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Understanding the Concept
The Internal Revenue Service (IRS) devised a benefit-payment scheme in which employees can choose to receive taxable or non-taxable fringe benefits on a pretax basis. Said benefits qualify from being excluded in the employees' gross annual compensation and will not alter the status of a tax-exempt benefit as such.
For this purpose, a flexible spending account is set up and a written plan should be executed detailing all the benefits that the employee has elected under the agreement. In addition, it must contain all the rules for election and the requirements for the employee's eligibility. Moreover, they should all be in accordance with the IRS' prescribed contributions structure for cafeteria plans.
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The rationale behind this benefits payment-arrangement is to:
- Enable employees to optimize the value of the benefits received, since their choice will be based on their personal needs and those of their dependents.
- Enable the employer to provide the IRS a clear accounting of fringe benefits that were not received by employees in the form of cash in order to qualify them as pre-tax or as a tax-exempt remuneration of the latter. In fact, IRS has a created an electronic system by which employees can indicate the benefits they have chosen.
- Enable employees to contribute to the flex-plan by way of salary deductions; this shall be excluded from the computations of withholding taxes and, in some cases, SS and FUTA. Payment for benefits are drawn against the fund on a year-to-year basis.
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Important Rules to Consider
Take into consideration the following important IRS rules that qualify an employer, an employee or the payment-arrangement:
1. Employees' contributions to the flex-plan should be used up as a benefit under the agreement and should in no way be used as means to defer the payment of employee's income, except for 401k purposes.
2. A qualified employer is one who has an average of 100 or fewer employees during the most recent past two years or if the employer is a newly established business entity, it expects to employ an everage of 100 or fewer employees for the next years.
3. This type of payment arrangement may consider highly compensated employees as eiligible, but the latter's fringe benefits are not pre-taxed and shall be included in their gross taxable compensation income.
4. An employee is considered as highly compensated if:
- He or she is among five of the highest paid officers of the business organization or among the highest paid 25 percent of all employees. If the plan includes self-insurance for medical expenses not covered by an accident or health insurance policy.
- The employee owns more than 10 percent of the total employees' stocks if the plan includes a self-insurance for medical expenses not covered by an accident or health insurance policy.
- Effective 2011, an employee is considered a key employee if he or she is a shareholder or owns five percent of the employer's business or if the employee owns one percent of the business and with an annual pay of $150,000 or if the employee earns an annual salary of $160,000.
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5. Cafeteria plans covering the dependents of highly compensated employee shall likewise be included in the taxable gross compensation of the latter.
6. The payment arrangement qualifies the condition: "tax exemptions for contributions received by the employee if this was required as working conditions". The term “working conditions" is interpreted to mean as the costs that would have been incurred by the company if the employee had not provided the services.
7. Employees should be allowed to choose at least one of the benefits qualified for tax exemptions and at least one taxable fringe benefit.
8. Any excess contributions cannot be carried over as funds for the succeeding year but are forfeited at year's end under the “use or lose" rule.
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The Tax Exempt Benefits and Their Exceptions
It should be clear that only the following benefits are qualified as tax-exempt benefits, and their inclusion in a flex-plan arrangement does not alter their eligibility for tax exemption. The employee shall elect at least one from any of the following tax exempt benefits.
- Accident and health care benefits for the employee and his dependents except Archer MSA's or long term insurance. They are also exempt from SS and FUTA taxes. The following are excluded from the tax exemption: (1) S corporation employees who are 2% shareholders and (2) Highly compensated employees under a self-insured plan in their favor.
- Adoption assistance - S corporation employees who are 2% shareholders and highly compensated employees are excluded from the tax exemption.
- Dependent care assistance – Tax exempt up to $5,000; $2,500 for married employees if taxes are filed separately. Highly compensated employees are excluded from the tax exemption.
- Group-term life insurance – Tax exempt for policies below $50,000. S corporation employees who are 2% shareholders and key employees enjoying plans favorable to them are excluded from the tax exemption.
