Cafeteria plans

An attractive employee-benefits program is an important step in building your small business. It helps to recruit and retain key employees. It can also be useful in providing incentives that link employees' interests to the financial success of your firm.

While you may decide to hire a benefits consulting firm, there are also good sources of information on the Web. The Employee Benefits Research Institute (EBRI), International Foundation of Employee Benefit Plans (IFEBP), and American Benefits Council (the Council) are three of the many independent sources of employee-benefit plans.

As part of your employee benefits package, you may wish to add a cafeteria plan. Cafeteria plans allow employees to pick from a range of benefits and select those benefits that they desire the most. Cafeteria plans are also called Section 125 plans after the section of tax code that governs them. A common format for using a cafeteria plan is a flexible-spending account.

With a flexible-spending account, your employees have you set aside a designated amount each year, up to allowable limits, to pay for expenses that you do not already pay as a fringe benefit. (Fringe benefits are generally considered taxable income.)

The two most common types of flexible-spending accounts are dependent care reimbursement (DCRAs) and health care reimbursement accounts (HCRAs). Employees pay for non-reimbursed expenses from these accounts. Flexible-spending accounts are "use-it-or-lose-it" accounts; any leftover funds at the end of the year are forfeited.

Generally, amounts set aside in a cafeteria plan's flexible-spending account are exempt from income, payroll, and unemployment taxes. This exemption generally also applies to payroll and unemployment taxes you pay on behalf of the employee. (See IRS Pub. 15-B for exceptions, including treatment of highly compensated employees and certain shareholders of Subchapter S corporations.)

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Premiums that you pay to a group life insurance policy are generally exempt from income and unemployment taxes. In addition, premiums paid for up to $50,000 of policy coverage per employee are generally exempt from payroll taxes. For details, see IRS Pub. 15-B. Exceptions to these limits exist for key employees.

Cafeteria plans give you some versatility in putting together a benefits plan for your employees. There are other categories of fringe benefits that you can offer your employees in a cafeteria plan that may be excluded from taxable income under IRS benefit-exclusion rules. Using a flexible-spending account -- namely, establishing a DCRA and HCRA -- may help to jump-start a cafeteria plan for your employees. If you maintain a cafeteria plan, the IRS requires you to complete IRS Form 5500.

To help you keep track of employment-related costs, the U.S. Bureau of Labor Statistics (BLS) publishes a quarterly statistic called the employment cost index. The cost index measures changes in employee-compensation costs, which include salaries, wages, and benefits. In addition to publishing the cost index four times a year, the BLS publishes a yearly survey of employee-compensation costs.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.