A cafeteria plan is basically an employer sponsored benefit package that offers employees a choice between taking cash and qualified benefits (such as accident, health coverage and group term life insurance). It is important to note that participation in the benefits of a cafeteria plan will cause the taxpayer to not include any of those benefits in taxable income. However, if the taxpayer chooses to receive cash instead, the cash will be required to be included in taxable income.
Defining a Qualified Benefit
The cafeteria plan must limit its offering of benefits only between cash and qualified benefits to employees. A qualified benefit is any benefit that is not includible in the gross income of the employee by reason of an express provision of the law.
The only taxable benefit that a cafeteria plan may offer is cash. The menu of items in a cafeteria plan may include such nontaxable benefits as group term life insurance, disability benefits, and accident and health benefits. Other fridge benefits which may be included are dental plans, vacation days, and qualified dependent care assistance.
It is important to keep in mind that unused benefits from one plan year may not be accumulated by an employee and carried over to succeeding years. This means that it is important for an employee to use all their benefits to get the most out of them.
The following plans have been expressly prohibited from inclusion:
1. Qualified scholarships
2. Educational assistance programs
3. Excludible fridge benefits
Exceptions are made for employer contributions to profit sharing or stock bonus plans under a qualified cash or deferred arrangement as defined by Code Sec 401(k)(2).
Participation in the cafeteria plan must be restricted to employees. The maximum number of years that can be required by the employer of the employee before allowing an employee to have access into the plan is three years.
The plan can also not discriminate in favor of highly compensated individuals, shareholders owning more than 5 percent of the voting power or value of the stock, or certain key employees within the company.
The reporting requirements for cafeteria plans can be very strict for employers. Employers must report to the IRS the name and address of and the amount of benefits provided to highly compensated employees. They must also report the number of highly compensated employees, along with a list of the number eligible to participate in the plan, the number who actually participate, and the amount of fringe benefits includible in income.
As you can see, setting up a cafeteria plan for a business is a very transparent process and requires an employer to be upfront with the IRS at all times. This can cause problems when a business starts to become more lax with their reporting and the IRS is having trouble getting the proper information from them.