Rules & Limits on Section 125 Plans & Self Employed Individuals

A Section 125 plan, sometimes called a cafeteria plan, is one of the most valuable tools available to employers for helping employees pay for benefits with pre-tax dollars. However, the tax rules that make Section 125 plans valuable for employees can create limitations for certain business owners. Individuals who are treated as self-employed are generally not permitted to participate in a Section 125 plan as employees, and attempting to include them can jeopardize the tax advantages of the arrangement for the plan as a whole.

What is a Section 125 plan?

Under Section 125 of the Internal Revenue Code (IRC), an employer can establish a plan that allows employees to choose between taxable compensation (cash) and certain non-taxable benefits. When an employee elects a benefit under the plan, such as health insurance premiums, a Health Flexible Spending Account (FSA) or a Dependent Care FSA (DCFSA), the amount is deducted from their paycheck before federal income and payroll taxes are calculated. This reduces the employee’s taxable income, as well as the employer’s payroll tax obligation.

The tax exclusion under Section 125 is available only to employees as defined by the IRC. Put simply, if the Internal Revenue Service (IRS) treats an individual as an owner rather than an employee, they are not eligible for pre-tax deductions under Section 125. Therefore, individuals who are considered self-employed for tax purposes do not qualify as employees under this definition and cannot participate in a Section 125 plan on the same basis as W-2 employees.

It is also important to remember that eligibility for pre-tax deductions is separate and distinct from eligibility for an underlying health plan or benefit. It is possible that someone may be eligible for an employer’s health benefit, like the medical or dental plan, but may also NOT be eligible to pay premiums for that benefit on a pre-tax basis.

Who is considered self-employed?

The restriction noted above applies to four categories of individuals, each treated as self-employed under the Internal Revenue Code:

• Sole proprietors are individuals who own and operate a business as a single person without forming a separate legal entity. The business and the owner are treated as the same taxpayer for federal tax purposes, which means the owner cannot also be an employee of their own sole proprietorship.
• Partners in a partnership are also treated as self-employed, regardless of how active they are in the business. A partner who works full-time in the partnership is still not considered an employee for purposes of Section 125.
• S corporation shareholders who own more than two percent of the corporation’s stock are treated similarly to partners under the tax code. This two-percent threshold is important: a shareholder who owns two percent or less is treated as an employee and may participate in the Section 125 plan. A shareholder above that threshold is not.
• LLC members are treated based on how the LLC is taxed. If the LLC is taxed as a sole proprietorship or partnership, the members are treated as self-employed and cannot participate. If the LLC has elected to be taxed as a C corporation, its members may be treated as employees. If taxed as an S corporation, the two-percent ownership rule described above applies.

Entity names that include terms such as “Corporation” or “LLC” do not provide enough detail on how the entity is taxed. Thus, an entity’s name alone does not indicate whether the owners can participate in a cafeteria plan.

Health FSA restrictions

A Health FSA allows employees to set aside pre-tax dollars to pay for eligible out-of-pocket medical expenses such as deductibles, copays and certain over-the-counter items. Because a Health FSA is offered through a Section 125 plan, the individuals described in the prior section cannot participate.

HSA restrictions and contribution rules

A Health Savings Account (HSA) is a tax-advantaged account available to individuals enrolled in a qualifying High Deductible Health Plan (HDHP). Unlike a Health FSA, an HSA is not tied to an employer plan, which means self-employed individuals can open and contribute to one directly. However, the Section 125 restriction still affects how contributions work.

W-2 employees who contribute to an HSA through their employer’s Section 125 plan avoid both income taxes and payroll taxes (Social Security and Medicare) on those contributions. Self-employed individuals who contribute directly to an HSA can deduct the contributions on their personal tax return, which reduces their income tax. But those contributions are still subject to self-employment tax. The practical effect is that self-employed individuals pay slightly more in tax on the same HSA contribution than a W-2 employee would.

Dependent Care FSA restrictions

A DCFSA allows employees to set aside pre-tax dollars to pay for eligible dependent care expenses, such as daycare, after-school programs or care for a dependent adult. Like the Health FSA, a DCFSA is offered through a Section 125 plan, and the same restrictions apply.

Premium-Only Plan restrictions

A Premium-Only Plan (POP) is the simplest form of a Section 125 plan. It only allows employees to pay their share of employer-sponsored health insurance premiums with pre-tax dollars. Many employers establish a POP simply to reduce the payroll tax cost of offering health coverage.

Self-employed individuals in the covered categories cannot participate in a POP for the same reason they cannot participate in any other Section 125 arrangement. A more-than-two-percent S corporation shareholder, for example, cannot have their health insurance premium deducted on a pre-tax basis through the company’s POP. Instead, the premium must be included in the shareholder’s W-2 wages in Box 1. The shareholder may then claim the self-employed health insurance deduction on their personal return. The deduction is still available, but it works differently and does not reduce self-employment tax the way a POP deduction would for a regular employee.

