees to reduce their salaries through a flexible spending account (FSA). An FSA allows an employer to expand the range of pretax deductions to include dependent care, dental, orthodontics, and vision care, as well as out-of-pocket medical expenses such as deductibles and copayments.

Dependent-care plan (DCAP). A dependent-care plan allows employees to pay day-care expenses with pretax dollars. This can significantly reduce the financial burden for single parents and employees with growing families or senior-care responsibilities. Examples of DCAP expenses are babysitter or daycare provider expenses for children under the age of 13 with working parents. DCAPs have an annual limit of $5,000.

Medical expense reimbursement. This allows employees to pay for out-of-pocket medical expenses not covered by insurance, such as deductibles, copayments, prescriptions, dental expenses, vision care, and eyeglasses and contact lenses.

IRC Section 132 Pretax Benefits

In metropolitan areas with high commuting expenses, pretax benefits can be significant. An employer can offer its employees pretax transportation fringe benefits such as qualified parking, transit passes, and van pooling.

The limits on pretax amounts depend upon the type of benefit. For example, transit passes and van pooling have a combined limit of $100 per month for 2002.
These limits may be increased for inflation.

A formal plan document is not required for these plans, but is recommended. It should be similar to the document for a cafeteria plan; however, nondiscrimination rules do not apply and there is no Form 5500 requirement.

Deciding Whether to Establish a Pretax Plan

A company can use the following six steps to help in deciding whether to establish a pretax plan:

The following are some steps in setting up a plan:


Any employer, regardless of size, can sponsor a cafeteria plan. Eligible employers include corporations (Subchapter S or C), partnerships, nonprofit organizations, government entities, limited liability companies (LLC), limited liability partnerships (LLP), and sole proprietorships. Only employees of the sponsoring employer can participate. Individuals not eligible to participate include:

To be eligible for tax savings, cafeteria plans must not discriminate in favor of highly compensated employees (HCE) and key employees. If a plan fails federal nondiscrimination tests, then HCEs and key employees might have to pay taxes on the amount of their salary reductions.

The nondiscrimination tests are complicated, but there are two major reasons why a plan would fail. The first is if not enough non-HCEs can get into the plan. The second is if HCEs or key employees are allowed more benefits than other employees.

Pretax Plan Administration

The employer, an accountant, a legal counsel, a third-party administrator, or a payroll company can administer a cafeteria plan. To administer the plan, one must be capable of preparing the plan documents; fulfilling all the necessary provisions required by IRC section 125; working with the employees; dealing with the day-to-day record-keeping; performing the testing; and completing the necessary filings.

If the employer is comfortable with completing the necessary tasks of plan administration, this can be performed internally. Outsourcing is strongly recommended if plan administration will be a burden to the employer.

Accountants and attorneys can administer cafeteria plans if they have the proper staffing and can give participating employees periodic balances, process claims, advise employees of denied claims and procedures, and ensure compliance. They should also have adequate errors and omissions liability coverage in force.

Third-party administrators often specialize in the administration of pretax plans. The legal and compliance responsibilities must be clearly defined between the employer and outside administrator. It must be clear who will handle such issues as change-in-status determinations, filing of Form 5500, discrimination testing, issuing checks to plan participants, and coordinating with the payroll department.

An employer that decides to outsource also needs to be clear about start-up fees, annual fees, and termination penalties.

Even with an accountant, attorney, or third party performing this function, a great deal of paperwork and coordination still needs to take place weekly and monthly with employees and payroll. As a result, payroll companies can make for efficient third-party administrators. Whatever option an employer chooses, it must be comfortable with the person or organization it works with.

Theresa A. Cardello is director of sales in the employee benefits division of InterPay, Inc. (www.interpay.com), the nation’s fourth-largest payroll company and employee benefits administrator. She can be reached at tcardello@interpay.com.

Sheldon M. Geller, Esq.
Geller & Wind, Ltd.

Mitchell J. Smilowtiz
GBS Retirement Services Inc.

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