Cafeteria Plan Compliance Requirements for Employers and Administrators

A Cafeteria Plan, governed by Section 125 of the Internal Revenue Code, is a powerful tool that allows employees to choose from a menu of benefits and pay for them with pre-tax dollars. This simple mechanism generates significant tax savings for both employees and employers, making it a cornerstone of modern benefits strategy. However, this tax-favored status comes with a stringent set of rules.�

The administration of a compliant Cafeteria Plan requires precise adherence to IRS regulations governing eligibility, elections, documentation, and nondiscrimination. A single misstep can disqualify the plan, leading to adverse tax consequences for employees and penalties for the employer.

Mastering these requirements is essential for any HR professional, benefits leader, or Third-Party Administrator (TPA) involved in plan administration. Our Certification Programs are designed to equip you and your team with the expert knowledge needed to maintain compliance, maximize plan value, and avoid costly fines.

Purpose and Advantages

The primary purpose of a Cafeteria Plan is to provide tax advantages. By allowing employees to pay for their share of insurance premiums or fund accounts like a Flexible Spending Account (FSA) with pre-tax dollars, their taxable income is reduced. This results in lower federal, state, and FICA (Social Security and Medicare) taxes. Employers also save money because they do not have to pay their share of FICA and FUTA (federal unemployment) taxes on the amounts employees contribute pre-tax.

Beyond tax savings, these plans offer:

• Greater Flexibility: Employees can tailor their benefits package to their individual needs, choosing more of what they value and less of what they don't.
• Recruiting and Retention: A well-designed Cafeteria Plan is a competitive advantage, demonstrating an employer's commitment to employee choice and financial well-being.

Key Components of Cafeteria Plan Administration

Effective administration requires a deep understanding of the plan's lifecycle, from initial design to ongoing compliance.

Plan Design

Every Cafeteria Plan must be established and maintained according to a formal, written plan document. This is a non-negotiable IRS requirement. The plan document must specify the plan year, eligibility rules (e.g., classes of employees, waiting periods), entry dates, the benefits offered, employer contributions (if any), and the rules for making and changing elections.

Plans can range in complexity from a simple Premium-Only Plan (POP), which only allows employees to pay for their health insurance premiums on a pre-tax basis, to a full Cafeteria Plan offering a wide array of benefits. For Health FSAs, the plan must also specify whether it will offer a grace period (allowing up to 2.5 months after the plan year ends to incur claims) or a carryover (allowing a certain amount to be carried over to the next year), but not both.

Benefit Options

A compliant Cafeteria Plan can only offer "qualified benefits" and cash. Typical qualified benefits include:

• Accident and health plans (medical, dental, vision)
• Health Flexible Spending Accounts (FSAs)
• Dependent Care Assistance Programs (DCAPs) or Dependent Care FSAs
• Health Savings Account (HSA) contributions
• Limited-Purpose FSAs (for dental and vision expenses, compatible with HSAs)
• Group Term Life Insurance (coverage up to $50,000; the cost of coverage over $50,000 is imputed income)
• Adoption Assistance
• Commuter benefits (qualified transportation fringes)

Offering cash-in-lieu of benefits is permissible but requires careful handling to avoid constructive receipt issues and must be accounted for in nondiscrimination testing.

Communication and Employee Education

A plan's value is lost if employees do not understand it. Clear, effective communication is a critical administrative function. Employers must provide a Summary Plan Description (SPD) that explains the plan's terms in plain language. During open enrollment, employers should use multiple channels?such as group meetings, webinars, videos, and written guides?to educate employees on their options, the tax advantages, and the "use-it-or-lose-it" nature of FSAs. Communication is also essential when an employee experiences a life event that permits a mid-year election change, so they know their rights and deadlines.

Enrollment and Election Procedures

The hallmark of a Cafeteria Plan is the irrevocable election. Employees must make their benefit elections for the upcoming plan year during an annual open enrollment period, and these elections generally cannot be changed until the next open enrollment.

However, the IRS permits mid-year election changes if the employee experiences a permitted election change event. These include:

• Changes in status (e.g., marriage, divorce, birth of a child, change in employment status)
• HIPAA special enrollment rights (e.g., losing other health coverage)
• Significant changes in the cost or coverage of a benefit option

The plan document must specify which mid-year change events it will permit, and the employee must request the change within a reasonable period (typically 30 days).

