Payroll taxes and flexible spending accounts.by Miller, Elbert G.
The changing composition of the American work force has caused many employers to modify employee benefit programs. With the number of two wage-earner families increasing, companies often find it advantageous to offer a "cafeteria" or "flexible spending account" program where employees select the benefits they want from an assortment of employer- provided fringes.
Such fringe benefit programs are not costless to employers, however, and many companies believe such plans are too expensive and their employees too unsophisticated to utilize such plans. However, increased competition among third-party providers and the development of more sophisticated software programs have reduced the cost of administering such plans. Furthermore, the exclusion of the cost of these benefits from employees' income can create a significant reduction in an employer's payroll taxes.
Flexible Spending Accounts
A cafeteria plan is a written plan under which employees may choose among two or more benefits consisting of cash and qualified benefits. Qualified benefits excludable under specified IRC sections include group term life insurance coverage under IRC Sec. 79, medical expense benefits under IRC Sec. 105, accident and health plan coverage under IRC Sec. 106, and dependent care assistance benefits under IRC Sec. 129.
Employers can make contributions to such plans under a salary reduction agreement with the employee. A plan can also include flexible spending accounts (FSAs, also referred to as reimbursement accounts) that are funded by employee contributions on a pre-tax salary reduction basis to provide coverage for reimbursement of specified expenses for qualified medical care or dependent care assistance costs not otherwise reimbursed.
Under a typical FSA arrangement, a participating employee may seek reimbursement for any medical expenses deductible under IRC Sec. 213 or any dependent care expenses eligible for the IRC Sec. 21 credit. The latter expenses are subject to the IRC Sec. 129 statutory limit of $5,000 (or, if less, the lesser earned income of the employee or his or her spouse).
Although medical care reimbursements are not subject to a statutory limit, the employer may impose a limit. Furthermore, FSAs are subject to a "use it or lose it" rule. Once an employee designates an amount for the FSA at the beginning of the year, any unused amounts in the account at the end of the plan year are forfeited.
The IRC Sec. 125 cafeteria plan rules applicable to such FSAs provide an exception to the constructive receipt doctrine that would otherwise apply to elections that include a taxable option, such as cash. To the extent a participant chooses a nontaxable benefit, such salary reduction contributions are not subject to Federal income tax, FICA (Social Security) tax, or the Federal unemployment tax (FUTA). However, certain nondiscriminatory tests described later must be met to retain this exemption. Additionally, such contributions may also be exempt from state income or state unemployment (SUTA) taxes, depending on state statutes. As a result of these tax exemptions, employers will realize employment tax savings to the extent such taxes apply to the amounts selected by employees for qualifying nontaxable fringe benefits.
Administration of an FSA Program
Establishing and operating a cafeteria plan that incorporates a flexible spending account arrangement is a time-consuming and potentially costly process. A concerted effort to educate employees about the benefits of such a program is a prerequisite for a successful program. Employers should attempt to determine employee interest in such a program, and employees will invariably have numerous questions. Once the program begins, employers must deal with numerous accounting and reporting details regarding the program. Instead of dealing with such painstaking tasks, many employers choose to retain a third-party administrator. Many firms now offer such comprehensive services and charges are typically based on a one-time set-up charge plus a continuing administrative charge quoted on a per-employee, per-month basis. For example, Virginia Commonwealth University recently instituted a FSA arrangement for health care and dependent care services and the continuing charge by the third- party administrator is $1.50 monthly per employee, per month.
Incorporating Employment Tax Savings into the Analysis
The potential employment-tax savings generated by an FSA assume a more important role in such an analysis for tax years after 1990. The RRA '90 increased the wage base for the hospital insurance component (1.45% for both employer and employee) of the FICA tax (15.3% total) from $53,200 to $125,000 in 1991. This was adjusted periodically in the same manner as the Social Security contribution and benefit base. RRA '93 eliminated this cap entirely for 1994 and thereafter so the entire amount of wages and self-employment income is subject to this portion of the tax. This dramatic increase in the hospital insurance component of the FICA tax, along with annual inflation adjustments to each wage base, can substantially increase the payroll tax liability for employers with highly paid professional employees.
