* Accident and Health Plans
* Flexible Spending Arrangements
* Dependent Care Assistance
* Disability Insurance
* Group Term Life Insurance
* Health Insurance Premiums for Small Employers (< 50 Employees)
There are several restrictions involved as the first section covers eligibility for employers. The next section covers the accounting variations with an in-depth example and the final section provides some insights of how to maximize the value with small business. The cafeteria plan is by far the best option to providing overall tax benefits to both employer and employees.
Section 125 Plan Eligibility and Compliance
There are two groups of cafeteria plans. One is designed for large employers (> 100 employees) that has strict rules related to highly compensated employees and non-discrimination tests. These plans are known as regular cafeteria plans. For this section, this type of cafeteria plan is not explained.
The second group of Section 125 plans is known as simple cafeteria plans. It is designed for employers with less than 100 employees. The employer is considered small so long as it had 100 or fewer employees when the plan started and has less than 200 in subsequent years. Employees may participate if they worked at least 1,000 hours in the prior year. However, the employer may elect to exclude:
(1) Employees under the age of 21;
(2) Employees with less than one year of service;
(3) Employees covered under a union contract; OR
(4) Non-resident aliens working outside the U.S.
Eligible employees may only select those benefits they are entitled to in the plan. The employer must contribute either:
(1) A uniform percentage of least two percent of an employee’s compensation; OR
(2) Under Code Section 125(j)(3) twice the amount of an employee’s elective contribution.
The employer is not allowed to contribute to highly compensated employees in excess of the average for all other employees. In general, it is easier to maintain compliance by simply contributing at least 2% of an employee’s wages.
Accounting For Section 125 Plans
The bookkeeping portion of the accounting is straight forward; the employer’s share is recorded as a cost in cost of sales/labor – benefits tied to the control ID for that respective benefit as explained in Lesson 91 as a current liability under accrued payroll – benefits for an employee contribution. The employee’s share is debited as labor cost – wages as a function of total compensation. For payroll tax purposes it is simply subtracted from total compensation before calculating the respective tax components as illustrated here:
Payroll for Employee LAS
Item Amount Trial Balance Account
Gross Wages: 40 Hrs @29.75 $1,190.00 Labor – Wages
. – Health Insurance Premium (47.80) Accrued Payroll – Benefits/HI
. – Cafeteria Plan (106.10) Accrued Payroll – Benefits/125
Social Security & Medi Wages 1,036.10
SIMPLE Contribution (60.00) Accrued Payroll – Benefits/SIMPLE
Income Taxable Wages 976.10
Social Security Taxes W/H (64.24) Accrued Payroll – Taxes
Medicare Taxes W/H (14.15) Accrued Payroll – Taxes
Federal Income Taxes W/H (117.40) Accrued Payroll – Taxes
State Income Taxes W/H (59.72) Accrued Payroll – Taxes
Net Check $720.59 Payroll Checking
Notice three distinct tiers of compensation: 1) gross wages; 2) Social Security/Medicare earnings; and 3) income taxable wages. The income taxable wages are determined after adjusting for retirement plan benefits and/or other tax deferred benefits. Section 125 plans are a function of tax-free benefits (FICA and income) and are customarily included as an adjustment (subtraction) to the total gross wages (tier one) to determine the second tier of income which is taxable for all forms of employment taxes; i.e. FICA and income taxes.
For the accountant it is of the utmost importance to keep track of the various tiers in both the payroll software program and the benefits spreadsheet. Most payroll software programs require the accountant to code each benefit as one of three types:
(1) Total Tax-Free – The benefit or item is subtracted from gross wages before calculating FICA and income taxes;
(2) Income Tax (Free or Deferred) – The benefit or item is subtracted from FICA wages before calculating income taxes; OR
(3) Net – The item or benefit is paid with after-tax dollars, i.e. net income as a post tax item (life insurance premiums, dues etc.).
