Section 125 cafeteria plans are relatively easy to set up and are extremely beneficial to both employers and employees, but they should not be considered “set-it-and-forget-it plans.” An increase in Department of Labor audits warrants a much closer look by employers to ensure compliance and proper administration.

Under Section 125, employers can offer certain benefits on a pre-tax basis. These include accident insurance, dependent care assistance, group-term life insurance (employee only), disability insurance, health savings accounts and flexible spending accounts. Both employers and employees save money on taxes, but only if the cafeteria plan is done right.

Just because a benefit can be offered on pre-tax basis does not mean it’s the most beneficial way to purchase it.

[Image Credit: Bloomberg]
[Image Credit: Bloomberg]

One example is disability — a benefit that can be paid pre-tax, but if done so is taxable when it is paid out. While the few dollars you are saving by pre-taxing your short-term disability policy might not affect your bottom line, the story is different when your employees are out on disability and need every penny. To start, most policies pay a max of 60% of your salary and if you include additional “medical” expenses those tax deductions can be a killer.

While there is no downside to offering most medical, dental and vision benefits pre-tax, there are certain scenarios you should take into consideration when setting them up.

Test for nondiscrimination earlier rather than later
Because employers and employees get a tax break through Section 125 plans, employers have to meet nondiscrimination rules to prevent plans from favoring highly compensated or key employees.

A nondiscrimination test can be complicated but boils down to three basic (and potentially troublesome) areas:

· Eligibility: too many non-highly-compensated or non-key employees are ineligible
· Availability of benefit: highly-compensated or key employees have access to more or better benefits than others
· Utilization: highly-compensated or key employees elect more benefits under the plan

Employers should have no problem passing eligibility and availability tests if the plan was designed properly. However, utilization can change from year to year and must be tested annually for compliance.

Even when plans are set up properly issues can still arise; one of the most common issues accurse with Dependent Care Assistance Plans. Even though all employees might be eligible, it is often only the “higher compensated” ones that take advantage of it.

When testing takes place is important. Since utilization depends on which benefits are elected and the mix of employees on the plan may change throughout the year, employers will not know the results of the test until the end of the plan year. However, the actual test should be conducted earlier so that any adjustments to the plans can be made before the last day of the plan year.

If a plan is found to be discriminatory, the value of the benefits that fail the tests will be included as taxable income. This is certainly not a good situation to encounter, especially if it’s at the end of the plan year.

Domestic partners prompt tax confusion
Another scenario that can cause confusion is how to tax non-tax dependent domestic partners if they are offered benefits. While many companies allow employees to cover domestic partners on their plans, taxing them is always an issue. First, coverage must be paid with post-tax dollars. Second, the employee has to pay taxes on the employer’s share of benefits as imputed income. This wrinkle occurs because domestic partners aren’t considered spouses under federal tax law.

If an employer opts to offer after-tax coverage for non-tax dependent domestic partners under its HRA, administration can get tricky. Potential issues include:

· How to document the enrollment and tax status of a non-tax dependent domestic partner
· How to determine the fair market value of the non-tax dependent domestic partner’s coverage (for purposes of taxing that value to the employee)
· When to tax that fair market value to the employee

Ask employees to provide proof that the domestic partner is not a tax dependent. An affidavit can be used for this purpose. Create a formal enrollment process to enroll non-tax dependent domestic partners for coverage under the HRA…before it begins.

These scenarios not only cause confusion, they can also cost employers and employees money. Taking a closer look at the Section 125 plan, and being more diligent about testing, can help derail costly surprises and headaches in the event of a DOL audit.

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