Many employers allow employees to pay their share of health insurance premiums through pre-tax payroll deductions. While this has become a standard employee benefit, the favorable tax treatment is not created simply by adopting a payroll practice. It depends on the employer maintaining a compliant Section 125 plan.
Because this requirement is rather esoteric and can be overlooked by employers, and often these plans are adopted when a benefits program is first established and then rarely revisited, employers may not realize that outdated or missing plan documents can create significant tax exposure.
What Is a Section 125 Plan?
Section 125 of the Internal Revenue Code authorizes employers to offer certain benefits on a tax-favored basis through a written benefit plan, which can be called many different things, depending, in part, on the plan structure: Cafeteria Plan, Premium Only Plan, Premium Conversion Plan, or Flexible Benefits Plan. Most employers use these plans to permit employees to pay their share of health insurance premiums with pre-tax salary reductions, lowering employees’ taxable income while also reducing the employer’s payroll tax liability.
The plan document establishes the terms under which employees may elect pre-tax benefits and serves as the legal basis for the tax treatment of those elections. Among other things, it identifies the benefits offered, defines employee eligibility, sets election procedures, specifies when mid-year election changes are permitted, and outlines the rules governing plan administration.
Without a compliant written plan, employee salary reductions generally cannot receive the favorable tax treatment available under Section 125. As a result, the amounts intended to be excluded from taxable wages may instead become subject to employment and income taxes.
Why Does This Matter?
Many employers assume that because pre-tax deductions have been processed through payroll for years, they are automatically compliant. In reality, the tax treatment depends on the existence of a written plan that satisfies the requirements on the Internal Revenue Code and Treasury Regulations. This issue often comes to light only during an IRS examination, a corporate transaction, or an internal compliance review. When the required documentation is missing or outdated, employers may face employment tax assessments, withholding issues, interest, and penalties.
Who Needs a Section 125 Plan?
Any employer that permits employees to pay for qualified benefits through pre-tax salary reductions should have a compliant Section 125 plan in place prior to engaging in the pretax deductions. This commonly includes employers offering pre-tax deductions for medical, dental, or vision insurance, health flexible spending arrangements (FSAs), or dependent care assistance programs.
Employers that use a professional employer organization (PEO) or third-party payroll provider should not assume those vendors have satisfied the employer’s legal obligations. Although these providers frequently assist with payroll and benefits administration, responsibility for maintaining a compliant Section 125 plan remains with the employer.
A Simple Compliance Check
Employers should be able to answer a few basic questions:
- Do we have a written Section 125 plan?
- Does the plan accurately reflect the benefits we currently offer?
- Are employee elections and mid-year election changes administered in accordance with the plan’s terms?
If the answer to any of these questions is uncertain, reviewing the plan documents before an audit or transaction is time well spent. Even though you cannot retroactively implement a Section 125 plan, if the plan is missing, or if you never had one, putting one in place once the issue is discovered is still an important compliance step.
The Bottom Line
Section 125 plans are easy to overlook because, once adopted, they often receive little attention. You should review the plan document each time you make changes to your healthcare plans and confirm that it reflects current law and the employer’s benefit offerings.
A current compliant Section 125 plan is a relatively modest administrative requirement, but one that can significantly reduce tax and compliance risk.
For more information on this and other employment compliance issues, please contact Neva Stotler or Anna Truckley.