Compliance and Regulatory Oversight

Cafeteria Plans are under the jurisdiction of the IRS and the Department of Labor (DOL). Key compliance touchpoints include:

• Form 5500: A Cafeteria Plan that is also an ERISA welfare plan with 100 or more participants at the beginning of the plan year must generally file an annual Form 5500.
• Written Plan Document: The IRS requires a formal, written plan document and will ask for it during an audit. This is separate from the SPD.
• Fiduciary Duties: Under ERISA, the plan administrator has a fiduciary duty to act solely in the interest of the plan participants.

Claims Processing and Reimbursement

For FSAs and DCAPs, administrators must have a rigorous process for claims substantiation. All expenses must be substantiated to prove they are eligible medical or dependent care expenses incurred during the plan year. This can be done via receipts or explanations of benefits (EOBs). For FSA debit cards, most transactions must still be substantiated unless they meet certain IRS-approved auto-substantiation methods.

The plan must define a run-out period?a timeframe after the plan year ends during which employees can submit claims for expenses incurred during the prior year. Any funds left in an FSA after the run-out period expires are subject to the "use-it-or-lose-it" rule and are forfeited to the employer.

Recordkeeping and Reporting

Meticulous recordkeeping is essential for audit readiness. Employers must maintain:

• The signed plan document and all amendments.
• Employee election forms.
• Records of all claims submitted and their substantiation.
• Results of annual nondiscrimination testing.

These records should be retained for at least seven years to be safe from an IRS or DOL audit.

Stay compliant with Section 125 regulations ? Enroll in our Cafeteria Plan Certification Program.

Common Cafeteria Plan Administration Mistakes

The strict rules governing Section 125 plans create many opportunities for error. Here are some of the most common and costly mistakes:

• Missing or Defective Plan Documents: Operating a Cafeteria Plan without a formal, written plan document is a fatal flaw in an IRS audit. Using a generic template without customizing it is also a risk.
• Outdated Amendments: Failing to formally amend the plan document to reflect changes in the law or plan design.
• Nondiscrimination Testing Errors: Either failing to perform the annual tests altogether, using incorrect data, or not taking corrective action when a test fails.
• Missed Enrollment Windows: Not allowing employees to make timely elections during open enrollment or after a permitted status change event.
• Ineligible Participants: Allowing ineligible individuals, such as >2% S-Corp owners or partners, to participate in the plan on a pre-tax basis.
• Improper FSA Substantiation: Reimbursing employees for expenses without adequate proof that they are eligible medical expenses, a common issue with debit card programs that have weak controls.
• HSA/FSA Incompatibility: Allowing an employee to contribute to both a Health Savings Account (HSA) and a general-purpose Health FSA in the same year, which is prohibited.
• Cash-in-Lieu Mishandling: Offering a cash-out option without properly including it in nondiscrimination testing or reporting it as taxable income.
• Inadequate Records: Being unable to produce election forms, test results, or substantiation records during an audit.
• COBRA Coordination Errors: Failing to offer COBRA continuation for a Health FSA when required.

Avoid costly IRS penalties ? Get certified in Cafeteria Plan Administration.

Advanced Administration Topics

Beyond the basics, experienced administrators must navigate several complex scenarios.

Partner and Owner Eligibility Rules

One of the most confusing areas of Cafeteria Plan eligibility concerns business owners. The rules are clear: individuals who are considered self-employed are not employees and therefore cannot participate in a Cafeteria Plan on a pre-tax basis. This includes:

• Partners in a partnership.
• Shareholders who own more than 2% of an S-corporation. Their spouses, children, parents, and grandparents are also generally excluded.
• Sole proprietors.
• Independent contractors.

These individuals can still be covered by the company's health plan, but they must pay for their premiums on a post-tax basis. Forgetting this rule and allowing an owner to make pre-tax contributions is a common and serious compliance error. For example, if a law firm names an attorney as a partner, that individual immediately becomes ineligible to participate in the firm's Section 125 plan.