- Health savings accounts (HSA) - Exempt for those qualified and up to the contribution limits.
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The Fringe Benefits Allowed for Inclusion Under a Flex-Plan
Not all fringe benefits are allowed to be paid under the contributions structure of cafeteria plans. However, those that are allowed for inclusion have to observe special rules regarding their eligibility for exclusion in the taxable gross compensation. The employee shall elect at least one of the following non-health care benefits according to his or need and the election shall be made on a year-to-year basis.
The flexi-plan shall purely serve as a contribution pool for the employee, from which he can draw funds for his non-health care needs. The employer adds his or her share to the contribution at the same time that the employee's contributions are deducted from his or her salary and added to the pool.
- Achievement awards – Tax exempt up to $1,600 under a qualified plan award or $400 for non-qualified plan. S corporation employees who are 2% shareholders are excluded from the exemption.
- Athletic facilities - Exempt from withholding tax computations, if the facilities are leased or operated by the employer and if substantially used during the calendar year by the employee, his spouse, and his dependents.
- Contributions for 401k plans, which become taxable if pre-withdrawn.
- Paid time-off (vacation or holiday leaves)
- Premiums for COBRA continuation coverage if the insurance plan does not fall under accident and health care benefits.
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- Employee discounts - Tax exempt up to a certain limit while highly compensated employees are excluded from the tax exemption. Discounts referred are the same discounts granted to customers as part of the business.
- Employee stock option - See separate article for Tax Treatment of Severance Pay Benefits.
- Short-term and long-term benefits. In the event that the benefit will be paid out to an employee, the amount received by the employee will be taxable if the entire contributions were sponsored by the employer or under the cafeteria agreement. Otherwise, the premiums paid will be considered as additional income of the employee or paid for using after-tax dollars.
- Educational assistance – Tax exempt up to $5,250 of benefits received annually. Contributions received as benefits are tax exempt only if the program is sponsored by the employer and benefits employees who are not highly compensated. Educational assistance granted as part of a collective bargaining agreement is not included under cafeteria agreements. Moreover, the educational assistance program is known to all qualified employees, and it should not be granted with an option to choose cash instead of the academic assistance.
- Lodging expenses if furnished by the employer as a condition for the employee’s convenience and a condition for employment. S corporation employees who are 2% shareholders are excluded from the tax exemption.
- Meals are exempt if minimal and furnished by the employer within the business premises.
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- Reimbursement for moving expenses becomes tax exempt if the employee pays for the move. S corporation employees who are 2% shareholders are excluded from the tax exemption.
- Retirement planning services are exempt from IRS, SS, and FUTA taxes. Tax exemptions do not apply if services rendered are for tax preparation, accounting, legal, or brokerage.
- Transportation benefits are tax exempt up to $230 for qualified commuter highway vehicle, transit pass, or parking benefits or $20 for bicycle commuting reimbursements. Employees who receive qualified bicycle commuting reimbursements cannot avail of other commuting benefits for the same month. In addition, S corporation employees who are 2% shareholders are excluded from the tax exemption.
- Tuition reduction is exempt for undergraduate education or graduate education of employee if work performed involves teaching or research. Highly compensated employees enjoying a program that favors them are excluded from the tax exemption.
- Benefits as volunteer firefighter or medical responder are tax exempt for IRS, SS, and FUTA.
- Benefits granted as working conditions are tax exempt for IRS, SS, and FUTA.
For more details and explanations pertaining to the contribution structure of cafeteria plans, and the taxable fringe benefits not allowed for inclusion under the plan's flexible spending fund, readers are encouraged to view Publication 15-B of IRS rules and regulations.
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Reference and Image Credit Section:
- IRS - The image is a work of the United States Department of the Treasury; / Wikimedia Commons
- From the FEMA Photo Library / Wikimedia Commons