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.

What is a Qualifying Event?

One of your employee’s comes to you and asks to cancel their medical insurance in the middle of the year. Seems like a simple request but is it really? Since most employers are deducting health, dental, vision, and/or supplement coverage premiums from employees on a pre-tax basis,  the employee’s request must first meet certain requirements before they are eligible to adjust their election mid plan year. 

 

With a valid Section 125 Cafeteria Premium Only Plan in place, the IRS allows employers to withhold premium deductions from employees for certain cover pre-tax. Part of the IRS requirement for taking deductions pre-tax is that employees must experience a qualifying event in order to change their election in the middle of the group’s plan year. The employee must notify their employer of the qualifying event (aka change in status) within 30 days of the event date to be able to adjust their election. If the employee fails to meet the requirements of a qualifying event or does not notify their employer within the allotted time frame, the employee must either wait until they experience another qualifying event or until the next open enrollment period at the group to adjust their election.

What Is A Qualifying Event?

A qualifying event is simply explained as any major life event that affects and employee or dependent(s) eligibility for benefits. The following are qualifying events that may allow an employee to change their election mid plan year:

 

1. Change in legal martial status (i.e marriage, divorce, death of spouse, legal separation, etc.)

2. Change in number of dependents (i.e. birth, adoption, etc)

3. Change in the employment status of employee, spouse, or dependent which results in change in benefits (i.e. termination or start of employment, change in worksite, etc).

5. Dependent ceasing to satisfy eligibility requirements for coverage due to attainment of age, student status, marital status, etc.

6.Change in place of residence of employee, spouse, or dependent where current coverage is not available

7. Judgements, decrees, or orders 

8. Change in the coverage of a spouse or dependent under another employer’s plan

9.Open enrollment under the plan of another employer for employee, spouse, or dependent.

10. COBRA qualifying event

11. Loss of coverage under the group health plan of governmental or education institution (i.e SHOP, Medicaid,  etc)

12. Entitlement to Medicare or Medicaid

13. Change in Citizenship Status

14. Loss / Gain of coverage in the Marketplace or Exchange by employee, spouse or dependent

 

Now What?

Once you have determined if an employee has experienced a qualifying event, you will need to have them complete a new election form (or change form) indicating the reason for their mid-year change and the date of the qualifying event. An employer is not required to keep copies of additional documents as proof of the qualifying event (i.e birth certificate, marriage certificate, etc) but you are required to inspect any necessary documents to validate an appropriate qualifying event has occurred and the date of occurrence. Be sure to indicate on the employee’s updated election/change form the date of the actual qualifying event as this will be the date that the coverage change takes effect with the carrier(s). 

 

Example- Employee gets married on August 5th and wishes to add their new spouse to their coverage. They notify you within the allotted 30 day time frame. The spouse’s new coverage begins under your group plan as of the date of marriage (August 5th) and you will need to adjust any payroll deductions accordingly.

 

It is important to make sure you (as the employer) have documentation of any employee elections /change in the event that your group experiences an audit or an employee questions any elections/payroll deductions.

 

Depending on how your current contracts are set up with your insurance carriers will depend on how qualifying event changes affect your premiums with respect to any mid-month changes. Make certain any qualifying event changes are also processed with payroll and their deductions are adjusted accordingly once changes are processed with the insurance carriers. 

 

Should you have any questions about how to properly administer a qualifying event change or if you want to implement a Section 125 Premium Only Plan, please contact our office for assistance.