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How to Write a Business Plan for Opening a Cafe

• by Lightspeed

minute read

Think of your plan as a roadmap for your entrepreneurial adventure—one that’s easier to create than you might think! In this article, we’ll show you how to write a business plan that will set your cafe up for success.

How to write a business plan for opening a cafe

What is a cafe business plan, start with your vision, study other business plans, building your business plan template, section 1: the executive summary, section 2: how will your cafe business succeed, section 3: study your competition, section 4: analyze your target market, section 5: tell us what you’ll sell and how you’ll sell it, section 6: create a marketing plan, section 7: ownership structure, section 8: your operations plan.

• Section 9: Financial planning

Section 10: Plans for growth

Finally, we’ll end with an example business plan to show you what it looks like in action. 

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  Want a quick summary of what to include in your cafe business plan? Consult this handy table. 

At its core, a cafe or coffee shop business plan is a document that explains what your business idea is and how it will succeed. It answers questions like how much it costs to set up shop, how those costs will be funded and how much money you expect to make from your cafe. A coffee shop business plan includes information about your competitors, target market and pricing structure.

When it’s finished, your business plan can be shown to potential investors, bankers, partners and anybody else who will help you open your cafe. As you can probably tell, it’s an extremely important document, so it’s worth your time and effort to get it right. First, you’ll learn about all the different pieces of information that will go into your business plan and then we’ll help you pull the pieces together.

A business plan is the first step in making your cafe-ownership dream a reality, so take time to dream by laying out your vision for your future cafe or coffee shop. What will your cafe look like? How will it be decorated? Where will it be located? Which items will you sell? Who will frequent it? How will your customers navigate your cafe, from the moment they walk through the door to the moment they swip e or tap their credit card to check out?

Pull inspiration from cafes you love, images you’ve seen, your favorite films or books, even your travels. Then write it all down or post pictures on a wall to create an inspirational mood board . As you spend hours working on your business plan, it will be incredibly motivating to glance up at your initial vision and be reminded of the finish line.

Before you pen your masterpiece, look at business plan examples from your industry: cafes, coffee shops and quick-serve restaurants. Study how they planned their business and make sure that your cafe is on the right track.

Real-world examples from business owners are also invaluable. Seek out current or former coffee shop owners or even franchise owners in your town and ask them how they succeeded and what they would have done differently. While you’re at it, you can seek recommendations for, say, an accountant who can help you write your business plan. Even if local business owners are your future competition, they might be willing to share their experiences.

A blank page can be overwhelming, but there are countless business plan templates available online to help get your started. We’ve outlined the basic sections you should include in your business plan below, as well as further tips on how to build out each one. 

At the end of the day, your template doesn’t have to be fancy or include imagery. The most important thing is that it contains all the necessary information and is logically organized so it’s digestible to anyone reading it.

When a reader opens your business plan, they will see the executive summary first. This gives a high-lev el overview of all the sections in your business plan. A well-written executive summary will get your foot in the door, so be sure to read examples to get a feel for how the summary is worded and to see how all the information is presented.

Just as you thought about the customers who will visit your soon-to-be-open cafe, consider who will read your business plan and tailor the opening paragraphs to your audience. As you’re preparing to open your cafe, your executive summary is the most important marketing tool your cafe has.

It’s designed to capture the attention of your reader, and give them an overview that’s brief and compelling. Here are some tips on writing a strong executive summary:

• Clearly state the purpose and unique value proposition of your business at the start
• Highlight what sets you apart from competitors
• Take your audience and potential investors into consideration as you write
• Summarize the business opportunity you’re presenting

The second section answers questions like, “What problem does your cafe solve?” and “How will your cafe be the solution?” Maybe there is no coffee house or cafe in a busy retail center near you. Or maybe a restaurant just closed downtown.

This summary provides a brief overview of your industry, mentions where your cafe will be located and describes how it will stand out. Will your shop specialize in breakfast sandwiches near an airport? Sell your locally famous pie? You’ve envisioned how your future cafe will be a success. Make sure the readers of your business plan understand that too.

You can talk about the following in this section:

• Your cafe’s unique selling points (these could relate to your menu, brand, other offerings, etc.)
• Your location strategy (how will you maximize foot traffic? What factors were involved in your decision?)
• What your menu will look like compared to competitors 
• A sneak peek into your marketing strategy (more on that later, though)
• How you’ll optimize your operations for efficiency, cost-effectiveness, etc.

The next part of your business plan is usually referred to as the competitive analysis . It explains how your cafe will compete with similar food and beverage businesses—including big coffee chains like Starbucks and fast food giants like McDonald’s. Nearby restaurants, coffee shops and even public gathering areas like movie theaters are all your competition. So now is the time to do the research of visiting your potential competitors and making a note of who their customers are, as well as what’s for sale and how much it costs.

By understanding the pricing strategy for similar businesses, you’ll know how much you need to charge for your coffee, pastries, sandwiches and whatever else you’re selling in order to remain competitive in your particular market. Gross margins (the amount of money you make based on what you sell) for cafes and coffee shops can be high, but small cafes have notoriously small operating incomes (read: profits) due to the high cost of overhead.

However, if you put in the time to undertake a thorough analysis of your competition, your cafe has a higher chance of being successful. By writing down how your cafe will compete against similar businesses, you will convince your reader (and, most importantly, yourself) that your goal of opening a restaurant or cozy cafe is realistic and sustainable.

In order for your cafe to succeed, it needs a steady flow of customers. Unfortunately, attracting foot traffic is not quite as easy as “if you build it, they will come.” In your business plan, your future customers are known as your market , the number of potential customers is your market size and how you’ll reach them is your marketing plan. 

In your cafe or restaurant business plan, you’ll then take your market and divide it further into market segments . For example, if your coffee shop or cafe is close to an elementary school, a market segment might be parents or caretakers who stop by for high-end coffee after dropping their children off at school. Or college students studying for exams as they swig espresso. 

Now that you know what the competition charges, it’s time to create a pricing strategy for your cafe. 

When creating your menu and prices , be smart. You’ll be buying ingredients in bulk, so try to use the same ingredients in many different dishes. Are you thinking of selling wine at your cafe? Liquor, like coffee, offers some of the largest profit margins in the industry, but a liquor license will cost you money and there may be a waiting period, so you might want to start with non-alcoholic beverages.

Don’t be afraid to get creative. If you charge less for a croissant and coffee combination than you do for those items alone, you’ll encourage customers to buy more and cut down on food waste . Once you open for business, you’ll probably end up making changes to your menu. But for the purpose of a business plan, you’ll need to know how much you will charge for the coffee or soup you plan to sell, which you’ll determine by breaking down the ingredients needed to make each item and researching your competition.

Take Toronto cafe and bakery Le Beau , for instance. They’re known for their freshly baked croissants, which come in many different flavors. People go to the cafe specifically for their famous croissants, and of course usually end up buying other items as well. If you want to cultivate this type of loyalty, you’ll have to start early. 

Your marketing plan can be part of your sales plan or it can be a separate section. Will you advertise your specials every morning on social media ? Will you partner with another local business for special promotions? In addition to marketing, this is also a great section to explain your plans for retaining your customers. Will you offer loyalty programs or have your employees give your top customers a free cookie on their birthday? With a cafe point of sale system , it’s easier than ever to reward—and keep—the customers who will frequent your cafe. 

It’s also important to create a strong brand identity. Allow this to guide your marketing plan so that the reader is confident that your business will be able to create more successful marketing campaigns. 

You can also include information about:

• Using your online presence to market your business
• Whether you’ll implement customer loyalty programs 
• Events you plan to host to boost your business profile
• The programs and tools you’ll use to monitor the progress of your marketing initiatives

Your business plan will include the ownership structure of your business. Explain how much experience you and your partners bring to the table and why you’re the right person (or people) to go into business.

Clearly outline the legal structure of your business and what form that will take. That could be an LLC, corporation, sole proprietorship or partnership. To further legitimize your business plan, identify the roles and responsibilities that each owner or partner will take on. Explain how you’ll work together to ensure effective management and decision-making. 

You could even include any plans or contingencies for future ownership, as well as the governance structure of your business and how decisions will be made. 

