Section 125

What is Section 125 or Flexible Spending Accounts?

Sometimes referred to as a cafeteria plan, flexible spending account, or a Section 125 plan, this type of account lets employees set aside a certain amount of each paycheck into an account — before paying income taxes. Therefore, Section 125 provides no benefits it simply provides the exemption from constructive receipt for benefits that qualify to be in a cafeteria plan.

During the year, participants have access to this account for reimbursement of expenses — not covered by insurance — that they regularly pay for, such as:

• Health insurance, other premiums, and co-pays
• Prescription drugs and medical supplies
• Dental services, orthodontics, and dentures
• Eyeglasses, contacts, solutions, and eye surgery
• Weight-loss programs (associated with a specific disease).
• Chiropractic services
• Psychiatric care and psychologist's fees
• Smoking cessation programs
• Adult and child daycare services
• Adoption expenses

When employees use tax-free dollars to pay for these expenses, they realize an increase in their spending power and substantial tax savings. The company saves too — about 8% (FICA match) on every dollar employees contribute to the plan.

Plan Options

The examples of flex spending account plans may include:

• Premium Only or Premium Conversion Plan (Employee-paid insurance premiums)

Allows an employee to pay their share of qualifying group insurance premiums to be automatically deducted from their pay with tax-free dollars. These payroll-deducted health insurance plan premiums and other employer-sponsored insurance coverages may include dental, disability, accident, and group-term life insurance premiums.

• Health Care Flexible Spending Account (Medical expenses not covered by insurance)

Allows an employee to pay for health care expenses for themselves and their family with tax-free dollars. Typical expenses may include eye exams, eyeglasses, eye surgery, contact lenses and solutions, dental visits, orthodontic care, medical examinations, mental healthcare, chiropractic services, prescription drugs, insurance co-pays and deductibles, and expenses that are not reimbursed by health insurance.

• Dependent Care Flexible Spending Account (Adult and child daycare expenses)

Allows an employee to pay for child day care or dependent care expenses up to $5,000 per year tax-free, while the employee and spouse (if married) work.

Advantages to an Employer

• Save Payroll Taxes — The employer will save 8% on every dollar an employee redirects to the Flex plan. (This is true for employees earning less than the maximum amount taxed for social security.)

• Increase take-home pay — An employer can increase the employees’ share of insurance premiums without reducing their take-home pay.

• Cushion insurance rate increases — Many employers are changing coverages and/or passing increases along to employees. A Flex plan can be implemented with a change, and lessen the impact on an employee's paycheck.

• Lower the health insurance costs — An employer's insurance cost can be lowered by coordinating changes to your insurance plan with the installation of a Flex plan.

• Cut the retirement plan expense — Since profit sharing, 401(k) and pension plan contributions are based on employees' taxable salaries, an employer’s retirement expenses may be reduced.

• Save on other insurance premiums — Contributions for other coverages (like workers' compensation or disability) may be reduced because they are based on employees' taxable salaries.

• Plan administration fees are deductible — Administrative costs are tax deductible and can be paid by the employer and/or the employees. Fees can even be collected by payroll deduction on a pre-tax basis.

Advantages to an Employee

The portion of salary that an employee directs to the FSA plan is not taxed. The employee will save:

• Federal income tax.
• State and local taxes (where applicable).
• Social security tax (assuming the employee’s salary is below the maximum social security wage base).

The employee’s savings will depend on the amount directed to the FSA plan and the employee’s tax rate.

What happens to the money that an employee puts into the FSA Plan?

The employee’s redirected salary is "banked" by the employer in an account maintained for the employee. Qualified expenses incurred by the employee are reimbursed tax-free from dollars "banked" in the account.

If the employee does not use the full amount before the end of the plan year, the left over amount is forfeited to the employer. Every effort should be made to educate the employees on this risk and to be conservative in their estimates of eligible expenses. As a result of good communication and the employee’s understanding, the forfeitures can be minimal.

Government Requirements

The following entities can save money on taxes by establishing an FSA plan: Regular Corporations, Partnerships, S Corporations, Limited Liability Companies (LLCs), Sole Proprietorships, Professional Corporations, and Not-For-Profits.

While regulations prohibit a sole proprietor, partner, members of an LLC (in most cases), or individuals owning more than 2% of an S corporation from participating in the FSA plan, they may still sponsor a plan and benefit from the savings on payroll taxes. "Employee" shareholders of regular corporations may also participate.

