Cafeteria plans are benefit plans that allow a company's employees to select their choice of benefits. The list of choices must contain at least one taxable and one non-taxable benefit. A taxable benefit would be to continue to receive regular compensation through payroll. The nontaxable benefit could include group-term life insurance, accident and health insurance, group legal services coverage, and dependent care assistance coverage.

At the beginning of each year, the employee makes an election, which is generally irrevocable, as to the amount, if any, he or she wants subtracted from wages to cover the selected expenses. The cost of these non-taxable benefits are specifically excluded from an employee's gross income through this salary reduction plan.

Requirements of Cafeteria Plans

Cafeteria plans must be in writing and contain information:

1. A specific description of each of the benefits available under the plan;

2. The plan's eligibility, rules for participation;

3. The procedures to be followed by the employees in making their election; and

4. the maximum amount of employer contributions available to each employee under the plan.

In addition, all participants in the plan must be employees, thereby excluding self-employed individuals such as sole proprietors or members of a partnership. Corporate employee-shareholders are eligible, except for more than 2% shareholders of S corporations. An employee's election as to the amount of salary reduction under the plan must be made before the beginning of the plan year and cannot be revoked unless there is a change in family status, such as the birth of a child, marriage or divorce of a participant. The timing of this election is important because it provides the basis for the non-taxability of the benefit.

Smaller companies that cannot or choose not to implement a comprehensive cafeteria plan, can adopt a plan that provides some, but not all, of the possible tax-free benefits. The choice as to which benefits to include in the plan is up to the employer. Even a limited form of cafeteria plan still provides advantages to both the employees and the employer.

The Employer Benefits

An employer who must deal with the ever increasing costs for group medical insurance premiums may be faced with the decision to pass these costs onto the employees. By adopting a cafeteria plan, even one with limited types of benefits, the cost to the employees can be reduced by allowing them to pay the expense with pre-tax dollars. The employee elects to reduce his or her compensation by the amount of the premiums and have that amount contributed to the plan by the employers on their behalf The monies contributed reduce the amount of payroll taxes that the employers are required to pay, including the employers share of social security taxes.

Another benefit under a cafeteria plan could be the creation of a Flexible Spending Arrangement (FSA) where employees can elect to pay, for example, for those medical expenses not covered under an insurance contract using pre-tax dollars. Here the employee designates a fixed sum of money to be set aside in a special account to cover uninsured medical expenses. A FSA would require an employee to estimate his or her total medical expenses for the year at the beginning of the year and have this amount deducted from his or her paycheck in equal installments. As medical expenses are incurred during the plan year, the employee would submit the bills to the administrator of the special account and would be reimbursed for this amount up to the fixed sum elected for the year. Any excess funds in the account at the end of the year are retained by the plan and accordingly, lost to the employee. It is, therefore, important to carefully estimate the total potential expense for the year in order to avoid this result. Since this arrangement is easy to implement and has minimal costs associated with it, it is of great benefit to all employers.

The Employee Benefits

Cafeteria plans benefit employees as well, by giving them the ability to elect to pay their share of health insurance premiums and uninsured medical costs on a pre-tax bases. The monies contributed are not subject to federal, state or local income taxes, and the employee's share of social security taxes. The uninsured medical costs can include payments required to be made under a medical insurance plan such as the annual deductible and the co-insurance amount (employees share of expenses partially covered by the policy), as well as qualifying medical costs not covered by many plans such as dental expenses.

An Example

The advantage to an employee can be seen from the following illustration. Assume employee A, who is single, incurred the following medical costs during 1989: 1) annual deductible under the Company's medical plan of $500; 2) employee's share of medical expenses partially covered under the medical plan of $1,600; 3) dental expenses not covered under the medical plan of $800; and 4) other medical expenses not covered under the medical plan of $700 for a total of $3,000. Also assume that employee A's adjusted gross income for 1989 is$100,000 in the absence of a salary reduction agreement. If employee A participated in the plan having elected a salary reduction of $3,000, he or she would receive reimbursement of up to this amount during the year. Since the $3,000 is not subject to federal, state or local income tax, the adjusted gross income for 1989 would be reduced to $97,000 resulting in an income tax savings of $1,200 assuming a combined federal, state and local tax bracket of 40%. If, however, employee A did not elect a salary reduction arrangement he or she would have paid for the $3,000 of medical expenses with after-tax dollars. He or she would not be entitled to a medical expense deduction on the personal tax return since the total 1989 medical expenses of $3,000 does not exceed 7-1/2% of the 1989 adjusted gross income. To the extent an employee is under the social security wage base the plan would also save both the employee and employer social security tax.

FSA affords employees protection in case of termination. Since the employer must bear some of the risk under this health plan, an employee will be entitled to full reimbursement of the medical expenses incurred before termination up to the maximum amount designated under the plan. This is so even though it exceeds the amount that has been deducted from an employee's salary as of the date of termination. The excess amount is lost to the employer.

Record Keeping Requirements

Employers who adopt a cafeteria plan are required to keep such records as necessary to determine whether they are in compliance with provisions contained in the IRC. For example, these records can be used to determine whether the plan wrongly discriminates in favor of certain highly compensated individuals such as officers of the company and shareholders owning more than 5% of the stock of the employer. In addition, employers are required to file an annual report with the IRS.

Today's changing economic environment has made it more beneficial for employers to establish a cafeteria plan on behalf of their employees. Determining the type of plan to set up involves the consideration of many factors, including the number of employees and their current needs.