In this section, you’ll include information about your facilities, employees, equipment and supplies. Think about the direct costs of rent, barista wages, ingredients like coffee beans and technology. Try to get many services out of individual tools, like a POS system that lets your customers check out, your part-time employees clock in and also manages the inventory of your cafe. This will maximize your efficiency and allow you to run your business from one platform, which your employees and customers will also benefit from. 

Approximate how often you’ll need to reorder ingredients like flour and eggs. Carefully considering your operating costs during the business planning stage pays off. For instance, a coffee roaster is an upfront start-up cost, but roasting your own coffee at your cafe can save you operating costs in the long run. Save money where you can (secondhand chairs, anyone?) and don’t scrimp where it’s important, like your espresso machine.

Section 9: Financial planning 

Now you’re ready to craft a financial plan for your cafe. This is usually the most time-consuming and important section of your business plan, especially for lenders and investors. It should include an overview of your start-up costs, an income statement, projected cash flow, a balance sheet and a break-even analysis .

Startup costs

You’ve heard the adage that it takes money to make money, and this is because most businesses need initial funding to get them off the ground. A major reason you might be writing a business plan in the first place is to secure funding, like a business loan, for your cafe, but remember that your start-up funds can come from anywhere. How much money do you need to borrow? Will you dip into your savings? Crowdfund from your fans? No matter where you find your initial financing, a business plan lays out how your cafe will be funded and how that money will cover your business start-up costs.

Income statement

Once you know your start-up costs, operating costs, pricing strategy and target market, you are ready to lay out all this information into an easy-to-digest income statement . Take all of your expenses (mainly operating costs) and your projected sales volume (the amount that you are selling each month based on your pricing strategy and market research) to prove that your cafe business will turn a profit. In your case, create a projected monthly income statement for the first year your cafe will be in business. Explore some examples of income statements to see what your final analysis will look like.

Looking ahead to the future

A big part of writing a business plan for your cafe is figuring out the projected cash flow your cafe will earn over time. Depending on the audience for your business plan, you may have to project your cafe’s cash flow up to five years in advance, broken up into months or quarters. Though this exercise might seem difficult, it’s not impossible. You’ve already completed most of the financial legwork.

Combine those crunched numbers with your personal experience as a customer and a worker to project how much money your cafe will make in the future. Consider seasonal differences, like a spike in business around the holidays if you’re in a busy shopping district, or a lull in business during the summer if your cafe caters to college students. Just like your income statement, these cash flow projections will go into your business plan as easy-to-view statements.

Balance sheet

A balance sheet details the assets, liabilities and equity of your cafe business on the day it opens. It’s generally used to determine how much money a business has to work with. For a small cafe, it’s not as important as the income statement, but it’s useful as a realistic snapshot of the financial health of your restaurant.

Breaking even

Now that you’ve detailed how you will make a profit and you know how much money you are working with, you can approximate how long it will take your cafe to turn a profit. This is called the break-even point.

Did you know? Lightspeed offers funding to businesses through Lightspeed Capital, our merchant cash advance program. Eligible Lightspeed customers can use the funding for any business purpose.

Section 10: Planning for growth

Include a section that discusses potential avenues for expansion in the future. This will show important stakeholders you’ve already started thinking about the future direction of your business.

Review the scalability of your business model and operations to support expansion efforts effectively. Determine whether the infrastructure, systems, and processes you’ll start with can support your visions of growth.

The opportunities you mention could include opening additional cafe locations in new neighborhoods or cities, expanding your product offerings to include catering services or packaged goods, or diversifying into related businesses such as coffee roasting or wholesale distribution.

Example business plan

We’ve created a business plan for a hypothetical cafe called Sip & Savor Café. Keep in mind that it’s shorter than is typical. 

Section 1: Executive summary

Sip & Savor Café is a quaint yet vibrant coffee shop nestled in the bustling downtown district. Our vision is to create a welcoming space where patrons can indulge in artisanal coffee, delectable pastries, and light bites while fostering connections and savoring moments of tranquility amid the urban hustle. With a dedication to exceptional service and a commitment to community engagement, Sip & Savor Café aims to become the preferred destination for coffee enthusiasts and locals seeking a reprieve from the daily grind.

Section 2: How Sip & Savor will succeed

Sip & Savor Café will differentiate itself by offering a curated selection of specialty coffees, locally sourced ingredients, and unique menu offerings that reflect the diverse tastes and preferences of our customers. Our prime downtown location, near office buildings and shopping centers, will maximize foot traffic and visibility. We will optimize our operations for efficiency and cost-effectiveness by selecting suppliers carefully and using a streamlined tech solution while maintaining a strong emphasis on quality and customer satisfaction.

Section 3: Competitive analysis

Through a comprehensive competitive analysis, we have identified key competitors in the area, including national coffee chains and independent cafes. By offering personalized service, a welcoming atmosphere, and distinctive menu items, Sip & Savor Café will differentiate itself from competitors and attract a loyal customer base. We’ll also create a strong loyalty program for our customers to rival the likes of big chains.

Section 4: Our target market

Our target market includes urban professionals, students and local residents seeking a convenient and comfortable place to enjoy coffee and light meals. We’ll create a space that encourages people to sit, stay and work. By understanding the preferences and behaviors of our target market segments, we will tailor our offerings and marketing efforts to effectively reach and engage with our customers. 

Section 5: What we’ll sell

Sip & Savor Café will offer a diverse menu of specialty coffees, teas, and seasonal beverages, accompanied by a selection of freshly baked pastries and sandwiches. We will implement a smart pricing strategy, utilizing high-quality ingredients and creative combinations to maximize value for our customers. Our menu will evolve based on customer feedback and seasonal trends, ensuring a dynamic and appealing selection of offerings.

Section 6: Our marketing strategy

Our marketing plan will focus on building brand awareness, driving foot traffic, and fostering customer loyalty. Strategies include social media campaigns, local partnerships, community events, and loyalty programs to engage customers and generate buzz around Sip & Savor Café. We will also prioritize customer retention through personalized service and rewards programs.

Sip & Savor Café is structured as a partnership between founders Emma and Liam, who collectively bring over 20 years of experience in the hospitality industry. Each partner holds a 50% ownership stake and shares responsibility for day-to-day operations, strategic decision-making and financial management.

Section 8: Operations plan

Our operations plan outlines efficient workflows, staffing requirements, inventory management systems, and quality control measures to ensure smooth and consistent operations. We will invest in modern equipment, staff training, and technology to optimize efficiency and deliver a superior customer experience.

Section 9: Financial plan

Sip & Savor Café will require initial funding to cover startup costs, including leasehold improvements, equipment purchases, and initial inventory. We have secured financing through a combination of personal savings, small business loans, and investor contributions. Our financial projections indicate steady revenue growth and profitability over the first three years of operation, supported by growing customer traffic and cost-effective operations.

As Sip & Savor Café establishes itself as a local favorite, we plan to explore opportunities for expansion, including additional locations and new menu offerings. By maintaining a focus on quality, customer satisfaction, and community engagement, we aim to sustain long-term growth and success in the competitive cafe market.

Keeping the restaurant dream alive

Though creating a business plan can seem complicated, remember that it’s an important step you should take before starting a cafe. A thoughtful business plan proves to others (and yourself) that your cafe can be successful. 

Looking to invest in the right tools for your cafe? Chat with one of our experts to see how cloud software can make your day-to-day more efficient.

1. How profitable is owning a cafe?

Profitability varies, but successful cafes can generate healthy profits with the right management, location, and business model.

2. How do I start a cafe business?

Start by creating a solid business plan, securing financing, finding a suitable location, obtaining necessary permits/licenses, hiring staff, sourcing suppliers, and marketing your cafe.

3. Is a cafe a successful business?

Cafes can be successful if managed effectively, offering quality products, good customer service, and a welcoming atmosphere.

4. How do I write a business proposal for a cafe?

Include sections on your concept, target market, location analysis, marketing strategy, financial projections, and management plan.

5. What is the failure rate of coffee shops?

Failure rates vary, but some studies suggest around 60% of new coffee shops close within the first five years due to various factors like location, competition, and mismanagement.

