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How to Utilize Section 125 of the IRS Tax Code to Reduce Payroll Taxes

| October 16, 2018
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If you’re a tax professional, CFO, HR professional, or a business owner you’ve probably heard of “Section 125 Plans” which are also often referred to as “cafeteria plans.” While most of these plans have tax benefits for both the business and the employee, I often do not see them structured in a manner that takes full advantage of the tax code.

If you properly structure a Section 125 Plan, you can reduce the business’s payroll (FICA) taxes by up to $1,101 a year per participating employee and increase employee benefits. All while having no effect on the employees’ net pay. At first this may sound too good to be true, but I will walk you through exactly how we do it.

To obtain these benefits we must utilize a limited medical benefit provider (LMBP). The LMBP is required to provide a limited medical benefit plan. The LMBP must provide real benefits, they cannot be used as a shell just to create pre and post-tax deductions. The participating employees will be required to actively participate in the plan, generally this is done by the employee filling out a Health Risk Assessment form (HRA) and acknowledging the receipt of monthly literature. This can be done by receiving an email, and just clicking a link within the email from the LMBP or by downloading the LMBPs mobile app (if available) and receiving a notification and clicking on a button within the app.

The employee can also participate in any of the other programs the LMBP offers to fulfill this requirement. Most LMBP have “wellness programs” that can help employees quit smoking, track their health, assist in weight loss, and a range of many other benefits that can pertain to lifestyle issues. Participation in any of these also fulfills the “active participation” requirement. The LMBP generally provides other benefits such as; Teladoc services, vision discounts, dental discounts, pharmacy discounts etc. which are all of substantial value as well.

The employee’s participation allows the LMBP to take a pre-tax premium of up to $1,200 a month, which can then be reimbursed post tax as preventative health care cost. By doing so we are reducing the employee’s taxable income, which gives the business a reduction in FICA and payroll taxes, and increases the employees net pay. The increase in the employees’ net pay is then used to purchase additional insurance and health care benefits. Those benefits can be but are not limited to: disability income insurance, long term care insurance, accident/gap insurance, life insurance, health savings account contributions etc.

The below example gives a before and after of an employee pay check

This illustration shows an actual "before" and "after" paycheck for an employee who participated in the program. This employee used his tax credits to purchase additional life insurance and an accident plan. Actual insurance benefits offered are determined by the employer and employee.

In the above example you see that all the “tax credits” were used for additional benefits and the employees net pay did not change.

A common question we get from employees is “can I just keep the increase in pay?”

The answer is; absolutely not. There are several sections, and subsections of the IRS code that clearly prohibit an employer from giving a “cash” incentive to their employees to create a tax benefit to the business. If the employee were to keep the increase in their pay, it may be interpreted as a cash incentive. However, by using the tax credits to purchase additional healthcare and insurance benefits, we are in complete compliance with the tax code, and the benefits are clearly not a CASH incentive.

It’s important when we are doing advanced tax planning work and implementing plans like this, that we take full advantage of the tax code. What’s equally as important is that we do not abuse the tax code. I want to reiterate that just one more time, we do not abuse the tax code.

By ensuring that we are compliant and not abusing the tax code we are doing several things. The most important being; protecting our clients from any tax consequences, back taxes, penalties or fees. But also, we are ensuring that tax planning strategies like this stick around. Generally, legislators are not going to put new regulation in place that eliminate tax plans like this, as long as the tax code is not being abused. When the tax code is being blatantly abused, it’s no surprise that the IRS and legislators are not fond of this, and then put in legislation to prevent such abuse.

A common question I get from business owners is “Why isn’t every business doing this?”

There are a couple reasons; not all businesses are eligible for a plan like this. For a business to be eligible, the business must currently have a health care plan in place. You cannot have a limited medical benefit plan, without first having a health car plan. The business also must have 10 or more W2 employees making more that $25,000 a year. Also, while it does not eliminate eligibility, we need the employees pay to be consistent to make sure the premium amounts are correct, and we are creating the correct amount of tax credits. This tends to eliminate many businesses that have a lot of hourly and/or commission paid employees.

Another factor that limits our ability to implement these plans is; there are not many limited medical benefit providers. The health care industry is very highly regulated, which limits the amount of LMBPs there are. This is a large barrier to entry, and it is much more profitable to just be a health care company than to be a LMBP. Most companies that manage to navigate through the regulation, are going to pick the more profitable route.

