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CEBS GBA1 - Section 125 Plans Questions and Answers Latest Updated 2024
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CEBS GBA1 - Section 125 PlansWhat are the two primary factors that contribute to the popularity of cafeteria plans? - answer The two primary factors that contribute to the popularity of cafeteria plans (often called flexible benefit plans or flex plans) are:
(1) The ever-increasing costs of benefits
(2) A diverse workforce with vastly differing employee benefit needs.
Permitting employees to select those benefits that are most applicable to their personal financial circumstances makes sense for both the employee and the employer. With employee benefits representing a large component of labor costs for most organizations, it is important to spend employee benefit dollars in a cost-efficient way that maximizes value. A cafeteria plan ensures that the employer maximizes the value of its benefit dollars and avoids spending money on duplicated or unneeded benefits.
Before the advent of flex plans, optional or supplemental benefits were paid by the employee using after-tax dollars. A flexible benefit plan allows employees to contribute toward benefits on a tax-favored basis. As certain benefit programs have become more costly, notably health care, and more employees are asked to share costs with the employer, the tax advantages and choice in benefits selection become particularly appealing.
Describe the tax doctrine of constructive receipt within the context of cafeteria plans. - answer Cafeteria plans operate as an exception to the tax doctrine of constructive receipt. Usually, when an individual has control over how money is spent, it becomes taxable to that individual. However, provided a cafeteria plan is designed in accordance with all applicable tax laws, a cafeteria plan participant can avoid taxation and instead receive tax-free benefits.
Describe the concept of a cafeteria plan and how it operates in connection with other employee benefit plans sponsored by an employer. - answer A cafeteria plan operates in connection with other employee benefit plans sponsored by an employer. In fact, an essential concept in understanding a cafeteria plan is recognition that the cafeteria plan really is an umbrella plan under which tax-favored employee benefits are offered. The cafeteria plan is merely a mechanism to pay for employee benefits. Internal
Revenue Code (IRC) Section 125 and the regulations related thereto govern cafeteria plan arrangements while other IRC sections apply to the underlying benefits funded within the cafeteria plan. Section 125 was added to the IRC by the Revenue Act of 1978. Prior to the enactment of this section of the IRC, the tax treatment of benefits involving participant choice was quite different. If a participant had any type of choice with respect to available benefits, the tax doctrine of constructive receipt required that the participant be taxed as if they had elected the maximum available taxable benefits. The rationale was that since participants could elect these amounts in cash, they should
be taxed as if they had elected the cash. This was the case even if the participants elected benefits that, if paid for by the employer, could be offered to participants on a tax-free basis.
Explain the tax treatment for employee benefits under IRC Section 125 and the scope of
Section 125 (i.e., which benefit plans are included or excluded from preferential tax treatment). - answer IRC Section 125 significantly changed the tax treatment under prior law, as described previously. Section 125 provided favorable tax treatment to certain benefits funded through a cafeteria plan. It specifically defined a cafeteria plan to
mean a plan under which all participants are employees (Note: The plan may only benefit employees, not owners, such as partners paid according to a Form K-1 or 2% or
greater shareholders of an S corporation) and under which all participants may choose among two or more benefits consisting of a combination of qualified benefits and cash. If the requirements of IRC Section 125 are met and the benefits are eligible for inclusion
in a cafeteria plan, then the benefits are not considered as taxable income to the participant if benefit coverage is chosen. On the other hand, if cash is selected and paid
to participants, the cash payment would be fully taxable as compensation. It is important
to note that Section 125 has a clearly defined scope, with some benefits that are permissible for cafeteria plan tax treatment and other benefits that may not be included in a cafeteria plan.
Candidate Note: Among benefits that cannot be offered in a cafeteria plan are whole life
insurance and long-term care insurance. Oddly, though, a health savings account (HSA)
funded through a cafeteria plan may be used to pay premiums for long-term care insurance or for long-term care services. HSA contributions permissible under a cafeteria plan are themselves an exception to the Section 125 special rule that prohibits the deferral of compensation.
What are the primary advantages to an employee in receiving benefits under a cafeteria
plan? - answer There are a number of advantages when an employee receives benefits under a cafeteria plan. However, the most notable advantage is probably the preferential tax treatment afforded to these benefits. Employees directly save money since they pay for their share of benefit expenses on a tax-favored basis. Contributions to a cafeteria plan are exempt from federal income tax and are not subject to the Federal Insurance Contributions Act (FICA-Social Security) and the Federal Unemployment Tax Act (FUTA) taxes. Also, most state and local tax laws follow the federal tax treatment.
What are the primary disadvantages to an employee in receiving benefits under the umbrella of a cafeteria plan? - answer From an employee's perspective, the primary disadvantage of a cafeteria plan is the fact that benefit elections generally must be made prior to the beginning of the plan year and, with limited exception, the election is irrevocable during the entire period of coverage. Another significant disadvantage that applies to a health care FSA is the use-it-or-lose-it rule subjecting unused benefit dollars
at the end of the plan year to forfeiture. (Discussed later, the use-it-or-lose-it rule has
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