6. How much do small cafe owners make?

Earnings vary greatly depending on factors like location, size, and business model, but small cafe owners may make anywhere from modest incomes to substantial profits.

7. How much does it cost to run a coffee shop per month?

Costs can vary widely based on factors like rent, utilities, staff wages, inventory, and marketing expenses, but estimates range from several thousand to tens of thousands of dollars per month.

8. Are cafes a good investment?

Cafes can be a good investment if carefully planned and managed, offering opportunities for profitability and growth in the food and beverage industry.

9. Are cafes more profitable than restaurants?

Profitability depends on various factors including location, target market, and operating expenses. While cafes may have lower overhead costs than full-service restaurants, profitability can vary widely between individual establishments.

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Lightspeed is a cloud-based commerce platform powering small and medium-sized businesses in over 100 countries around the world. With smart, scalable and dependable point of sale systems, it's an all-in-one solution that helps restaurants and retailers sell across channels, manage operations, engage with consumers, accept payments and grow their business.

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The Small Business Owner’s Guide to Starting a Section 125 Cafeteria Plan

by Misty Berryman | Apr 7, 2024 | Health Savings Account | 0 comments

What is a Section 125 Cafeteria Plan?

A Section 125 cafeteria plan is a type of employee benefit plan that allows employees to pay pre-tax dollars for a variety of benefits.

This means that employees can elect to have a portion of their salary deducted before taxes are applied, specifically to cover the cost of their health insurance premiums. This reduces the employee’s taxable income, which in turn reduces the amount of federal, state, and sometimes local taxes owed. For the employer, it can reduce payroll taxes.

The employer provides a menu of options within the Section 125 plan. Workers can then pick and choose which benefits they want to purchase, like one would load up a lunch tray in a cafeteria.

The employer then deducts the money needed to pay premiums and other costs for the benefits selected, and pays them with pre-tax dollars on the employees’ behalf.

Note: The terms “Section 125” plan and “cafeteria” plan are used interchangeably. A section 125 plan is a separate written plan maintained by an employer for employees that meets the specific requirements of and regulations of Section 125 of the Internal Revenue Code.

Cafeteria plans also save money for employers, as well. Because employees are paying pre-tax for benefits, the money spent for these benefits does not show up as income on their W-2s. Therefore, you don’t have to pay payroll taxes on this money.

By offering a Section 125 cafeteria plan, you can help your employees save money on taxes while also providing them with a comprehensive benefits package that can help attract and retain top talent – while reducing your own payroll tax liability at the same time.

How do Cafeteria Plans Work?

In a nutshell, cafeteria plans help reduce taxes.

Here’s how it works: 

A cafeteria plan allows employees to choose between receiving taxable cash compensation or certain qualified benefits that are excluded from their  taxable income.

Instead of receiving this compensation in the form of taxable cash income, employees can choose from a menu of benefits. Examples include health insurance, dental and vision insurance, disability insurance, life insurance, and more.

Under Section 125 of the Internal Revenue Code, cafeteria plan sponsors must offer employees a choice between at least one taxable benefit (such as cash) and one pre-tax benefit (such as disability insurance).

When an employee elects to participate in a cafeteria plan, you as the employer will provide them an amount of money each year that they can use to pay for their chosen benefits via a cafeteria plan.

They then pay for these benefits via payroll deduction. That is, their premiums or fees for these benefits are deducted from their paycheck before taxes are calculated and deducted from their paychecks.

This has two benefits for the employee:

• It makes these benefits more affordable and accessible for them;
• It reduces their taxable income and lowers their tax liability.

For example, let’s say an employee earns $50,000 per year and elects to contribute $2,000 to their cafeteria plan to buy disability insurance, life insurance, and a critical illness insurance policy.

Their taxable income is then reduced to $48,000, which lowers their tax liability. If the employee is in the effective 25% tax bracket, they save $500 in income taxes.

It also means that neither you as the employer nor the employee have to pay payroll taxes on that $2,000 subject to payroll deduction.

So both you and the employee save money by reducing your tax burden.

How does a Section 125 cafeteria plan save employers money?

A cafeteria plan can save employers money in several ways.

First, it reduces payroll taxes. When employees contribute to a cafeteria plan, their contributions are exempt from federal income tax, Social Security tax, and Medicare tax. This means that the employer does not have to pay payroll taxes on the amount of money contributed to the cafeteria plan.

This alone can save more than 7% of payroll costs.

Second, a cafeteria plan can help employers attract and retain top talent. By offering a comprehensive benefits package, employers can show their employees that they value their health and wellbeing. This can lead to increased job satisfaction, higher morale, and lower turnover rates.

What Benefits Are Typically Included in Section 125 Cafeteria plans?

A Section 125 cafeteria plan can include a wide range of benefits, including:

• Health insurance premiums
• Dental insurance premiums
• Vision insurance premiums
• Disability insurance premiums
• Life insurance premiums
• Dependent care expenses
• Healthcare expenses (such as deductibles, copays, and coinsurance)

Section 125 plans cannot include benefits that are not considered qualified benefits under the IRS code. This includes benefits such as:

• Cash or other taxable compensation
• Stock options
• Retirement plan contributions
• Educational assistance 
• Healthsharing expenses
• Commuting expenses
• Employee discounts

Compare Pricing on the Best HSA Plans Available

Section 125 plans vs. fsas.

Unlike flexible spending accounts (FSAs), which are a type of reimbursement account that allows employees to set aside pre-tax dollars to pay for eligible healthcare or dependent care expenses, a cafeteria plan allows employees to use pre-tax dollars to pay for a much wider range of benefits.

Optimizing Tax Savings Using a Section 125 Plan

Integrating a Section 125 cafeteria plan with a health savings account (HSA) can be a powerful way to help your employees save money on healthcare expenses and build up savings for future healthcare needs.

Here are some best practices for integrating these two types of plans:

• Offer both plans. To integrate a Section 125 plan with an HSA, you will need to offer both plans to your employees. Your Section 125 plan can be used to pay for eligible healthcare expenses, such as insurance premiums and deductibles, while your HSA can be used to save for future healthcare expenses.
• Educate your employees. Just offering the plan isn’t enough. You also need to put emphasis on communication. Provide clear and concise communications about the benefits offered, enrollment procedures, contribution limits, and other important details. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plans work and how they can use them to save money on healthcare expenses. Try to communicate benefits information throughout the year, and not just during open enrollment and onboarding. Use a variety of media, and if appropriate, provide materials in Spanish and other languages as needed. Learn more: Best Practices for Communicating Employee Benefits
• Coordinate contributions. When integrating a Section 125 plan with an HSA, it’s important to coordinate contributions to ensure that employees don’t exceed the contribution limits for either plan. You will need to establish contribution limits for both plans and ensure that employees are aware of these limits. You may also want to provide tools or calculators to help employees determine the optimal contribution amounts for each plan.

          Learn more: Higher Communication Limits Allow You To Save Even More in Taxes

• Monitor and administer the plans. Once your plans are in place, you will need to monitor and administer them on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator , and ensuring that your plans remain compliant with IRS regulations. You may also want to periodically review your plans to ensure that they are meeting the needs of your employees and your business.

By integrating your HSA offering with a Section 125 plan, you can provide your employees with a powerful tool for managing healthcare expenses and building up savings for future needs.

Types of Cafeteria Plans

There are several different types of cafeteria plans that employers can offer to their employees.  Here are some of the most common types of cafeteria plans

• Health savings account (HSA). An HSA is a tax-advantaged savings account that can be used to pay for eligible healthcare expenses. To be eligible for an HSA, an employee must have a high-deductible health plan (HDHP). HSAs allow employees to save money on taxes while also building up savings for future healthcare expenses.
• Premium-only plan (POP). A POP allows employees to pay for their share of health insurance premiums with pre-tax dollars. These plans only cover insurance premiums and no other expenditures.This can help employees save money on taxes and reduce their taxable income.
• Health flexible spending account (FSA). An FSA allows employees to set aside pre-tax dollars to pay for eligible healthcare expenses, such as deductibles, copays, and coinsurance. Employees can use FSA dollars to pay pre-tax a wide range of other healthcare expenses, including prescription drugs, glasses/contact lenses, orthodontia, dental care, mental health treatment, and even medically necessary alternative medical treatments such as acupuncture and chiropractic care.
• Dependent care flexible spending account (DCFSA). A DCFSA allows employees to set aside pre-tax dollars to pay for eligible dependent care expenses, such as daycare or afterschool care for children under the age of 13, or elderly dependents who are unable to care for themselves.
• Premium reimbursement arrangements (PRA). A PRA is similar to a POP, but it allows employees to be reimbursed for their share of health insurance premiums rather than paying for them with pre-tax dollars. PRAs can be used in conjunction with other types of cafeteria plans to provide employees with additional flexibility.
• Section 125(e) Qualified Small Employer Health Reimbursement Arrangement (QSEHRA) . A QSEHRA is a type of health reimbursement arrangement (HRA) that allows small employers to reimburse employees for eligible healthcare expenses, including premiums for individual health insurance policies. QSEHRAs are available to employers with fewer than 50 full-time equivalent employees who do not offer a group health plan.

