The practice of paying for benefits on a pre-tax basis has become so common that employers often forget that if done incorrectly, both employer and employee may face significant tax consequences. Prior to 1978 there was no mechanism to give employees the choice between taxable compensation and tax-free benefits without the application of “constructive receipt.” Under the doctrine of constructive receipt, an individual owes income tax on any amounts for which they have unfettered control, even if those amounts are not actually received. Section 125 of the Internal Revenue Code allowed employers to adopt plans (“125 Plans,” “Cafeteria Plans” or “Premium only Plans”), by which employees may make such a choice. Initially employers often offered a choice between a higher level of compensation or continuation of tax-free benefits. Today an employee more frequently reduces their taxable compensation in exchange for tax-free benefits. In either case the choice is effectively the same, higher taxable income or tax-free benefits.
By today’s standards, the cost of healthcare was comparatively low in 1978. Total per capita annual healthcare expenditures were approximately $1,100 (inflation-adjusted), compared to about $8,400 today. Premiums have followed a similar trajectory, with the average total cost of family coverage more than doubling in the past decade. This dramatic healthcare inflation has only increased the importance of the unglamorous 125 Plan as employees elect ever greater amounts to cover the growing cost of insurance.
Perhaps the greatest 125 Plan peril is the written plan requirement. IRC § 125 explicitly requires that a plan must be in writing. We often encounter employers who fail this first critical requirement of the code. A plan document may have existed, but was misplaced or discarded. In other circumstances the employer may have never formally established a plan, assuming that benefit deductions were automatically tax-free. Even when a plan document can be located, we often find that the employer’s actual practices differ substantively from the provisions of the plan; a situation called “operational failure.” Operational failure can occur when an employer is conducting elections during the wrong time of the year or in the wrong manner; including deductions for unallowable or unlisted benefits; or failing to enforce the irrevocability rule.
The plan document must stipulate when and how elections will be conducted. Absent a proper election, salary amounts reduced by the plan become taxable. In many cases the improper elections are a result of an undocumented change to the plan year. As an example, an employer may have chosen to change insurance companies “off renewal” at some point in the past and forgotten to amend the plan. In other cases an employer has switched to “automatic” or “negative” elections when their plan document requires “positive” elections. In either case, the elections are invalid, as they do not conform to the procedures outlined in the plan document.
Salary reductions under a 125 Plan are one-year irrevocable elections. Although several exceptions to the irrevocability rule exist, no longer wishing to have the coverage or believing the coverage to be too expensive are not valid reasons to revoke an election. Even when one of the irrevocability exceptions may apply, we must check the plan document to ensure that it was included, as some are optional provisions.
Following are a few simple ways of quickly assessing the state of your 125 Plan.
- Locate the plan document; if you can’t find it, you probably don’t have a plan.
- Is the plan year correct? If your health insurance renews in July but your plan year is January 1st to December 31st, you likely have a problem.
- Are you conducting elections in the manner described by the plan document? Elections that do not comply with the written plan may be invalid.
- Have you allowed employees to revoke elections for reasons not listed in the plan document?
- Are all of the benefits you currently allow pre-tax listed in the document? Regulations require that each benefit be described in the plan document. If you’ve added benefits, such as an HSA account, is it listed?
- When was the plan last amended? Changes to the code may have required changes to your document, if it’s old, it may not be up-to-date.
Although few 125 Plans are directly audited, the consequences of failing to adhere to the requirements of the code can be severe. Given the relative ease of bringing a plan into compliance, we advise all employers to review their 125 Plan annually.