Selling Paid Time-Off (PTO) Days

A Cafeteria Plan can be designed to include a "PTO sell-back" or "PTO cash-out" arrangement. This allows employees to make a prospective, irrevocable election before the start of the plan year to cash out a certain number of accrued PTO days. The cash received is taxable income. This feature can be attractive to employees who consistently have excess PTO. However, it must be carefully designed to comply with wage and hour laws and to ensure that employees cannot simply choose to receive cash for unused days at the end of the year, which would violate the irrevocable election rule.

Timing of Election Changes

The plan document must specify a timeframe for employees to request an election change following a permitted status change event. A common and best practice is to set a 30-day window. This aligns with the 30-day special enrollment period required by HIPAA for events like loss of other coverage or acquisition of a new dependent. For events related to Medicaid or the Children's Health Insurance Program (CHIP), the window must be at least 60 days. It's also important to remember that the COBRA election period is 60 days, and the initial premium payment has a 45-day grace period, which must be coordinated with the plan's election change rules.

Nondiscrimination Testing and Compliance

Nondiscrimination testing is a critical annual requirement designed to ensure that a Cafeteria Plan does not unfairly benefit the company's owners and most highly compensated employees.

Why Testing Is Required

If a plan is found to be discriminatory, the tax benefits are lost for the Highly Compensated Employees (HCEs) and Key Employees. This means the value of the benefits they elected on a pre-tax basis becomes taxable income to them. The benefits for non-highly compensated employees remain tax-free. This creates a significant, negative tax situation for leadership and exposes the employer to payroll tax penalties.

Types of Nondiscrimination Tests

Several tests must be performed, typically after the end of the plan year using data from that year. The main tests for a Section 125 plan are:

• Eligibility Test: Checks whether the plan is available to a broad enough group of employees.
• Contributions and Benefits Test: Ensures that both contributions and benefits are not skewed in favor of HCEs.
• Key Employee Concentration Test: Limits the value of benefits provided to Key Employees to no more than 25% of the total benefits provided to all employees.

Additionally, the underlying benefits have their own tests. For example, a Dependent Care FSA has a 55% Average Benefits Test, and group term life insurance has its own nondiscrimination rules under Section 79.

How to Correct Failures

If a plan fails testing, the administrator must take corrective action. This is typically done by "grossing up" the taxable income of the affected HCEs and Key Employees. This means the employer recharacterizes their pre-tax contributions as post-tax income and reports it on their W-2s. While this fixes the immediate tax issue, the best long-term solution is to adjust the plan design for future years, perhaps by increasing employer contributions for non-HCEs or limiting the contributions HCEs can make.

Training and Certification Programs

Given the complexity and high stakes of Cafeteria Plan administration, professional training is an essential investment.

Cafeteria Plan Training & Certification Program

This program is designed to provide deep, practical expertise on every aspect of Section 125 compliance. Key learning outcomes include:

• Mastering the IRS documentation requirements, including the written plan document and SPD.
• Understanding the nuanced eligibility rules, especially for owners and partners.
• Learning how to perform and interpret the results of nondiscrimination tests.
• Implementing compliant procedures for claims substantiation and reimbursement for FSAs.
• Developing strategies for correcting testing failures and preparing for an IRS audit.

Related Programs

Because Cafeteria Plans intersect with many other benefits and leave laws, expertise in related areas is invaluable. We also offer:

• HSA Training & Certification Program: For mastering the rules of Health Savings Accounts.
• Integrating FMLA, ADA, COBRA, and Workers' Compensation Certification: For senior administrators who manage the full spectrum of employee absence.
• Certified Administrator and Certified TPA Designations: Credentials that validate your expertise across a range of benefits compliance topics.

Build your compliance expertise. Explore our full suite of certification programs today.

Certified Administrator & Certified TPA Designations

Our certification programs provide more than just knowledge; they offer a credential that validates your expertise and commitment to excellence.

Certified Administrator Designation

This designation is ideal for HR and benefits professionals who manage their company's plans internally. By completing one of our certification programs and passing the associated exam, you receive:

• Official certification recognizing you as an expert in the field.
• Lifetime updates to the course material whenever laws change.
• Increased credibility and professional recognition within your organization.