Click here for more information about HRAs, (including QSEHRAs) and how to start one.

It’s important to note that not all types of cafeteria plans are available to all employers, and eligibility requirements may vary depending on a variety of factors.

For any employers that we are helping with health insurance or health sharing benefits, we also help them with setting up their Section 125 benefits, if appropriate. For a free, no-obligation consultation on your specific situation, contact a Personal Benefits Manager .

Section 125 Compliance

Non-discrimination rules.

To ensure that Section 125 plans benefit all employees fairly, Section 125 plan sponsors must adhere to these non-discrimination provisions.

These rules prevent business owners from setting up tax-advantaged plans that benefit themselves and senior management only, leaving rank-and-file employees out.

Should a plan violate these rules in any given year, they may be deemed discriminatory. If that happens, any benefits that were preferentially given will be considered taxable income for those high-earning or key employees who received them.

Under section 125 rules, an employee is classified as “highly-compensated” if they meet any of these criteria:

• They hold an officer position within the company;
• They own 5% or more of the company’s shares;
• They earn an annual salary that exceeds the limit specified in Sec. 414(q)(1)(B) , which is $155,000 as of 2024 .
• Fall within the top 20% of earners in the company, should the employer choose this classification as per Sec. 414(q)(3) .

Key employees, along with their spouses and dependents, are identified as:

• For plan year 2024, officers receiving compensation according to Sec. 416(i)(1) amounting to $215,000 for the 2023 plan year are considered key employees.
• Individuals owning 1% of the company with annual earnings of $150,000 (not indexed) or more for the plan year; or
• Those owning 5% of the company or earned, no matter what they earned last year. 

Documentation Requirements

Section 125 sponsors must establish detailed written documentation for their plans.

Required documents include:

• A comprehensive plan document
• A summary document for employees

These documents must precisely define the fiscal period of the plan. Any alterations to this period must be justified by legitimate business reasons, such as synchronizing with the fiscal year of the healthcare provider. They cannot be arbitrary and only for the convenience of the employer.

The summary plan document must be distributed to all eligible employees within 90 days of their enrollment.

Detailed requirements for these documents can be found in Proposed Regulations Section 1.125-1(c).

Section 105 MERPs vs. Section 125 Cafeteria Plans

Both Cafeteria Plans and MERPs are tax-advantaged vehicles that allow employers to help employees access benefits and pay qualified medical expenses with tax-free dollars.

Contributions to both plans are fully tax-deductible to employers as a compensation expense, up to certain limits, in some cases.

Benefits under both plans are tax-free to workers. They are also exempt from payroll taxes as well as income taxes.

But there are important differences, as well. This section will dive into the differences between these two popular types of plans, and discuss when each of them may be most suitable for employers.

Let’s take a more detailed look at each of them, in turn:

The term MERP stands for medical expense reimbursement plan.

These are established under Section 105 for the U.S. Tax Code. MERPs are IRS-approved plans under which employers reimburse qualified medical expenses of employees and their family members.

Types of Section 105 MERPs

• Healthcare Flexible Spending Account (FSAs). FSAs allow employees to contribute a portion of their salary on a pre-tax basis to an account that can be used to reimburse eligible medical expenses not covered by insurance, such as deductibles, copayments, and certain over-the-counter medications.
• Health Reimbursement Arrangement (HRA)s. HRAs are employer-funded accounts that reimburse employees for eligible medical expenses. Employers establish and fund HRAs, and employees can use the funds to pay for qualifying healthcare expenses, including deductibles, copayments, and certain medical premiums.
• Post-Retirement Medical Reimbursement Plans. These plans are designed to reimburse retired employees for eligible medical expenses incurred after retirement. Employers may set aside funds to cover medical costs for retired employees, providing a valuable benefit to help cover healthcare expenses during retirement.
• Retiree Health Reimbursement Arrangements (Retiree HRA)s. Similar to a post-retirement medical reimbursement plan, Retiree HRAs are employer-funded accounts that provide tax-free reimbursements for medical expenses incurred by retired employees. These arrangements help retirees manage healthcare costs during their retirement years.
• Self-Insured Medical Reimbursement Plan. Some employers choose to self-insure their health benefits and establish a self-insured medical reimbursement plan to reimburse employees for eligible medical expenses. These plans give employers more control over healthcare costs and may offer flexibility in plan design.

Types of Section 105 HRAs

Employers have five basic options for Section 105 HRA plans

• Integrated HRAs. Integrated HRAs are designed to work alongside a group health insurance plan. Employers can use them to reimburse employees for out-of-pocket medical expenses not covered by the group health plan, such as deductibles, copayments, and coinsurance.
• Qualified Small Employer HRA (QSEHRAs) . QSEHRAs are available to small employers with fewer than 50 full-time equivalent employees who do not offer a group health plan. Employers can use QSEHRAs to reimburse employees for medical expenses, including health insurance premiums, up to a maximum annual limit set by the IRS.
• Excepted Benefit HRAs. Excepted Benefit HRAs are a type of HRA that provides limited reimbursements for certain medical expenses, such as dental and vision care, and premiums for COBRA continuation coverage, short-term health insurance, or other coverage that does not qualify as minimum essential coverage.
• Individual Coverage HRAs (ICHRAs). ICHRAs allow employers of any size to reimburse employees for individual health insurance premiums and other medical expenses. Unlike QSEHRAs, there are no limits on employer size or contribution amounts with ICHRAs. Employees must have individual health insurance coverage to participate in an ICHRA.
• Retiree HRAs. Retiree HRAs are used by employers to provide tax-free reimbursements for medical expenses to retired employees. These HRAs can help retired employees pay for health care expenses not covered by Medicare or other retirement benefits.

How Does a MERP Work? 

MERPs work differently from Section 105 Cafeteria plans in that Section 105 Cafeteria plans can be and usually are at least partially employee-funded. A MERP, in contrast, can only be funded by the employer. Employees cannot contribute to Section 105 Plan MERPs.

The MERP Process

When an employer sets up a MERP, they will establish a set monthly allowance per employee. The MERP will reimburse employees for out-of-pocket medical expenses up to that amount.

With a MERP, employers set a monthly allowance amount for each employee. That allowance represents the maximum amount an employer will reimburse the employee for their monthly healthcare expenses.

If an employee or covered dependent has a need, they purchase whatever healthcare services or goods they need, generally paying for them up front.

In some cases, depending on the type of MERP and the plan rules, employees can also buy ACA-qualified Marketplace coverage on the individual market.

Workers then submit proof of expenses to the plan, and the plan reimburses them.

Section 105 MERP benefits are pre-tax, and not subject to payroll taxes. This potentially saves workers thousands of dollars per year, and results in substantial savings for the employer, as well, thanks to the payroll tax exemption.

With Section 105, the emphasis is on reimbursing employees for the actual medical expenses they incur out of pocket.

Using MERPs to Customize Employee Health Plans

MERPs and health reimbursement arrangements (HRAs) are very similar in concept. However, MERPs have one key advantage over HRAs: Employers can “stack” multiple types of MERPs along with a single underlying health plan.

For example: You can offer employees a high-deductible health plan, which allows your workers to contribute to a health savings account, if desired.

Then, in addition to your basic health insurance plan, you can offer two MERP options to allow employees to customize their health plan to better meet their unique circumstance.

