What's offered in a cafeteria plan?

Association and staff alike can benefit from a Section 125 plan.

"Cafeteria plans" are fringe-benefit plans that allow employees to choose the benefits they want from their employer, including cash in lieu of other benefits. Employees may choose among a variety of taxable benefits, such as cash, or nontaxable benefits, such as health coverage. Cafeteria plans are authorized by Section 125 of the Internal Revenue Code.

While nothing in the code is simple, of course, the basic requirements of cafeteria plans are that they be in writing, give employees choices among cash and other benefits, and not discriminate in favor of highly paid employees. A plan must offer at least one taxable benefit and at least one nontaxable benefit.

Advantages. The advantages that are afforded by a Section 125 plan are that

* both employer and employee receive certain tax advantages (which may not be as important for nonprofit organizations as for for-profit companies) and

* employees have the freedom to choose cash instead of unwanted or unneeded benefits.

There may be an additional advantage for the association. By offering a cafeteria plan, it may be easier to shift more of the cost of employee benefits to the employees.

By providing benefits under a cafeteria plan, an association can provide its employees with a mechanism to avoid taxation of the employer-provided benefits. While the Internal Revenue Service takes the position that employer-provided benefits are taxable to the employee, if the benefits meet the criteria of Section 125, they will not be taxable.

Taxable benefits. Even under a cafeteria plan, certain benefits may be taxable to the employee. Cash is taxable. But so are other benefits that are treated like cash - for example, vacation pay, group term life insurance coverage in excess of $50,000, or other benefits that do not satisfy the nondiscrimination rules of Section 125.

Nontaxable benefits. To be nontaxable, the benefit must be a "qualified" benefit under Section 125. Such qualified benefits include accident or health plans, disability benefits, accidental death and dismemberment benefits, the first $50,000 of group term life insurance, a group dependent care assistance plan, and a group legal services plan.

If a nontaxable benefit is chosen, the employee and the association avoid social security taxes and the employee avoids income taxes. If the employee takes cash, the employee and the association are subject to social security taxes. The employee also has to pay income tax on the cash.

Excluded benefits. Some employee benefits cannot be included in a cafeteria plan. These include scholarships, employee discounts, and no-additional-cost services, such as free registration at the association's own events.

In most cases, a cafeteria plan cannot offer a benefit that defers compensation, although it can offer employees the opportunity to make elective contributions to a 401 (k) plan.

Three types of plans. Benefits under a cafeteria plan are usually offered in one of the following three forms:

* Premium conversion: With premium conversion, which is the simplest form of flexible benefits, the employee elects to have his or her salary reduced, and the amount of the reduction is used to pay for one or more nontaxable benefits. By contributing on a pretax basis, the employee saves federal and state income taxes in most states. The employee and employer save on social security taxes (except for life insurance). Health insurance, group term life insurance, long-term disability, accidental death and dismemberment, and group legal services can all be paid for on a pretax basis.

* Flexible spending account: In this version, employees typically reduce their salaries by a uniform amount during a 12-month period and set up accounts. Money is then taken from these accounts to pay for medical expenses not covered, such as deductibles and coinsurance. Account reimbursements are tax-free. In other words, the employee is reimbursed from his or her account for qualified expenses after they have been incurred, and this reimbursement is not taxed.

* Full flex (also called "core" or "buffet"): Full flex is the most complex plan, giving employees the greatest amount of choice. A full flex plan carries risk for the association, however, if benefits are not properly priced. Full flex is also the costliest and most time-consuming type of cafeteria plan in terms of design, administration, maintenance, and implementation.

The future. Although associations may adopt, and association employees may desire, cafeteria plans primarily for tax purposes, these plans are evolving to meet needs perhaps more important and more fundamental than saving or avoiding taxes.

For example, with a cafeteria plan, the association can manage costs more efficiently over time. A cafeteria plan also gives the employee greater choice in determining how the employer's dollars are spent on his or her behalf. Introducing wider choice and more options can satisfy the diverse needs of employees, perhaps without increasing employer costs.

If Congress adopts legislative changes, such as allowing medical savings accounts, the need for and shape of cafeteria plans will have to be reevaluated.

George D. Webster is general counsel emeritus to ASAE and a partner in Webster, Chamberlain & Bean. This Washington, D.C., law firm is counsel to more than 200 nonprofit organizations.