Question: What are the risks an employer faces if they took pretax deductions for employee health benefits, but never had a § 125 cafeteria plan in place?
Answer: We do not provide tax or legal advice to clients. For general information, we note that a cafeteria plan is the only method under which employees can contribute to the cost of group health coverage on a pretax basis (that is, reduce their salary to make the contributions before taxes are calculated). A cafeteria plan offers significant tax savings both to the employee (reduced income taxes) and to the employer and employee (reduced employment taxes), but the plan must comply with specific requirements under § 125 of the Internal Revenue Code in order to enjoy those tax advantages.
The IRS regulates and enforces § 125. Under IRS regulation § 1.125-1, the plan must be in writing:
(c) Written plan requirements–(1) General rule. A cafeteria plan must contain in writing the information described in this paragraph (c), and depending on the qualified benefits offered in the plan, may also be required to contain additional information described in paragraphs (c)(2) and (c)(3) of this section. The cafeteria plan must be adopted and effective on or before the first day of the cafeteria plan year to which it relates. The terms of the plan must apply uniformly to all participants. The cafeteria plan document may be comprised of multiple documents. … [end of excerpt; for complete text, see http://www.gpo.gov/fdsys/pkg/FR-2007-08-06/html/E7-14827.htm]
Further, regulation § 1.125-1 explains the consequence of failing to comply with the written plan requirement:
(6) Failure to satisfy written plan requirements. If there is no written cafeteria plan, or if the written plan fails to satisfy any of the requirements in this paragraph (c) (including cross-referenced requirements), the plan is not a cafeteria plan and an employee’s election between taxable and nontaxable benefits results in gross income to the employee.
In summary, failure to satisfy the written plan requirement causes the plan to lose its status as a cafeteria plan. In that case, all contributions made through the plan must be reported as gross income which is subject to income taxes and employment taxes. The IRS may also impose penalties on the employer for failure to report taxable compensation, failure to comply with payroll withholding requirements, and failure to remit employment taxes (e.g., Social Security and Medicare taxes) when due. The employer is advised to review this matter with its legal counsel and tax advisors in order to correct any plan deficiencies promptly.