For example, one MERP plan may simply reimburse employees for deductibles under the HDHP, while another separate MERP may include reimbursement for additional benefits, such as dental and vision care and alternative medicine treatments such as chiropractic care.

It’s like allowing workers to choose pizza toppings:

Everyone likes different toppings. But everyone gets the same basic crust and tomato sauce.

The MERPs are the custom toppings on the “pizza” of your basic employer group health plan.

By using multiple MERPs to provide supplemental benefits over and above the base one-size-fits-all group health insurance plan, you can help employees with vastly different coverage needs customize your health benefits to suit their own exact circumstances. 

Eligible Medical Expenses in Section 105 Plans vs. Section 125 Cafeteria plans

Section 105 plans allow for a much broader array of reimbursable medical expenses compared to Section 125 cafeteria plans. 105-eligible plans include a wide range of expenses not covered under individual health insurance plans.

In contrast, only certain types of benefits in Section 125 plans qualify for pre-tax dollar treatment.

• Group health benefits
• Accident and disability coverage
• Adoption assistance
• Dependent care assistance
• Group-term life insurance coverage
• Health savings accounts (HSAs)

There are many other potential benefits for employees that may not be paid for with pre-tax dollars. These include:

• Long-term care insurance
• Employee discount programs
• Commuter benefits
• Gym memberships
• Minimal or de minimis benefits

MERPs vs. Health Reimbursement Arrangement (HRA)s

Health Reimbursement Arrangement (HRAs) and MERPs are very similar in concept: 

• Both allow employers to reimburse employees for eligible medical expenses with tax-free dollars.
• Both are solely employer-funded. Employees cannot contribute to either type of plan.

But HRAs have some restrictions that MERPs don’t.

• HRA rules don’t allow for  stacking multiple types of HRA plans to customize a single health plan.
• With HRAs, you can only have one arrangement per health plan.
• Qualified Small Employer HRAs (QSEHRAs) cannot be coupled with an employer-sponsored group health plan at all.

Table 1. Section 105 Plans Vs. Section 125 Cafeteria Plans

Table 2. Types of Health Reimbursement Arrangements (HRAs)

Section 125 Premium Only Plans

The premium only plan is the simplest form of a Section 125 plan and allows employees to pay their health insurance premiums with pre-tax dollars. This means that.

Unlike more comprehensive Section 125 plans that may include flexible spending accounts (FSAs) for health care and dependent care expenses, a premium only plan is limited to just the insurance premium deductions. It does not include options for pre-tax savings on other types of expenses, like medical out-of-pocket costs or dependent care costs.

Employers who offer a premium only plan must create a written plan document that outlines the benefits, establish the plan with the IRS, and adhere to certain non-discrimination tests to ensure the plan doesn’t favor highly compensated employees over others.

These plans only reimburse employees for insurance premiums, and not for anything else.

Eligibility

Section 125 eligibility criteria.

Generally, most W-2 employees can participate in your Section 125 plan. However, the following categories of workers are not eligible to participate:

• Self-employed workers
• Partners (within the partnership)
• Shareholders with more than a 2% interest in an S-corporation

Section 105 Plan Eligibility Criteria

• Generally, anyone considered a statutory employee can participate in a 105 plan.
• Owners are not eligible – unless they are owner-employees of their own corporation or LLC.

Section 125 or Section 105: Which Should You Choose?

Both of these types of plans have advantages that are worth consideration for employers of all sizes.

But they have important differences in plan design, contribution structure, and in what types of expenses are qualified for the most favorable tax treatment.

The main difference between these two sections is in how these benefits are funded.

If you are planning on having the company pay for all these benefits, then Section 105 may be the way to go.

Section 105 allows employees to use your benefit for a much wider array of qualified medical expenses than Section 125 plans. And you as the employer still get the same tax benefits: Contributions to Section 105 plans are fully deductible to the employer, and not taxable to the employee.

This is much more tax efficient than trying to provide an equivalent value in direct cash or other taxable compensation.

The drawback to Section 105 plans is that they must be 100% employer-funded. Employees don’t get to contribute to Section 105 plans.

That’s where Section 125 Cafeteria plans have some important advantages:

Unlike Section 105 plans, Section 125 plans let employees contribute to the costs of running these plans via pre-tax payroll deductions.

This reduces taxes for the employee, reduces payroll taxes for employers, and helps provide the maximum “bang for the buck” when it comes to offering employee benefits.

Section 125 plans are extremely flexible: It’s easy for employees to pick and choose which benefits suit their lifestyle and circumstances best. So there are no worries about imposing a “one-size-fits-all” package on a diverse workforce.

And because they are employee funded rather than funded out of company coffers, Section 125 plans allow you to provide these valuable benefits at little to no cost to the employer.

How To Start a Section 125 cafeteria plan

Here’s a step-by-step guide to help you get started offering a Section 125 cafeteria plan.

• Choose a plan administrator. You will need to choose a plan administrator to manage your cafeteria plan. You can have someone do this in house, but the vast majority of small businesses outsource this function to a third-party benefits administrator.
• Determine which benefits to offer . You will need to decide which benefits to offer in your cafeteria plan. Consider surveying your employees to find out which benefits are most important to them.
• Set up your plan documents. Your plan document outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You can work with your plan administrator or consult with a benefits consultant or attorney to help you draft your plan documents.
• Communicate the plan to your employees. Once your plan is in place, you will need to communicate it to your employees. Provide them with information on the benefits offered, enrollment deadlines, and contribution limits. You can also offer educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Monitor and administer the plan. Once your cafeteria plan is up and running, you will need to monitor and administer it on an ongoing basis. This includes processing employee contributions, coordinating with your plan administrator, and ensuring that your plan remains compliant with IRS regulations.

What documents do you need to start a Cafeteria plan?

To start a cafeteria plan, you will need to have several documents in place. Here are some of the most important documents you will need:

• Plan document. A plan document is a legal document that outlines the terms and conditions of your cafeteria plan. It should include information on the benefits offered, eligibility requirements, enrollment procedures, contribution limits, and other important details. Your plan document should also comply with IRS regulations and other applicable laws.
• Summary plan description (SPD). An SPD is a document that summarizes the key features of your cafeteria plan in plain language. It should be written in a way that is easy for employees to understand and should include information on the benefits offered, enrollment procedures, contribution limits, and other important details.
• Enrollment forms. You will need to provide employees with enrollment forms that they can use to elect the benefits they want to participate in. Your enrollment forms should include clear instructions on how to enroll and should collect all the necessary information from employees, such as their name, address, social security number, and benefit elections.
• Employee communications. You should provide employees with clear and concise communications about your cafeteria plan, including information on the benefits offered, eligibility requirements, enrollment procedures, and contribution limits. You may also want to provide educational materials or hold informational sessions to help your employees understand how the plan works and how they can maximize their benefits.
• Plan administration agreements. If you are using a third-party administrator to manage your cafeteria plan, you will need to have a plan administration agreement in place. This agreement should outline the roles and responsibilities of both parties and should include information on fees, services, and other important details.
• IRS forms. You will need to file various IRS forms to establish and maintain your cafeteria plan, including Form 5500, Form 5500-SF, Form 5500-EZ, and Form 1095-C. You may also need to file additional forms depending on the type of plan you offer and other factors.

Note: The documents required to start a cafeteria plan may vary depending on the type of plan you offer and other factors. Employers should consult with a benefits consultant or tax professional to ensure that they have all the necessary documents in place to establish and maintain their cafeteria plan.

If you already use a major payroll vendor, such as ADP, they can help you with the requirements to start a cafeteria plan for your small business.

Section 125 cafeteria plans can be a great way for small business owners to offer competitive employee benefits while also saving money on taxes.

By following these steps, you can set up a cafeteria plan that meets the needs of your employees and helps you attract and retain top talent.

As always, it is important to consult with a tax professional or benefits consultant to ensure that you meet all the necessary requirements and regulations.

Here are some additional articles for further reading: Healthsharing for Small Businesses: What Business Owners Need to Know | Employers: What To Do If Your Humana Group Plan Cancels | The Small Business Health Care Tax Credit: Who Can Get It, How To Claim It

Here are some additional pages related to this article: Healthshare Plans | HSA Insurance Plans | Health Insurance for Small Business Owners

Frequently Asked Questions about Section 125 Cafeteria Plans and HSAs

What is a health savings account (hsa), and why should my business consider offering it.

