A Cafeteria Plan is a tax program that allows employees to pay for expenses on a pre-tax basis (e.g. health insurance, other employee benefit plan insurance premiums, health FSA – Flexible Spending Account, dependent care, etc.). Generally, under federal tax law, all benefits received from an employer by an employee are taxable, unless there is an exception. The simplest form of Cafeteria Plan is a Premium Only Plan (“POP”), which permits employees to pay for premiums on a pre-tax basis. Other Cafeteria Plans may include a Health FSA or a Dependent Care Plan.
In order to implement a Cafeteria Plan, an employer must have a Plan Document, which must be adopted prior to the first day of the Plan Year. If a Plan Document is not adopted prior to the establishment of a Cafeteria Program, the employees’ “election between taxable and nontaxable benefits results in gross income to the employee.” (Prop. Treas. Reg. §1.125-1(c)(6).) Cafeteria Plans are also subject to non-discrimination testing requirements, which means an employer cannot discriminate in favor of highly compensated employees.
A number of compliance issues may arise from an employer’s failure to properly adopt the Cafeteria Plan prior to the establishment of the pre-tax program. For example, contributions will be taxable and the employer may be subject to penalties for failing to provide proper tax returns (e.g. W2s). In addition, employers must ensure the terms of the Plan Document are followed. Failure to follow the terms of the Plan Document may result in taxable income to employees.