For example, in 1990 the maximum FICA tax imposed on an employer for an employee with an annual salary of $150,000 was $3,924 (the $51,300 maximum wage base multiplied by 7.65%, or the employer's matching one- half share of the 15.3% FICA tax). In 1994, the employer's matching share of the FICA liability is $5,932, computed as follows:
The increased base for the hospital insurance portion of the FICA tax in years after 1990 has the potential to greatly increase the employment tax savings of an employer who implements an FSA and successfully convinces high-salary employees to elect non-taxable benefits through a salary reduction arrangement. This may not be a difficult sell, since employees in the highest marginal tax brackets may find nontaxable benefits an attractive part of a compensation package.
Since most third-party administrators of flexible benefit plans charge based on a fixed dollar amount per employee per month, it would be of interest to an employer to have an estimate of the total employment tax savings that would result if such a plan were implemented. Obviously, the most accurate method of determining this estimate would be to explain in detail the potential benefits of an FSA arrangement to each employee and then ask the employee for an estimate of the salary dollars he or she is willing to allocate to the reimbursement account. However, this is a time-consuming process, and it is possible to gain some insight into the potential tax savings by projecting hypothetical conversion rates based on current salaries of eligible employees.
Small Services, Inc., currently has 20 employees and is considering implementing a cafeteria plan FSA arrangement that includes medical and dependent care options. All contributions under the plan would be made through salary reduction agreements between the employee and the employer. The employer would not make separate contributions. A service provider has estimated the one-time costs of establishing the plan to be $1,200, with a continuing administrative charge of $2.00 per employee per month. Both charges will be paid by the employer.
Table 1 illustrates a simple worksheet for projecting the hypothetical payroll tax savings (based on 1994 rates) of such a program assuming employees will on the average allocate four percent of their total salary to the FSA. Obviously, this may not turn out to be the case, and with only 20 employees, more accurate projections can be obtained with extensive consultations with each employee. Nevertheless, Table 1 illustrates a method that can be used to obtain estimates of employment tax savings under various scenarios for firms with much larger work forces.
Column two of Table 1 lists the current annual salary of each employee, and column three shows the projected salary reduction elected by each employee (4% of salary, in this case). Columns four and five are used to estimate the projected employment tax savings from implementing the cafeteria plan. Column four estimates the savings associated with the OASDI component of the FICA tax, which is 6.2% of any salary reduction below the 1994 base of $60,600, and column six estimates the savings associated with the hospital insurance component ("MDC Tax") of the FICA tax, which is 1.45% of the salary reduction. Column six is the total projected employment tax savings for each employee.
The total projected payroll-tax savings is $1,690, or an average of $7.04 per employee per month. If these estimates are realized, the third-party provider $1,200 set-up charge and $2.00 per employee per month continuing charge are covered by the projected employment tax savings in the first year. As illustrated in Table 2, employment tax savings continue thereafter so that at the end of five years, there is a cumulative savings of $4,850. These projections are somewhat understated. Savings will slowly increase as bases for employment taxes and total wages increase in future years.
The procedure used in Table 1 is easily incorporated into a spreadsheet using common software programs. One advantage of constructing such a spread-sheet is the ease with which various assumptions may be tested. For example, if employees allocate an average of 6% of their annual compensation to the FSA (as opposed to the 4% used in Table 1), the projected total savings will be $2,534, or an average of $10.56 per employee per month. Other variations of plan operation may be easily tested. For example, Small Services may be willing to pay the $1,200 setup costs for the plan without reference to any employment tax savings. Therefore, the only unrecovered cost is the $2.00 per employee per month continuing charge. A few iterations of the spreadsheet through trial and error will disclose employment tax savings averaging $2.00 per employee per month result if employees on the average allocate approximately slightly more than one percent of their annual compensation to the FSA.