A Health Savings Account is a tax-advantaged savings account that employees can use to save for qualified medical expenses. Offering HSAs can help attract and retain employees by providing a valuable benefit and potentially reducing their tax burden.

Can small businesses offer HSAs to their employees?

Yes, small businesses can offer HSAs as part of their employee benefits package, regardless of their size. However, there may be certain eligibility requirements and contribution limits to consider.

What is a Section 125 “cafeteria” plan, and how can it be used with HSAs?

Section 125 cafeteria plan is an IRS-approved arrangement that allows employees to pay for certain benefits on a pre-tax basis. It can be used to offer HSAs alongside other eligible benefits, such as health insurance premiums.

What are the advantages of using a Section 125 plan to offer HSAs?

By utilizing a Section 125 plan, employees can contribute to their HSAs with pre-tax dollars, reducing their taxable income and potentially saving on payroll taxes for both the employer and employee.

Are there contribution limits for HSAs under a Section 125 plan?

Yes, there are annual contribution limits set by the IRS. For 2024, the limit for individuals is $4,150, and for family coverage, it’s $8,300. Additional “catch-up” contributions of $1,000 per person are allowed for employees aged 55 or older.

Can employees use HSA funds for non-medical expenses?

HSA funds used for non-medical expenses are subject to income tax and an additional 20% penalty. However, after age 65, HSA funds can be withdrawn for any purpose without the additional penalty (though income tax may still apply).

Can employees use their HSA funds to pay health insurance premiums?

The general rule is that HSA funds cannot be used to pay health insurance premiums, though there are exceptions. For example, taxpayers can use HSA funds to pay health insurance premiums while collecting federal or state unemployment, or to pay COBRA continuation coverage premiums.

If a taxpayer uses HSA dollars to pay for other medical insurance premiums other than COBRA or while collecting unemployment benefits, the withdrawal will be deemed a non-qualified medical expense. Any such withdrawals would be subject to income tax and a 20% penalty if the individual is younger than age 65 and not disabled.

Can employees use HSA funds to pay long term care insurance premiums?

Yes, subject to certain limitations that vary by age.

Are there any reporting or disclosure requirements for employers offering HSAs?

Employers offering HSAs may have reporting requirements, such as providing Form W-2 with HSA contributions and reporting HSA contributions on Form 5500 for larger plans. It’s important to stay compliant with IRS regulations.

Can employees carry over their HSA funds from year to year?

Yes, unlike Flexible Spending Accounts (FSAs), health savings accounts don’t have “use it or lose it” provisions. HSA funds can be carried over from year to year, and compound tax-deferred as long as the money remains in the HSA. Employees can accumulate and invest their HSA funds, building a long-term savings account for future healthcare expenses.

What happens to an employee’s HSA if they leave the company?

HSAs are individually owned, meaning the account stays with the employee even if they change jobs or leave the company. They can continue using the funds for eligible expenses or save for future medical costs.

Can employees contribute to an HSA if they have other healthcare coverage?

Generally, employees can contribute to an HSA as long as they have an HDHP and meet the other eligibility requirements. However, additional healthcare coverage like non-HDHP plans, Medicare, or access to TRICARE or VA health care may disqualify individuals from being able to make pre-tax HSA contributions.

However, those individuals can still use their HSA dollars for qualified medical expenses tax-and-penalty free.

Are there penalties for non-qualified HSA withdrawals?

Yes, non-qualified HSA withdrawals may be subject to income tax and an additional 20% penalty, up until age 65. After age 65, withdrawals for anything other than qualified medical expenses remain subject to ordinary income tax, similar to a traditional IRA. However, the 20% penalty goes away.  Health Savings Accounts can be a very useful tool for supplementing retirement income.

However, it’s crucial for employees to understand the rules surrounding what constitutes a qualified medical expense to avoid any penalties. Full information about qualified medical expenses can be found in IRS Publication 502 – Medical and Dental Expenses .

Should I consult with a benefits broker or professional to help set up an HSA and Section 125 plan?

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How to Write a Cafe Business Plan

Cafes are gathering grounds for people from all walks of life – plan your next cafe with this business plan template.

Tyler Martinez Author

Tyler Martinez

Coffee Shop Business Plan Template

Use this free coffee shop business plan template to easily create a great business plan that organizes your vision and helps you start, grow, or raise funding for your coffee shop., TEST

Use this free coffee shop business plan template to easily create a great business plan that organizes your vision and helps you start, grow, or raise funding for your coffee shop.

Business Plan for Cafes Guide

Great cafes are a combination of particularly good coffee, an inviting space to linger, and delicious treats to snack on while hanging out. Falling somewhere between a coffee stand, a sandwich shop, and a bistro, cafes occupy a  unique and vital place in the restaurant economy. But it is the space that they provide for people to meet, gather, share food, work, or just be in public that is distinct about a cafe.

The cafe is a lower-stakes business model that requires lower start-up costs and overhead than larger restaurants, but carving a space for your cafe in the market and charting a path to success are important considerations of opening any new cafe business. There's likely another cafe nearby, so how will you make sure to stand out?

Why You Need a Cafe Business Plan

Finding an open spot in the market for a cafe, and setting yourself apart from the local competition, will be necessary for the success of your business.

Building a business plan gets you to start making concrete decisions about your cafe, the space you will create, the types of food and beverages you’ll serve, and the kind of customer experience you imagine creating.

Curating a space where people gather to meet, conduct business, read, study, and eat takes detailed and nuanced decision making about the intricate overlapping details of your business model – details that you can begin to map out with this business plan. It takes a lot of work to open a cafe, and there's dozens of things to cross off a list, so business plans help keep you on track. They're also extremely useful when you're seeking out funding for your new business: business plans help show you're thinking about building a sustainable cafe that's set to be open (and successful!) for years to come.

How to Write a Cafe Business Plan (Description, Examples, Proposals)

Starting a writing project is often the most difficult part, contending with the unlimited possibility of a blank page. So don’t start with a blank page. Use this fully customizable cafe business plan template to start envisioning your next cafe, and read on to learn what to add in each section.

Related Restaurant Resources

• Cafe Business Plan Executive Summary
• Cafe Financial Plan
• Cafe Operations Plan
• Cafe Industry Market Analysis
• Cafe Management Team

Cafe and Bakery POS Comparison Tool

A free, customizable Cafe and Bakery POS Comparison Tool to research and compare point of sale systems in one Excel spreadsheet or editable PDF.

Elements of a Cafe Business Plan

Executive summary.

The first section of your business plan is your primary opportunity to catch the attention of potential investors and partners. Keep your audience in mind while providing a concise summary of your vision and motivations for opening a cafe.

Describe key elements of your business plan, such as the business’s mission and core values, an overview of the budget, and a coherent vision for your brand in vivid detail that provides information and gets potential partners excited about the opportunity to invest.

Paint a picture of the space you’ll be creating, who will use that space, and how it will become and stay a successful business model. Answer questions like what type of experience will you be providing and why customers will want to return.

Company Overview

This section is a comprehensive summary of your business plan and focuses on the detail that the executive summary replaced with persuasive tactics. The company overview is more practical than attention-grabbing. It works as a glossary and guide for the rest of your cafe’s business plan.

Start with a definition of your cafe. Is it espresso-focused, a tea house, a cozy stop for breakfast sandwiches and drip coffee, or a grab-and-go commuter cafe? Also introduce information about the ownership structure, financial projections, market analysis, publicity strategy, and the roles you’ll need to find talent to fill.

The company overview also gives you a chance to introduce branding, graphics, any charity work your business will engage in, and all the more conceptual visions of your brand. Between the executive summary and company overview, your audience should know about your business plan and where to look in the document for information about key elements.

Team and Management

The staffing needs of your cafe should be outlined in detail in this section. First, define your role in the cafe. Are you the research and development team, general manager, a hands-off owner who deals with timesheets, or some combination of those roles?

