A cafeteria plan is a means by which an employer can offer participating employees the option of choosing among cash (a taxable benefit) and various qualified nontaxable benefits.

Salary Reduction Agreement. An employer may want to consider having contributions to a cafeteria plan made under a salary reduction agreement. Under a salary reduction agreement, participants elect to reduce their compensation and to have such pre-tax amounts contributed as employer contributions. A salary reduction arrangement permits employees to "purchase" additional coverage with their own pre-tax dollars.

A premium-only plan (or POP) is a simplified form of a cafeteria plan that an employer can use to provide benefits which are available through insurance and are otherwise qualified benefits under the cafeteria plan rules. For example, an employer that requires employees to contribute toward the cost of providing coverage can run the employee contributions through the POP. This would allow the contributions to be made on a pre-tax basis, thereby avoiding federal and state income taxes, as well as Social Security taxes. Generally, the benefits which can be offered through pre-tax contributions include group-term life insurance and Accident and health insurance. Premiums paid under a POP that satisfies Internal Revenue Code requirements are not taxed as compensation.

Reimbursement Accounts Reimbursement accounts (also sometimes called flexible spending arrangements (FSAs) have become a large part of the cafeteria plan picture. A reimbursement account is established in an employee's name from which reimbursements are issued to the employee for certain allowable expenses. Reimbursement accounts have been used by employers as a vehicle to pre-fund dependent care, legal services, medical or dental expenses by using pre-tax dollars.

Tax Laws Governing Cafeteria Plans (IRS Section 125). The rules and regulations governing cafeteria plans are contained in Section 125 of the Internal Revenue Code. Allowable Uses of Cafeteria Plan Funds include: life insurance premiums for up to $50,000 of coverage; health care related expenses, such as vision, dental and prescription; dependent care expenses, if incurred for gainful employment; and personal legal expenses. Examples of nonreimbursable Expenses Under Section 125 include: expenses used as an income tax deduction, and expenses reimbursed by Medicare or any federal or state program.

Employer Responsibilities

Plan Design. The employer determines the type of allowable reimbursement expenses, the dollar amount of benefits allocable to each individual account, the funding arrangement, frequency of reimbursement, etc.

Designation of Carrier. The employer must select a carrier and/or plan administrator.

Recordkeeping. The employer is responsible for updating employee eligibility data, i.e., new employees, terminations, and reinstatements.

Communication. Employers should communicate clearly to employees all details of the plan and its operation and should have necessary forms and materials available for employee use in submitting reimbursement requests.

Before setting up a cafeteria plan for your company, be sure to consult with your accounting and legal counsel to determine your course of action.