Certified TPA Designation

For Third-Party Administrators, our Certified TPA designation is a powerful marketing and operational tool. By certifying your staff, you benefit from:

• Standardized, expert-level training for your entire team.
• A manager dashboard to track employee progress and test scores.
• The ability to use the Certified TPA Seal in your marketing, differentiating your firm based on proven expertise, not just price.

Lead your market ? Earn your Certified TPA Seal today.

Excerpts From Our Cafeteria Plan Certification Program

Our training provides practical, real-world guidance on complex administrative issues.

• Eligibility for Partners, Owners, and Contractors: The rule is simple: if you are considered self-employed for tax purposes, you cannot participate in a Cafeteria Plan. This means partners get a K-1, not a W-2, and are ineligible. Similarly, an S-Corp owner with more than a 2% stake must take health premiums as a taxable fringe benefit, not a pre-tax deduction under Section 125. We provide clear examples to help you identify these individuals and ensure they are handled correctly.
• PTO Sell-Back Arrangements: This can be a valuable feature, but it must be structured correctly. The election to sell back PTO must be made before the plan year begins and must be irrevocable. You cannot simply allow employees to cash out unused days at year-end. Our training provides plan design tips and checklists to ensure your PTO cash-out feature is compliant.
• Timing of Election Changes: To avoid disputes, your plan document should set a firm deadline?typically 30 days?for an employee to request an election change after a status change event. This creates a clear, consistent process and aligns with HIPAA's special enrollment rules. Our program provides sample language and administrative best practices for managing these mid-year changes.

FAQ: Section 125 and Cafeteria Plan Compliance

Who qualifies to participate in a Section 125 plan?

Generally, all common-law employees are eligible to participate. However, self-employed individuals like partners, sole proprietors, and S-corporation shareholders owning more than 2% of the company are not eligible to participate on a pre-tax basis.

What documentation must be maintained for compliance?

At a minimum, you must have a formal written plan document, a Summary Plan Description (SPD), signed employee election forms for each plan year, and the results of your annual nondiscrimination tests. For FSAs, you must also keep records of all claims and their substantiation.

How often should nondiscrimination testing be performed?

Testing must be performed for each plan year. While some preliminary "snapshot" testing can be done mid-year to check for potential issues, the official tests are performed after the plan year ends, using the full year's data.

Can owners participate in cafeteria plans?

No, not on a pre-tax basis if they are considered self-employed. Partners in a partnership and more-than-2% owners of an S-corporation cannot make pre-tax contributions through a Section 125 plan.

What are the penalties for non-compliance?

If a plan fails to meet the requirements of Section 125, it can be disqualified. The consequence is that the tax benefits are lost for highly compensated and key employees, and their pre-tax elections become taxable income. The employer may also be liable for back payroll taxes.

How does FSA debit card substantiation work?

While debit cards are convenient, every expense must still be proven to be an eligible medical expense. Some transactions, like co-payments at a doctor's office, can be auto-substantiated. For most others, such as purchases at a pharmacy, the employee must submit a receipt or EOB to the plan administrator to verify the expense.

Glossary of Cafeteria Plan Terms

• Section 125: The section of the Internal Revenue Code that authorizes Cafeteria Plans.
• Qualified Benefits: The specific, IRS-approved benefits that can be offered on a pre-tax basis through a Cafeteria Plan, such as health insurance or an FSA.
• Premium-Only Plan (POP): The simplest type of Cafeteria Plan, which only allows employees to pay for their insurance premiums pre-tax.
• Health FSA (Flexible Spending Account): An account that allows employees to set aside pre-tax dollars to pay for out-of-pocket medical, dental, and vision expenses.
• Dependent-Care FSA (DCAP): An account that allows employees to set aside pre-tax dollars for eligible dependent care expenses, such as daycare.
• Carryover: An FSA plan feature that allows participants to carry over a certain amount of unused funds to the next plan year.
• Grace Period: An FSA plan feature that provides a 2.5-month period after the end of the plan year to incur expenses against the prior year's balance.
• Election Change: A mid-year change to a Cafeteria Plan election, permitted only after specific life or employment status change events.
• Highly Compensated Employee (HCE): A specific IRS definition used for nondiscrimination testing, generally including certain officers, owners, and employees above a certain compensation threshold.
• Key Employee: A specific IRS definition used for nondiscrimination testing, generally including certain officers and owners.
• Nondiscrimination Testing: A series of annual tests required to ensure the plan does not favor HCEs or Key Employees.
• Substantiation: The process of proving that an expense reimbursed from an FSA or DCAP is an eligible expense.
• Run-Out Period: The period of time after the end of the plan year during which employees can submit claims for expenses incurred during the plan year.
• De-minimis Imputed Income: A small, taxable fringe benefit, sometimes relevant in benefits administration.
• COBRA Coordination: The process of coordinating COBRA continuation coverage rights, particularly for Health FSAs, after a qualifying event.
• HIPAA Special Enrollment: Rights that allow individuals to enroll in a health plan mid-year following certain events, like loss of other coverage.