Takeaways

Section 125 plans provide real tax benefits, but those benefits are limited to employees as defined by the tax code. Sole proprietors, partners, more-than-two-percent S corporation shareholders and most LLC members cannot participate in a Health FSA, DCFSA, HSA salary reduction arrangement or POP through their own business. Including these individuals in a Section 125 plan without recognizing these restrictions can create tax compliance problems for the business and for the individual.

New IRS Guidance Impacting Cafeteria Plan Election Changes and FSA Grace Periods and Rollovers

This week the IRS released two new sets of rules impacting Section 125 Cafeteria Plans.  Notice 2020-33 provides permanent rule changes that include an increase in the amount of unused benefits that Health FSA plans may allow plan participants to rollover from one plan year to the next.  Notice 2020-29 provides temporary rules designed to improve employer sponsored group health benefits for eligible employees in response to the coronavirus pandemic.  The relief provided under each notice is optional for employers. Employers who choose to take advantage of any of the offered plan options will be required to notify eligible employees and will eventually be required to execute written plan amendments.

Notice 2020-33 modifies the amount of annual rollover of unused benefits that Health FSA plans may offer to Plan participants.  Up until now, rollovers have been limited to $500 per Plan Year.  The new rule sets the annual rollover limit to 20% of the statutory maximum annual employee Health FSA contribution for the applicable Plan Year.  Because the statutory maximum is indexed for inflation, most years it increases (in mandated increments of $50).  

The notice provides that the increased rollover amount may apply to Plan Years beginning on or after January 1, 2020.  Because the corresponding annual Health FSA employee contribution limit for those Plan Years is $2,750, the annual rollover limit may be increased up to $550.

The relief provided under Notice 2020-29 falls into two major categories, both of which apply only for calendar year 2020.  First, the IRS introduces several significant exceptions to the mid-year change of election rules generally applicable to Section 125 Cafeteria Plans. Second, the notice contains a special grace period which offers Health Flexible Spending Arrangement (FSA) and Dependent Care Assistance Program (DCAP) Participants additional time to incur eligible expenses during 2020.

The temporary exceptions to mid-year participant election change rules for 2020 authorize employers to allow employees who are eligible to participate in a Section 125 Cafeteria Plan to:

1. make a new election to participate in employer sponsored group health plan coverage if the employee originally declined coverage at open enrollment (depending on if the insurance carrier will allow);
2. change coverage options previously elected during open enrollment;
3. drop group coverage for covered family members or themselves if they will be replacing the coverage for the impacted individual immediately with other coverage;
4. make a prospective election to add, change or drop a Health FSA election; and
5. make a prospective election to add, change or drop a DCAP election.

None of the above described election changes require compliance with the consistency rules which typically apply for mid-year Section 125 Cafeteria Plan election changes.  They also do not require a specific impact from the coronavirus pandemic for the employee.

Employers have the ability to limit election changes that would otherwise be permissible under the exceptions permitted by Notice 2020-29 so long as the limitations comply with the Section 125 non-discrimination rules.   For allowable Health FSA or DCAP election changes, employers may limit the amount of any election reduction to the amount previously reimbursed by the plan.  Interestingly, even though new elections to make Health FSA and DCAP contributions may not be retroactive, Notice 2020-29 provides that amounts contributed to a Health FSA after a revised mid-year election may be used for any medical expense incurred during the first Plan Year that begins on or after January 1, 2020.

For the election change described in item 3 above, the enrolled employee must make a written attestation that any coverage being dropped is being immediately replaced for the applicable individual.  Employers are allowed to rely on the employee’s written attestation without further documentation unless the employer has actual knowledge that the attestation is false.

The special grace period introduced in Notice 2020-29 allows all Health FSAs and DCAPs with a grace period or Plan Year ending during calendar year 2020 to allow otherwise eligible expenses to be incurred by Plan Participants until as late as December 31, 2020.  This temporary change will provide relief to non-calendar year based plans.  Calendar year Health FSA plans that offer rollovers of unused benefits will not benefit from this change.

The notice does clarify that this special grace period is permitted for non-calendar year Health FSA plans even if the plan provides rollover of unused benefits.  Previous guidance had prohibited Health FSA plans from offering both grace periods and rollovers but Notice 2020-29 provides a limited exception to that rule.

The notice raises one issue for employers to consider before amending their plan to offer the special grace period.  The special grace period will adversely affect the HSA contribution eligibility of individuals with unused Health FSA benefits at the end of the standard grace period or Plan Year for which a special grace period is offered.  This will be of particular importance for employers with employees who may be transitioning into a HDHP group health plan for the first time at open enrollment.

As mentioned above, employers wishing to incorporate any of the allowable changes offered under Notices 2020-29 and 2020-33 will be required to execute written amendments to their Plan Documents and the changes should be reflected in the Plan’s Summary Plan Description and/or a Summary of Material Modification.  Notice 2020-29 requires that any such Plan Amendment must be executed by the Plan Sponsor no later than December 31, 2021.