One final point needs to be mentioned regarding the projections in Table 1. These estimates are based solely on FICA tax savings. In some cases, employers may also realize Federal unemployment tax (FUTA) savings for employees who earned less than $7,000 per year. Additionally, some state laws may exempt nontaxable fringe benefits from state unemployment tax (SUTA). Finally, the exclusion of nontaxable benefits from the wage base may also reduce the premiums for workers' compensation insurance. These items could be easily incorporated into the analysis.
In considering an FSA arrangement, employers must be aware of the nondiscrimination rules of IRC Sec. 125. IRC Sec. 125(b) (1) and (2) provide that a plan may not discriminate as to eligibility to participate or as to contributions and benefits between "highly compensated employees" and other employees, and must not disproportionately benefit "key employees." A "highly compensated employee" is defined in IRC Sec. 125(e) as 1) any officer of the company, 2) an owner of over 5% of the voting power or value of the company stock, 3) anyone who would be considered to be a highly compensated employee based on the facts and circumstances, and 4) a spouse or dependent of an individual described in the first three categories. A "key employee" is defined in IRC Sec. 416(i) (1) as 1) an officer earning over $45,000 a year, 2) one of the 10 highest percentage owners of the company who earns over $30,000 per year, 3) a 5% owner of the company, or 4) a 1% owner who earns over $150,000 per year. Any employee who fails either test must include the benefit in income.
The "eligibility test" is met if the plan allows participation by a broad cross section of highly and non-highly compensated employees in a ratio that is representative of the total population of employees. A plan will not be discriminatory as to eligibility if it adheres to the requirements of IRC Sec. 410(b) (2) (A) (1) and no employee is required to complete more than three years of employment to participate.
The "contributions and benefits" test is met if the benefits (as a percentage of compensation) of highly compensated employees are not significantly higher than the benefits of other employees. Although "significantly" is not currently defined for cafeteria plans, a useful guide may be the 125% limit for cash or deferred arrangements under IRC Sec. 401(k), i.e., the percentage deferral of highly compensated employees may not exceed 125% of the percentage deferral of other employees. Obviously, such a test depends on the final allocations chosen by the employees, and this would have to be closely monitored by the employer. For a company like Small Services, this may pose a problem, since the "highly compensated" employees may be more inclined to allocate a larger percentage of their salaries to an FSA.
The "key employee" concentration test is met if the cost of nontaxable benefits provided to key employees does not exceed 25% of the total benefits provided, and benefits as a percentage of compensation are not "significantly higher" for highly compensated employees than for non- highly compensated employees. This may pose a problem for Small Services; for example, if P, R, and S are "key employees," their total benefits ($16,560) are exactly 25% of the total projected benefits of $66,240. Therefore, this ratio should be closely monitored by the company.
The FSA Advantage
FSA arrangements offer substantial benefits to both employees and employers. Such benefit packages generate potential tax savings for employees and may contribute to improved morale by offering employees the flexibility of designing benefits packages to meet their needs. Although the reduced employee salary may mean reduced Social Security benefits upon retirement, the difference is generally inconsequential.
For employers, flexible benefit packages can be a very important tool for recruiting new employees and retaining current employees. And, as demonstrated, the costs of administering such plans may be offset to a large extent by the payroll tax savings generated when employees convert previously taxable compensation into a nontaxable fringe benefit. Employers with highly compensated employees who rejected such plans as being too costly may want to reexamine such opportunities considering the elimination of the cap on the base for the hospital insurance portion of the FICA tax.
John O. Everett, PhD, CPA, is Professor of Accounting and Elbert G. Miller, PhD, is Associate Dean for Administration at the School of Business Administration, Virginia Commonwealth University.
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