The following are important elements to understand about Section 125 Cafeteria Plans:

• The plan must be in writing and a Summary Plan Description must be distributed to each plan participant.
• Elections must be made prior to the beginning of the plan year and cannot be changed or revoked at any time during the plan year unless the participant has a change of status, or the required contributions to pay premiums for the elected benefits change during the plan year.
• COBRA continuation forms should be provided to all terminating participants in the medical reimbursement portion of the plan. However, COBRA need not be offered for subsequent plan years.
• If disability insurance is paid on a pre-tax basis, benefits received from the insurance carrier by the employee may be taxable. Under most circumstances, it is recommended that disability insurance not be included in the plan.
• No more than $50,000 of employer-sponsored group-term life insurance may be provided to employees on a pre-tax basis.
• Insurance products with a return-of-premium feature cannot be paid for on a pre-tax basis.
• The plan may not discriminate in favor of highly compensated or key employees.
• The plan must provide a written statement by January 31 of every calendar year showing the amounts paid or expenses incurred for daycare expenses during the previous calendar year. This amount is shown on the employee’s W-2.
• Employers maintaining Section 125 plans must file IRS Form 5500 each year.
• For a medical FSA, the employer must make the full election amount available to participants on the first day of the plan. If an employee leaves employment before fully funding the plan, the company must complete funding. In case of a deficit in the plan account, the company must fund this deficit until employee deposits cover the balance. Generally, the employer’s FICA savings outweigh this risk.
• Eligible expenses must be incurred during the plan year. Funds elected by participants, but unused at the end of the year, will be forfeited to the plan.
• Because employees do not pay any social security tax on income redirected to the plan, their social security benefits may be slightly reduced.

Section 125 / Flexible Spending Account (FSA) Common Questions and Answers

Welcome to the Section 125 / Flexible Spending Account Questions and Answers (Q&A) review. Below is a listing of pertinent questions that help provide guidance on several issues dealing with Section 125 / Flexible Spending Account requirements.

(Answers are provided as general guidance on the subjects covered in the question and are not provided as specific legal advice. Each individual case should be reviewed by your legal counsel to apply the law to the particular facts of your situation.)

Q. What is a cafeteria plan under section 125?

A. Internal Revenue Code Section 125 refers to an arrangement in which an employee may choose between cash and benefits (without a tax consequence) as a "Cafeteria Plan". Without the benefit of a Cafeteria Plan, such a choice would create taxable income. A cafeteria plan is a plan maintained by an employer for the benefit of its employees that satisfies the requirements of section 89(k), under which all participants are employees, and under which each participant has the opportunity to choose among cash and qualified benefits. Additionally, a cafeteria plan satisfies the written plan document requirement only if the plan describes the maximum amount of elective contributions available to any employee under the plan either by stating the maximum dollar amount or maximum percentage of compensation that may be contributed as elective contributions under the plan by employees or by stating the method for determining the maximum amount or percentage of elective contributions that employees may make under the plan. The meaning of "elective contributions" under a cafeteria plan is the same as the meaning of "salary reduction contributions" under a cafeteria plan. In short, it is an employer-sponsored benefit plan which allows an employee to select from a list of available benefits those benefits needed by the employee.

Q. What is a Premium Only plan?

A. A Premium Only Plan is the most basic type of Section 125 Plan and the most popular. A Premium Only Plan allows employees to pay their portion of insurance premiums with pre-tax dollars. Benefits that are typically offered within a Premium Only Plan include: health, dental, vision, accidental death and dismemberment, short and long term disability, and group term life insurance.

Q. What is a Flexible Spending Account?

A. Under the Internal Revenue Code Section 125, employees may make pre-tax contributions to a Flexible Spending Account. An employee may seek reimbursement from the Flexible Spending Account for expenses paid for child care, deductibles, and eligible medical expenses not otherwise covered under a health insurance plan. A Flexible Spending Account allows an employee to increase his or her spendable income by allowing them to pay these expenses with pre-tax dollars.

There are two categories of expenses eligible for reimbursement under the FSA accounts:

• Medical care expenses
• Dependent care expenses.

Medical care expenses are defined, as those expenses not reimbursed under a health or dental insurance policy. The employer may choose to place a maximum on the amount an employee can withhold for this purpose.

Dependent care expenses are defined as expenses for care of a qualified individual (a child under 13 or a disabled dependent or spouse), so the employee and their spouse are enabled to work. An employee is able to set aside up to $5,000 annually for this purpose.

