Cafeteria plans are defined by the IRS in Code § 125(d) as follows: The term 'cafeteria plan' means a written plan under which-(A) all participants are employees, and (B) the participants may choose among 2 or more benefits consisting of cash and qualified benefits.
In other words, a cafeteria plan gives employees an opportunity to choose among a menu of benefits consisting of cash (regular pay) and certain nontaxable benefits (for example, health insurance benefits). The simplest cafeteria plan design and most common qualified benefit is where an employee can simply choose to reduce his or her earnings to purchase health insurance on a nontaxable (i.e. pre-tax) basis. The employee chooses a nontaxable benefit (health insurance) instead of cash (taxable earnings). In a more complex cafeteria plan design, the employer contributes an amount to the plan that the employee can use to buy various benefits. If the employer contribution exceeds the cost of the employee's chosen benefits, then the plan might permit the employee to take the excess cash as additional taxable wages. If the employer contribution is insufficient to pay for the cost of the employee's chosen benefits, then the employee can reduce his or her salary to pay for the excess cost on a pre-tax basis.
There is no "one-size-fits-all" cafeteria plan. Such plans can be tailored to meet individual employers' goals, viewed in light of the company's size, budget and employee demographics. The available options range from the simplest form of cafeteria plan at one end of the spectrum (salary reduction plan) to more complicated types with all the bells and whistles at the other end (full flex plans with employer and employee contributions).
A cafeteria plan must be in writing. The written document must incorporate all of the operating rules prescribed in Code § 125 and all of its regulations. The plan must be formally adopted by the employer prior to the first day of the plan year. Other Code sections may also require a separate written document for component plans that may be funded under a cafeteria plan. For example, a written plan document is required for health FSAs and DCAPs. The cafeteria plan document must contain certain operating rules, such as a benefit description, eligibility rules etc.
Cafeteria plans cannot discriminate in favor of highly compensated or key employees. For any year in which the plan discriminates in favor of:
Code § 125 exclusion from income does not apply, meaning that highly compensated participants will be taxed on benefits under the cafeteria plan. In addition, cafeteria plans are also subject to a key employee concentration test. Additional tests apply for certain component plans offered inside the cafeteria plan, such as health FSA or DCAP.
Any employer with employees subject to U.S. income taxes can sponsor a cafeteria plan, no matter what its size.
For more information on cafeteria plans, contact us.