How to Set Up Cafeteria Plan: Small Business Owner Tips

How to Set Up Cafeteria Plan: Small Business Owner Tips
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Cafeteria plans or Section 125 plans allows for flexible benefits. The intended purpose of such a plan is to accommodate the increasing diversity of the workforce. For instance, the benefits that young families value may vary greatly from the benefits that a single person, or an elderly couple may value.

The primary advantage of cafeteria plans small business owners achieve is tax savings for both the employee and the employer. Deductions under Section 125 are pre-tax deductions and not considered as part of income when computing income tax, in effect raising employee net take home pay. Such deductions are also exempt from FICA (social security and Medicare), FUTA, and workers compensation contributions for both employer and employee.

Check Eligibility

The first step in setting up a Section 125 cafeteria plan small business owners need to do is to determine eligibility. In a cafeteria plan, business owners may not be eligible. Sole proprietors, partners, and S Corp owners with more than two percent ownership stake in the company do not qualify to participate in Section 125 cafeteria plans. They may, however, sponsor the plan.

The employer cannot discriminate among employees in providing section 125 cafeteria plan benefits.

Decide the Benefits

Section 125 cafeteria plan regulations requires allowing participants the option to choose from among at least one taxable benefit such as cash bonus, annual leave reimbursement, sick leave or paid time off, or severance pay, and one qualified benefit, the contribution of which is excluded from the employees gross income.

Common options for qualified benefits include

  • Accident and health benefits including health care, vision and dental care, but excluding medical savings accounts and long-term care insurance.
  • Health flexible spending accounts for expenses not reimbursed under any other health plan.
  • Adoption assistance.
  • Dependent care assistance.
  • Group-term life insurance coverage.

Another important requirement to avail the benefits of a Section 125 plan is to ensure the cafeteria plan does not include any of the following benefits:

  • Scholarships and educational assistance.
  • Meals and lodging provided by employer.
  • Fringe benefits.
  • Group term life for an employee’s spouse, children and dependents.
  • Long-term care insurance and long-term care services.

Cafeteria plans allow employees to pay premium-only health insurance plans,and flexible spending accounts for out of pocket medical expenses and dependent care through payroll deductions and are exempt from tax.

Fix the Methodology

One important consideration when starting a cafeteria plan is to fix the methodology.

The cafeteria plan starts with the employee and employer making an agreement wherein the employee allows for deduction of a specific portion of pre tax salary to pay for the selected benefits. Any employer contributions come pursuant to such agreements.

The employee estimates the amount they would spend on the cafeteria benefits at the start of the year, and the employer deducts this amount over the course of the plan year from paychecks, and deposits the same into the employees’ flexible spending account. Employees pay out-of-pocket flexible spending expenses upfront and submit a claim backed up by documentation for reimbursement.

Understand the Rules

Administration of a Section 125 cafeteria plan small business owners must pay adherence to is understanding the rules and regulations stipulated by the IRS. Some key points to consider include the following:

  • There is no provision to carry over the benefits to the next year. Non-utilized benefits lapse at the end of the year except for long-term disability policy, reasonable policy dividends, and certain 2-year lock in medical policies, and some other similar exemptions.
  • Elected benefits are irrevocable and cannot be changed midway.
  • The employer has to provide all participants with a summary plan description (SPD) within 90 days the employee becomes a participant. The same also requires filing with the Department of Labor within 120 days.

The employer needs to publish a written plan that makes explicit all the benefits, the rules for eligibility, and the method of election of benefits. The regulations governing the scheme constantly changes, and the employer needs to update constantly.

Cafeteria benefits are a win-win approach for both the employer and the employee. By establishing a cafeteria plan, small business owners can implement a good benefits scheme without spending much to set up and maintain the scheme. The employees invariably spend on such schemes anyway, and with section 125 cafeteria plans, the company and employee will save on taxes.


  1. “Cafeteria Plans: Do It Yourself Cafeteria Plan Administration.” Retrieved 09 March 2011.
  2. Bryson, Tendt, D. “The benefits of Cafeteria Plans.” Retrieved 09 March 2011.

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