Use this section to plan the people structure of your business model. Give investors a picture of who is going to manage your cafe, build schedules, make the drinks and food, develop recipes, do marketing and publicity, and how they will work together to curate the customer experience of your cafe.

Make a timeline for hiring and training new staff and what you expect from each role. Staffing needs are a major factor in planning for your cafe’s budget and financial projections, so it’s crucial that you are detailed in this section to inform accurate financial estimates.

Sample Menu

Cafe menus are best when a little bit predictable and a little bit fun, and the sample menu is the heart of a good business plan. It communicates the types of food and beverages that you plan to serve, the equipment needed to serve those items, and the supply chains you’ll be entering to keep those stocked in your store(s).

If espresso drinks are on your menu, provide information in this section or elsewhere about the kind of espresso machine you’ll purchase, which can be a major investment depending on quality. Make the same kinds of decisions about grills, blenders, ovens, and the other cooking and kitchen equipment that you’ll need for your cafe. 

Those things will factor into your budget so it’s important to outline those decisions here. Design sample menus that let investors feel your passion for the food, drinks, and the experience you plan to create for customers.

Restaurant Menu Templates

Use these menu templates as a starting point for your menu design or to give your menus a refresh.

Market Analysis

The market analysis provides a detailed look at the location of your cafe, the customers that location gives you access to, how you’ll expand your reach with online ordering or delivery, and the competition you’ll encounter in that area. Use this section to impress upon your potential investors that you’ve charted a path to success  for your cafe before spending any of your (or their) investment. 

This section might include information about your motivations for opening a cafe and why you think it’s the right time for you, specifically, to enter this market. It’s a great opportunity to calm potential investors’ anxieties about partnering with your cafe. 

Marketing and Publicity

Once you’ve pinpointed the kind of customer you’re planning to serve, make a plan to grab and keep their attention. A grand opening might not be the right fit for a cafe so you might consider a soft opening instead to generate some mystique and word-of-mouth publicity for your brand.

A solid marketing and publicity strategy lets your investors know that you’re not just business savvy, but that you can convince customers to buy what you offer, which will help to impress them into investing or partnering in your cafe. Many coffee shops go all-in on digital marketing, staying active on social media and ensuring they have a robust web presence with a great website.  

Restaurant Marketing Plan

Create a marketing plan that'll drive repeat business with this customizable marketing playbook template and interactive calendar.

Branded Graphics

Because there is so much competition in the coffee market, a clear, cohesive brand is crucial to helping you attract customers — then, your consistent, quality coffee and service will create regular customers once they're in the door.

Creating graphics for your new cafe that capture the ethos of your brand and communicate it to customers in a memorable way is one of the most fun parts of planning a new business. Work with a designer or use the software available to you to create typography and logos that work coherently with your vision for your brand.

Graphics will be present in your cafe, on the packaging, on your websites, and will stick in your customers’ minds for brand recognition. Plan carefully how you want to brand your cafe because rebranding can be risky and costly.

Emissary , a cafe in Washington DC, uses a minimal style and simple typographic logo to foreground their commitment to a fresh menu and quality espresso beverages. Think about how you might capture your cafe’s style and mission with graphics like Emissary has.

Business Operations

The business operations section is where you plan for how your business will run from the micro-level of each customer transaction to the macro-level of quarterly and yearly profit and loss statements. If sample menus are the heart of the business plan, the business operations section is the brain, responsible for storing, sorting, and applying the information in the rest of the plan.

Map the network of operations that keep your business running smoothly. Include information about seasonal recipes, special drinks, or annual promotions that will make up for losses taking in slower parts of the year. The details of loyalty programs and how all the operations work together to create a customer experience worth returning for would also be at home in the business operations section.

Sales Forecasts and Operating Expenses

Use this section to carefully combine the details from across your cafe’s business plan and make a budget of your operating expenses. These include the costs of running your cafe, including training, equipment, maintenance, labor, supplies, rent, loan payments, etc. 

Business plans commonly include a “break-even analysis” which compares the sales required to break even with the cost of expenses each month. Investors will be interested in the potential for profit and loss to assess the risk of contributing to your business, but a profit and loss statement for a business that isn’t open yet requires some educated projections.

A cash flow analysis shows investors that the company can support itself without additional investments by detailing planned spending on labor, supplies, and operations.  Be sure to consider how the costs unique to your brewery, such as cleaning supplies or seasonal labor costs, balance at the end of each quarter.

Financing and Loans

The startup costs for a cafe will depend on a number of factors, such as the quality of equipment, coffee, teas, and foods you plan to serve. Use this section of your business plan to prepare to purchase equipment, pay to hire and train staff, purchase licenses, rent or lease a space, and market your cafe’s opening.

Consider all your financing options when planning to open a cafe – including lines of credit, small business administration (SBA) loans, merchant cash advances, crowdfunding, commercial real estate loans, equipment financing, purchase order financing, and bank or alternative loans.

How to Present a Cafe Business Plan

There are a few ways to prepare to communicate with investors about your business plan and get them interested. It can be helpful to build out a full-length presentation that you'll share at formal investor meetings, and then distill the main takeaways down to a short pitch of a few minutes for when you're trying to secure that meeting. Then, going even more condensed, a well-crafted 30-second elevator pitch can help you entice lots of potential investors in a wide variety of situations: from parties to networking events. Be sure to include something exciting or make an opportunity for questions to keep people talking.

It’s good to anticipate potential questions and prepare answers for questions you encounter for the first time. When networking, be honest and genuine, even if you don’t have a ready answer for each question that comes your way – just let your listeners know that you'll get an answer to them at a later date, and then follow up as soon as possible. 

Send your business plan to investors and banks far and wide – put your concept and plan in the hands and minds of as many people as possible. You can’t hear no (or yes!) unless you ask.

Related Cafe Resources

• Cost to Open a Cafe
• Cafe Business Plan Template
• Cafe Equipment List
• Best Cafe Websites
• Cafe Marketing Ideas
• How to Do Cafe Branding
• Cafe Ideas and Concepts
• Cafe Menu Ideas
• Cafe Name Ideas
• Cafe Floor Plans
• Cafe POS Comparison Tool

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DISCLAIMER: This information is provided for general informational purposes only, and publication does not constitute an endorsement. Toast does not warrant the accuracy or completeness of any information, text, graphics, links, or other items contained within this content. Toast does not guarantee you will achieve any specific results if you follow any advice herein. It may be advisable for you to consult with a professional such as a lawyer, accountant, or business advisor for advice specific to your situation.

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• What Is a Section 125 Plan?

Who Can Open a Section 125 Plan?

Use it or lose it, setting up a section 125 plan, the bottom line.

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About the Section 125 (or Cafeteria) Plan

Thomas J Catalano is a CFP and Registered Investment Adviser with the state of South Carolina, where he launched his own financial advisory firm in 2018. Thomas' experience gives him expertise in a variety of areas including investments, retirement, insurance, and financial planning.

Numerous employers across the U.S. set up and use various types of employee benefits plans allowed by the Internal Revenue Service (IRS) . One of these plans, the Section 125 (or cafeteria) plan , has been in existence since 1978. It offers some interesting advantages. 

Key Takeaways

• A Section 125 or cafeteria plan is an employer-sponsored benefit plan that gives employees access to certain taxable and nontaxable pretax benefits.
• The plan can be made available to employees, their spouses, and their dependents. Former employees are also allowed access, but the plan can't exist primarily for such people.
• Employees must be allowed to choose from at least one taxable benefit, such as cash, and one qualified benefit, such as a Health Savings Account.
• Employees agree to contribute a portion of their salary on a pretax basis to pay for the qualified benefits and that portion is not considered wages for federal income tax purposes.
• Cafeteria plan contributions are not usually subject to FICA taxes, which help fund Social Security or Medicare, or FUTA taxes, which fund the federal unemployment insurance program.

What Is a Section 125 (or Cafeteria) Plan?

A Section 125 plan is part of the IRS code that enables and allows employees to take taxable benefits, such as a cash salary, and convert them into nontaxable benefits. These benefits can be deducted from an employee's paycheck before taxes are paid. Cafeteria plans are particularly good for participants who have regular expenses that are related to medical issues and child care.