Q. What does section 125 of the Code provide?

A. In general, an employee who has an election among nontaxable benefits and taxable benefits (including cash) must include in gross income any taxable benefits that the employee could have actually received pursuant to the employee’s election. The amount of these benefits is included in the employee’s income in the year in which the employee would have actually received the taxable benefits if the employee had elected such benefits. This generally is the result even if the employee’s election between the nontaxable benefits and taxable benefits is made prior to the year in which the employee would have actually received the taxable benefits. However, section 125 provides that cash (including certain taxable benefits) provided under a nondiscriminatory cafeteria plan will not be included in a participant’s gross income merely because the participant has the opportunity, before the cash becomes currently available to the participant, to choose among cash and the nontaxable benefits under the cafeteria plan.

Q. What benefits constitute qualified benefits and what benefits constitute cash under a cafeteria plan?

A.

• Qualified benefits – accident or health plans, group-term life insurance, certain discriminatory benefits and certain dependent care assistance benefits.

• Currently taxable benefits treated as cash – In general, a benefit is treated as cash if it does not defer the receipt of compensation and an employee who receives it purchases the benefit with after-tax employee contributions or is treated, for all purposes under the Code (including, for example, reporting and withholding purposes,) as receiving, at the time the benefit is received, cash compensation equal to the full value of the benefit and then purchasing the benefit with after-tax employee contributions.

• Qualified cash or deferred arrangements – Elective contributions to a qualified cash or deferred arrangmeent section 401(k) are permitted under a cafeteria plan. In addition, after-tax employee contributions under a qualified plan subject to section 401(m) are permitted under a cafeteria plan.

• Benefits that do not constitute qualified benefits or cash – Benefits of the type descried in section 117 or 132 do not constitute qualified benefits or cash and thus may not be included in a cafeteria plan regardless of whether any such benefit is purchased with after-tax employee contributions or on any other basis (i.e. health diagnostic or examination plans).

Q. What does it take to be considered a key employee?

A. A key employee is an employee of the company who is any of the following:

1. An employee whose annual compensation exceeds $67,500 (in the year 2000), or
2. An employee who for any of the 4 preceding years was any of the following:

• one of the 10 employees having annual pay of more than $30,000 and owning the largest interest in the business,
• a 5% (or greater) owner of the business, or
• a 1% owner whose annual salary is greater than $150,000.

Q. May a cafeteria plan include a benefit that defers the receipt of compensation?

A. A cafeteria plan may not include any plan that offers a benefit that defers the receipt of compensation. In addition, a cafeteria plan may not operate in a manner that enables employees to defer compensation. For example, a plan that permits employees to carry over unused elective contributions or plan benefits (i.e. accident or health plan coverage) from one plan year to another operates to defer compensation. This is the case regardless of how the contributions or benefits are used by the employee in the subsequent plan year (i.e. whether they are automatically or electively converted into another taxable or nontaxable benefit in the subsequent plan year or used to provide additional benefits of the same type).

Q. In what circumstances may employees revoke existing elections and make new elections under a cafeteria plan?

A. A plan is not a cafeteria plan unless the plan requires that participants make elections among the benefits offered under the plan. In general, an election will not be deemed to have been made if, after a participant has elected and begun to receive a benefit under the plan, they are permitted to revoke the election during the period of coverage under the plan, even if the revocation relates only to the remaining portion of the coverage period with respect to the benefit and even if the revocation is in response to a change in the tax treatment of such benefit.

Q. Can participants make changes in elections during the plan year?

A. The only time tax regulations allow employees to make a change during the plan year is if there is a change in their family status affecting their need for benefits. Some examples of a family status change are a marriage or divorce, the death of a spouse or child, the birth or adoption of a child, or a change in the employment status of the employee or their spouse.

Q. What other features are in the plan in addition to not taxing one’s health and medical related insurance premiums?

A. The plan also allows employees to establish accounts to deduct unreimbursed medical expenses and dependent care expenses from their gross pay before taxes are calculated and deducted.

Q. What is a qualified medical expense for reimbursement under the plan?

A. Most medical expenditures not reimbursed by an insurance plan or any other source, such as payments, vision care, dental costs, and routine physicals, are qualified medical expenses. These expenses may be either for the employee or for their dependents. Some cosmetic surgery procedures and other health-related expenses do not qualify.

Q. Who is considered a qualified dependent for the reimbursement of dependent care expenses?

A. A dependent child under the age of 13 or a dependent spouse or other adult physically not able to care for himself or herself is considered to be a qualified dependent if their dependent care expenses could qualify for the federal income tax credit on their tax return.