Another constriction of this plan is that many large financial, insurance and wealth management companies do not offer plans like this. There are quite a few moving parts to these plans, and the bureaucracy within large organizations makes implementation more difficult and tends to displease internal compliance departments. Having been an employee with both large financial and insurance companies in the past, I can vouch for this. Generally, if you must ask the internal compliance division of these organizations, the answer will be no.

The other constriction to plans like this is that many insurance providers view these as high-risk plans. The insurance benefits offered to employees are guaranteed issued, meaning that all the employees will be eligible to receive the additional benefits, despite their medical history. The benefits may be limited, or premiums may be higher based off health history, but all employees that are eligible and apply will receive additional insurance benefits. There is also no medical examination for employees who apply. Medical exams are often required to purchase life, disability, and long-term care insurance. Because of these reasons many insurance carriers do not want to underwrite plans like this.

So how can a plan like this benefit you? If you’re an employee, it will benefit you by decreasing your taxable income, increase your healthcare and insurance benefits, and create a supplemental retirement plan through those insurance benefits. If you’re an employer, it will benefit your business by decreasing the businesses payroll (FICA) taxes, increasing employee morale, employee retention, and be an additional benefit to new employee recruitment.

On average the business will see a tax savings of $1,101 a year per participating employee. There have also been many studies and surveys over the years that have shown that increasing and customizing employee benefits drastically increases employee retention. Two recent studies by the Society for Human Resource Management shows that 76% of Millennials said benefits customization was important for increasing their loyalty to their employers, and 95% of employees consider health care to be their most important benefit.

To give a real-world example, a recent implementation of this plan was with a client of ours in Pennsylvania. The business had 67 eligible employees, 54 who participated (average participation is 80%). This created a net annual tax savings of $59,454. The plan also quadrupled employee benefits, and due to the underwriting guidelines, we were even able to give two of the employees who were recent cancer survivors additional life insurance and disability benefits.

To reiterate or give a brief synopsis of the plan. We use a limited medical benefit plan or “wellness program” to offer the tax savings. We are not replacing any current health benefits we are adding benefits to create the tax savings. This type of structure saves the employer money and has no effect on the employees' net pay. We use tax credits to fund additional employee benefits, and the employer saves by reducing their FICA and payroll tax burden.

Benefits of the plan:

  • The employer receives an annual tax savings of $1,101 per participating employee 
  • Through the limited medical benefit provider, employee receives tax credits to fund additional healthcare and insurance benefits
  • The tax credits reduce overall taxable income, decreasing the businesses FICA and payroll taxes
  • On average employee benefits quadruple and their net pay DOES NOT change

 Employer Eligibility Requirements:

  • 10 or more full time W2 employees making at least $25,000 a year.
  • Employer must currently offer a healthcare plan

 Employee Eligibility Requirements:

  • Must currently have healthcare (it does not have to be with the employer, it can be through a spouse, parent the exchange ect)
  • Must be full-time with the employer
  • Must be a W2 Employee
  • Must be 18 years or older
  • Must have an annual income of $25,000 or more with the same employer

We are transparent with the IRS, so we do have a complete Legal Tax Opinion Letter for this plan, if you would like to retain a copy we are happy to provide it upon request.

If you’ve made it this far in this article/newsletter, then your attention span is greater than most, but I’m also sure I may have raised a couple questions. If you do have questions you can reach out to our office on our website here or email me at my email address listed below. If you’d like to see if your business may be eligible for a plan like this, please feel free to contact us, we are always happy to help other businesses and their employees.

 

Dan Nuwash, MBA

 Co-Founder, Finance For Thought

dnuwash@americanportfolios.com

 

Sources:

https://www.irs.gov/

https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/retention-top-benefits-objective.aspx

https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/alter-benefits-attract-retain.aspx

https://www.irs.gov/government-entities/federal-state-local-governments/faqs-for-government-entities-regarding-cafeteria-plans

 

https://www.treasury.gov/press-center/press-releases/pages/hp526.aspx

 

https://www.investopedia.com/terms/c/cafeteriaplan.asp

 

https://www.investopedia.com/articles/personal-finance/080816/section-125-plan-cafeteria-plan-how-does-it-work.asp

 

https://www.investopedia.com/ask/answers/111015/are-cafeteria-plans-subject-fica-erisa-or-futa.asp

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