One of the organizational procedures I follow is to separate the benefits summation report into three sections: 1) a section summing all tax-free benefits; 2) a section summing all tax-deferred or income tax-free benefits and 3) benefits paid with after tax dollars.
To illustrate how this works, an in-depth example is provided that uses all the benefits discussed to this point.
Southern RV (Southern) has three lots located in a metropolitan area in Alabama. Altogether there are 53 full-time equivalent employees. Beverly manages the administration department and has been with the company for over 20 years. The company provides a high-deductible health plan along with a cafeteria plan. In addition, the company uses a SARSEP for retirement. The following are each plan’s respective terms.
HDHP – Southern selected a health plan that carries a $4,000 deductible (single) and $9,000 deductible (family coverage). Beverly is a single mother and opted for the family plan. Her premiums are $409.00 per month. Southern pays a flat $115.00 per employee per month.
Cafeteria – The cafeteria plan has both a FSA and dependent care assistance. Southern contributes 3% of an employee’s wages to the plan. The FSA component has a health insurance deductible part allowing up to $2,000 per year per employee. Beverly has a special needs child requiring home-care assistance several days per week. Beverly has elected to maximize the benefits in the cafeteria plan and contributes the maximum allowed by law.
SARSEP – Southern elects to make a 4% contribution to the plan across the board for all employees. Beverly elects to contribute $100 per month as a part of the salary reduction element of the plan.
Beverly earns $57,200 as a salary per year. The following are Southern’s and Beverly’s respective portion of the total benefit package. The report is calculated on a monthly basis.
Benefit Employer Share Employee Share Total
Health Insurance $115.00 $294.00 $409.00
Cafeteria: (3% = $1,716/Yr)
. – Dependent Care 143.00 273.67 416.67
. – FSA (Health Ins) 166.67 166.67
. – Employer Contribution 190.67 190.67
. – Employee (Elected Deferral) 100.00 100.00
Totals $448.67 $834.34 $1,283.01
The dealership pays twice a month. Beverly’s total compensation per pay period is $2,383.33 ($57,200/24). This is Beverly’s spreadsheet report per pay period.
Item DR/CR Amount Trial Balance Account
Gross Wages DR $2,383.33 Management Expenses – Labor/Wages
Health Insurance CR 147.00 Accrued Payroll – Benefits/HI
Dependent Care CR 136.84 Accrued Payroll – Benefits/CC
FSA (Health Ins) CR 83.34 Accrued Payroll – Benefits/FSA-H
SARSEP CR 50.00 Accrued Payroll – SARSEP
Social Security Taxes CR 125.00 Accrued Payroll – Taxes/SS
Medicare Taxes CR 29.23 Accrued Payroll – Taxes/Medi
Federal Taxes CR 164.17 Accrued Payroll – Taxes/Fed
State Taxes CR 113.05 Accrued Payroll – Taxes/AL
Net Check CR 1,534.70 Payroll Checking
Health Insurance DR 57.50 Management Expenses – Labor/Benefits
Health Insurance CR 57.50 Accrued Payroll – Benefits/HI
Cafeteria Plan CR 71.50 Accrued Payroll – Benefits/125
Cafeteria Plan DR 71.50 Management Expenses – Labor/Benefits
SEP DR 95.34 Management Expenses – Labor/Benefits
SEP CR 95.34 Accrued Payroll – Benefits/SEP
SS Matching Taxes DR 125.00 Management Expenses – Labor/Taxes
SS Matching Taxes CR 125.00 Accrued .Payroll – Taxes/SS
Medi Matching Taxes DR 29.23 Management Expenses – Labor/Taxes
Medi Matching Taxes CR 29.23 Accrued Payroll – Taxes/Medi
FUTA DR 12.10 Management Expenses – Labor/Taxes
FUTA CR 12.10 Accrued Payroll – Taxes/FUTA
SUTA DR 31.16 Management Expenses – Labor/Taxes
SUTA CR 31.16 Accrued Payroll – Taxes/SUTA
Total costs for the employer is $421.83 per pay period or approximately a 17.70% labor burden rate. Labor burden is a term referring to the average cost per wage dollar to the employer for taxes and benefits. Most employers pay between 14 and 24% for labor burden.