Download our Cafeteria Plan Glossary & Compliance Checklist.

What Is a Section 125 Cafeteria Plan?

A Section 125 Cafeteria Plan is a formal, written employee benefit plan that allows employees to make a choice between receiving their full salary in cash or redirecting a portion of that salary, before taxes are calculated, to pay for certain qualified benefits. This pre-tax treatment is a special exception to the tax principle of "constructive receipt," which would normally tax employees on money they have a right to receive, even if they choose not to. Section 125 provides the legal safe harbor that makes these pre-tax contributions possible, but only if the plan strictly follows all IRS rules.

How to Design a Compliant Cafeteria Plan

Designing a compliant plan starts with a comprehensive written plan document. This document is the plan's constitution and must detail all its operational rules. Key design decisions include:

• Eligibility: Which classes of employees are eligible? Is there a waiting period?
• Plan Year: Defining the 12-month period for elections (e.g., calendar year).
• Benefits Offered: Selecting which qualified benefits to include.
• FSA Rules: Deciding between a grace period, a carryover, or neither for the Health FSA.
• Employer Contributions: Determining if the employer will contribute to any benefits, like an FSA or HSA.
• Election Change Rules: Specifying which mid-year status change events the plan will permit.

The plan design must also be built with nondiscrimination testing in mind to ensure it will pass the required annual tests.

IRS Documentation Rules for Cafeteria Plans

The IRS has strict documentation requirements. The number one requirement is a written plan document. This is a formal legal document that establishes the plan and its rules. It is not the same as the Summary Plan Description (SPD), which is a simpler, employee-facing document explaining the plan. You must have both. Additionally, you must maintain signed and dated election forms for every participating employee for every plan year. During an audit, an IRS agent will ask for these three things first. Failure to produce them can lead to immediate plan disqualification.

Common Section 125 Testing Mistakes

Nondiscrimination testing is a common area of failure. Frequent mistakes include:

• Forgetting to Test: Simply not performing the tests at all.
• Using Bad Data: Using incorrect compensation data or misidentifying the HCEs and Key Employees.
• Testing at the Wrong Time: Performing tests too early in the year before the full picture is clear.
• Ignoring Component Plan Tests: Running the main Section 125 tests but forgetting the specific tests for the Dependent Care FSA (55% test) or group term life insurance.
• Not Taking Corrective Action: Identifying a failure but not making the necessary taxable adjustments to the HCEs' income, which leaves the plan non-compliant.

Cafeteria Plan Eligibility Rules Explained

Eligibility must be defined in the plan document. An employer can generally set its own eligibility rules, such as limiting participation to full-time employees or requiring a waiting period (e.g., 90 days). However, these rules must be non-discriminatory. The most critical eligibility rule is the one that excludes self-employed individuals. Partners, sole proprietors, and S-Corp shareholders owning more than 2% of the company cannot participate. This is because they are not considered "employees" for this purpose. Allowing them to make pre-tax contributions is a significant compliance failure.

How to Communicate Benefit Options to Employees

Effective communication is key to a plan's success. Use a multi-channel approach. Start with a clear, concise open enrollment guide that explains each benefit, provides examples of how FSAs work, and highlights the tax savings. Hold informational meetings (in-person or virtual) where employees can ask questions. Use email reminders to highlight deadlines. Host the materials on your company intranet for easy access. The goal is to move beyond legal disclosures to true employee education, helping them make informed decisions that benefit them and their families.

