Cafeteria Plans: A Bowl of Health Care, A Slice of Child Care

Q: Tax Playa, my employer offers a "cafeteria plan."  Much to my chagrin, I found out this didn't mean free lunch every day.  What do I need to know?
Brian, Washington DC

A: Employers can offer any number of tax-qualified fringe benefits, as I have already discussed.  Some of these benefits (especially health care) can be offered in the context of a "cafeteria plan," where employees can choose between benefits and pay...

For more information on cafeteria plans, see IRS Publication 15B, Employers' Tax Guide to Fringe Benefits.

Some tax-favored fringe benefits can be offered in the context of a cafeteria plan.  An employee can choose to take some or all of these benefits, or salary.  Any benefits he chooses are provided on a pre-tax basis from his paycheck, and are both pre-income tax and pre-FICA.

Employers like offering cafeteria plans because it means they don't have to offer a firm benefits package.  If the atheist single mother at the front desk would like dependent care assistance and the religious guy down the hall wants to adopt a baby, no one needs to be left out.

Eligible fringe benefits include:

1. Accident and health benefits.  These are by far the most common uses of cafeteria plans.  Health insurance premiums, health savings account contributions, and "use it or lose it" flexible spending account (FSA) plans all come under this umbrella.
2. Adoption assistance.  This is a pretty nice deal if your employer offers it because, unlike the adoption tax credit, there is virtually no limit for rank-and-file employees.
3. Dependent care assistance.  This is limited to $5000 per employee, per year (half that for married filing separately taxpayers).
4. Group term life insurance coverage.  Limited to $25,000 in coverage.  This figure is not indexed to anything, so these plans are becoming more and more rare.

401(k) elective deferrals are also like a cafeteria plan in that they allow workers to choose a salary or a benefit, but they are more like a close cousin.  Also, under a special rule, pre-tax parking and commuting benefits are allowed in a manner very similar to cafeteria plans.

Not every employee is eligible to participate in a cafeteria plan.  Restricted classes of employees include:

1. More than 2% owner-employees of S-corporations.  In general, most benefits are denied to these type of employees (with the exception of pensions and company-paid health benefits).
2. A highly-compensated employee when the plan favors him.  This can be an officer, a more than 5% shareholder, an employee who is highly compensated given the facts and circumstances, or a spouse of one of the above.
3. A key employee when the plan favors him.  The plan favors key employees when more than 25% of the value of the benefits goes to them. 

A key employee is defined as either:

• An officer having a salary of more than $140,000 (in 2006), or
• An employee who was either of the following: a 5% owner of the business, or a 1% owner of the business with pay of more than $150,000.