Southern pays $224.35 per pay period to provide benefits to Beverly and $197.48 in employer taxes.
Notice in the above set of line items both the employee and employer pay one-half of their respective monthly benefit amounts per pay period. The monthly benefit package above identifies $448.67 as the employer’s share and the actual amount Southern pays each payroll is $224.35; which is one-half. Beverly makes the following payments:
Health Insurance $147.00
Dependent Care 136.84
FSA (Health) 83.34
$417.18 is one-half of the $834.34 she must contribute monthly. Beverly’s three levels of benefits are as follows:
. Employee Employer
Gross Wages $57,200
– Health Insurance 3,528 $1,380
– Dependent Care 3,284 1,716
– FSA (Health) 2,000
FICA Wages 48,388
Income Tax Deferred Items:
– SARSEP 1,200 2,288
Taxable Wages 47,188
– FICA 3,701.52 3,701.52
– Income Taxes
— Federal 3,940.08
— Alabama 2,713.20
– FUTA 48.00
– SUTA 747.84
Sub-Total Taxes 10,354.80 4,497.36
Net Pay 36,833.30
Totals $57,200.00 $9,881.36
The total cost of the cafeteria plan is $1,716 to the employer but saves the employee $404.23 per year in FICA taxes attributable to her participation in the plan. In addition, Beverly saves approximately $744.99 in income taxes directly due to her participation. This does not include the FICA and income tax savings associated with her payroll deduction for health insurance premiums. Take note of something interesting here, her cafeteria plan tax savings is $1,149 at a cost of $1,716 to the employer. The employee receives $7,000 of benefits for a net cost of $4,139 ($5,288 actual cost minus $1,149 in tax savings). This brings up the issue of how small business employers can exercise this particular benefit.
For any benefit to be truly successful, employee participation is a must. First and foremost, educate employees on the significant tax savings involved by using the plan. Something as simple as the FSA-Health deductible is important. Even the healthiest of individuals will incur costs annually. Employees should at least contribute a few hundred dollars annually to this plan as they will likely spend the savings in just one visit to the doctor. Remember, almost every health insurance policy has out-of-pocket costs required. It is best for employees to use pre-tax dollars than post tax dollars to cover the deductible, co-pays and other out-of-pocket expenses.
One of the keys to success with this plan is to poll the employees as to how much of the plan would be exercised. The simplest contribution tool is a flat percentage of wages allowing employees to pick the benefit that best serves them and their family.
One last suggestion, this plan is rarely successful with a very young, high-turnover rate of employees operation. Young employees shy away from benefits and prefer cash instead. Therefore the employer’s contribution will most likely be taken as cash (additional compensation) in lieu of benefits by young employees. Due to the various restrictions and compliance requirements stay away from a cafeteria plan for the following youth based businesses:
* Fast Food Restaurants
* Seasonal Employers
* Resort Facilities
* Amusement Parks
Summary – Cafeteria Plans
The Internal Revenue Code §125 allows businesses to provide cafeteria plans. These plans allow employees to choose from a menu of benefits .a set or single benefit to suit their individual or family needs. All benefits provided through the plan are tax-free (FICA and Income) for any employee contributions. The employer’s contribution is excluded from the employee’s gross wages. The employer’s contributions may either be used for benefit purposes or taken as additional compensation by the employee. An employer may contribute no less than 2% of employee compensation to fulfill the minimum requirements.
This type of plan saves employees significant amounts for tax purposes as any amounts they contribute are also adjustments to gross wages prior to calculating FICA and income taxes. ACT ON KNOWLEDGE.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.