Understanding Pre-Tax vs. After-Tax Contributions

This is a fundamental concept for employees to grasp. Pre-tax contributions are deducted from an employee's gross pay before federal, state, and FICA taxes are calculated. This lowers their taxable income, resulting in a higher take-home pay compared to paying for the same benefit with after-tax dollars. After-tax contributions are taken from an employee's net pay, after all taxes have been withheld. Most benefits outside of a Cafeteria Plan, and contributions made by ineligible owners, are made on an after-tax basis.

How to Conduct a Cafeteria Plan Audit

A self-audit is a crucial risk management practice. To conduct one, create a checklist and review a sample of your operations.

1. Document Review: Pull your plan document and SPD. Are they signed and dated? Have they been updated for recent law changes?
2. Election Form Review: Sample a dozen employee files. Do you have a signed election form for each participant for the current plan year?
3. Testing Review: Locate your nondiscrimination test results for the prior year. Were they performed? Did they pass? If not, was corrective action taken and documented?
4. FSA Claims Review: Sample several FSA reimbursements. Is there adequate substantiation on file for each claim?
5. Participant Review: Review your list of participants. Are there any partners or S-Corp owners making pre-tax contributions?

Best Practices for FSA and Dependent-Care Reimbursements

For Health FSAs and Dependent Care FSAs (DCAPs), compliance hinges on proper claims adjudication.

• Substantiate Everything: Every single claim must be substantiated. A debit card swipe is not enough. You need an EOB or a detailed receipt showing the date of service, type of service, and cost.
• Train Your Team: Whether you administer in-house or use a TPA, the claims adjudicators must be trained on what constitutes an eligible expense under IRS rules.
• Follow Timing Rules: For a Health FSA, the full annual election is available on day one of the plan year. For a DCAP, employees can only be reimbursed up to the amount they have actually contributed to date.
• Manage the Run-Out: Have a clear, automated process for managing the run-out period and forfeiting unused funds according to the use-it-or-lose-it rule.

Cafeteria Plan Compliance Checklist for HR Managers

An HR Manager's checklist should cover the full administrative cycle:

• Pre-Plan Year: Review plan design and update plan documents/SPD. Prepare open enrollment materials.
• Open Enrollment: Communicate to employees and collect all election forms by the deadline.
• During Plan Year: Process mid-year election changes according to plan rules. Ensure FSA claims are being substantiated. Coordinate with payroll for correct deductions.
• End of Plan Year: Prepare data for nondiscrimination testing. Communicate FSA use-it-or-lose-it deadlines.
• Post-Plan Year: Complete nondiscrimination testing and make corrections if needed. Manage the FSA run-out period. Prepare for the next open enrollment.

How to Coordinate Cafeteria Plans with COBRA and HIPAA

Coordination with COBRA and HIPAA is critical. Under HIPAA, when an employee has a special enrollment event (e.g., gets married and wants to add their spouse to the health plan), they have a right to enroll mid-year. Your Cafeteria Plan must allow a corresponding election change to let them pay for the new coverage pre-tax. For COBRA, a Health FSA can be a group health plan subject to continuation. If an employee has an "underspent" FSA (their available balance is more than their contributions to date) when they have a qualifying event, you must offer them COBRA for the FSA. This is a commonly missed requirement.

Section 125 Updates and IRS Guidance for 2025

Staying ahead means monitoring IRS notices, revenue rulings, and proposed regulations that impact Cafeteria Plans. Key areas to watch in 2025 will likely include continued adjustments to contribution limits for benefits like FSAs and HSAs, any new guidance on digital substantiation methods for FSAs, and potential clarifications on how new state-level benefit mandates might interact with federal Section 125 rules. A commitment to ongoing education through webinars, alerts, and certification programs is the only way to ensure your plan remains compliant with the latest guidance.

In the intricate world of employee benefits, the Cafeteria Plan stands out for its power to deliver value and its unforgiving complexity. Proper administration is not an administrative task; it is a professional discipline. By investing in deep knowledge, robust processes, and expert training, you can transform your Section 125 plan from a source of compliance risk into a strategic asset that helps your organization attract, retain, and support its greatest asset?its people.

Take the next step in mastering benefits compliance. Enroll in our Cafeteria Plan and related certification programs today.