Employees who are enrolled in a Section 125 plan can set aside insurance premiums and other funds pretax, which can then go toward certain qualified medical and childcare expenses. Depending on where they live, participating employees can save from 20% to 40% in combined federal, state, and local taxes on a variety of items that they typically already purchase with out-of-pocket post-tax funds. Employers can save an additional 7.65% on their share of payroll taxes.  

Section 125 plans must be created by an employer. The benefits are available to employees, their spouses, and their dependents when a plan is created. Depending on the circumstances and details of the plan, Section 125 benefits may also extend to former employees but the plan cannot exist primarily for them.

Benefits to Employers and Employees

Section 125 plans offer employers a lot of tax-saving benefits. Employers save on the Federal Insurance Contributions Act (FICA) tax, the Federal Unemployment Tax Act (FUTA) tax, the State Unemployment Tax Act (SUTA) tax, and workers' compensation insurance premiums for each participant in the plan. Combined with the other tax savings, the Section 125 plan usually funds itself because the cost to open the plan is low.

As an added advantage, employees receive an effective raise without any additional cost to the employer. More participants in the plan equate to more tax savings for the employer so the employer is often encouraged to contribute to each employee's plan to promote increased participation by those who are not yet in the Section 125 plan.

The primary benefit is also tax-related for employees. A participant can typically expect to save 20% to 40% of every dollar put into the plan. The amount that the employee decides to put into the plan must be chosen each year. The "election" amount is deducted from the employee's paycheck automatically for each payroll period.

For example, $25 per pay period is automatically deducted tax-free if an employee elects to have $600 per year deducted from their pay and placed into the plan and the company has 24 pay periods. The money is sent to the plan's third party administrator to be held. It can then be distributed for reimbursement upon request for qualified expenses.

What Expenses Can a Section 125 Plan Cover?

A wide variety of medical and childcare expenses are eligible for reimbursement under a Section 125 plan. Dozens of eligible expenses for medical items and treatments can be reimbursed.

Eligible expenses include acupuncture, treatment for alcoholism, ambulance services, birth control, chiropractic services, dental and doctors' fees, eye exams, fertility treatment, hearing aids, long-term care services, nursing homes, operations, prescription drugs, psychiatric services, sterilization, wigs, and wheelchairs.

There's also a large variety of eligible over-the-counter items. Allergy medicines, cold medicines, contact lens solutions, first-aid kits, pain relievers, pregnancy tests, sleeping aids, and throat lozenges are among the dozens of eligible items.

Many dual-purpose items are eligible, such as dietary supplements, orthopedic shoes, prenatal vitamins, and sunscreen.

Section 125 plans do state that you must use any remaining funds in the account by the end of the year or the money is forfeited to your employer. But a carryover provision that was implemented in 2013 does allow plan participants to extend up to $500 of unused funds from one year to the next.

Contributing to a cafeteria plan may still result in a net benefit even if you do get dinged by an excess amount of funds. Assume that you placed $1,000 in your Section 125 plan. You notice that you have $100 remaining in the account at the end of the year. You've already saved $240 on taxes ($1,000 x 24%) if you're in the 24% marginal tax bracket. Forfeiting the $100 means that you still have a net benefit of $140.

Division EE of the Consolidated Appropriations Act of 2021 offers more discretion for FSA and dependent care assistance programs. The act allows for more flexibility when it comes to carrying over unused balances from plan years 2020 and 2021, as well as extending permissible grace periods for these plan years.

Setting up a Section 125 plan is straightforward. An employer must provide proper documentation, notify employees, and perform nondiscrimination testing. Section 125 plans must pass three nondiscrimination tests that are designed to determine if the plan discriminates in favor of highly compensated or key employees of the business: eligibility to participate, benefits and contributions, and concentration tests.

Cafeteria plans have different levels of benefits. A premium-only plan (POP) allows employees to pay their portion of insurance on a pretax basis. The flexible spending account (FSA) version allows for out-of-pocket qualified expenses to be paid pre-tax.

The full-blown plan is a consumer-driven healthcare (CDHC) plan. It involves a credit system that the employee can use on a discretionary basis for qualified expenses. Employees can then supplement the CDHC with their own money and use it to buy additional benefits or coverage.

Employers must hire and partner with a qualified Section 125 third party administrator who can provide the most up-to-date documentation for setting up a plan and update the employer on the latest requirements necessary for compliance. Typical third party administrators provide employers with an up-to-date plan document, summary plan descriptions, corporate resolution, customized forms, legal review, attorney opinion letters, discrimination testing, a signatory-ready Form 5500 if required, and employee education.

What Is Included in a Section 125 Plan?

A Section 125 plan typically lets employees use pretax money to pay for health insurance premiums for medical, dental, and vision. Other options include retirement deposits, supplemental life or disability insurance, Health Savings Accounts, and various medical or dependent care expenses.

What Is a Section 125 Premium-Only Plan?

A Section 125 premium-only plan (POP) is a cafeteria plan that allows employees to pay their health insurance premiums with tax-free dollars. As the name implies, these premiums are the only expense that the funds can cover. The premiums can be for employer-sponsored insurance plans or individual health policies. POPs are one of the most common types of Section 125 plans.

Who Isn't Eligible for a Section 125 Plan?

The Section 125 rules specifically prohibit the following individuals from participating in plans:

• Self-employed individuals
• Partners within a partnership
• Shareholders who own more than 2% of a subchapter S corporation

A Section 125 plan lets employees set aside insurance premiums and other funds on a pretax basis. This can save workers 20% to 40% in taxes per year but these plans offer employers some tax-saving benefits as well. It can be worth it to suggest that your employer set up such a plan or keep it in mind if you're job hunting so you can potentially hire on with a company that does offer a cafeteria plan.

IRS. " FAQs for Government Entities Regarding Cafeteria Plans ."

Cafeteria Plan Advisors. " Section 125 Cafeteria Plan - Premium Only Plan ."

National Conference of State Legislatures. " States' Use of "Cafeteria Plans" to Provide Health Insurance ."

IRS. " Publication 502 (2022), Medical and Dental Expenses ."

IRS. " Publication 15-B (2023), Employer's Tax Guide to Fringe Benefits ."

IRS. " Internal Revenue Bulletin: 2013-47 ."

IRS. " Additional Relief for Coronavirus Disease (COVID-19) Under § 125 Cafeteria Plans ."

PeopleKeep. " FAQ: What is a Section 125 POP (premium-only-plan) ."

Journal of Accountancy. “ Cafeteria Plan Compliance .”

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Section 125 (or cafeteria) plan: types and benefits.

Giving key employees a benefits package that is both affordable and appealing can be difficult for many firms. Despite the fact that rising healthcare prices have an impact on benefit costs, a section 125 plan, often known as a cafeteria plan, enables you to increase employee benefits without going over budget because of its considerable tax savings.

Section 125 plans are a fringe benefit that employers who want to compete for the best talent can use to entice and retain workers. A cafeteria plan, when implemented properly, can boost an employee’s take-home pay without affecting their remuneration.

Read on as we take a closer look at everything to do with a Section 125 plan. Including the different types, who can open one, the qualified benefits, and what expenses are covered.

Table of Contents

What Is a Section 125 (Or Cafeteria) Plan?

Types of section 125 plans, who can open a section 125 plan, benefits of section 125 plan, expenses covered in section 125 plan, how do you set up a section 125 plan, can you change a cafeteria plan, key takeaways.

Frequently Asked Questions

A Section 125 plan is a provision of the Internal Revenue Service (IRS) law that permits employees to convert taxable benefits, like a cash salary, into nontaxable benefits. Before taxes are paid, these perks may be taken out of the paycheck of an employee. Participants who often incur costs for child care and medical concerns benefit most from these programs.

Section 125 is also known as a cafeteria plan. 

Employees who participate in a Section 125 plan have the option to prepay insurance premiums and any further expenses that can later be used for certain child care and qualified medical costs.

Any employees that take part in this plan can save between 28% and 48% in cumulative local, state, and federal taxes. This is on a range of things that they generally already buy with their own money after taxes, depending on where in the country they reside.

Employers can reduce their portion of payroll taxes by an additional 7.65%.

There are a few different types of Section 125 plans. Typical examples of cafeteria plans include:

Premium Only Plans (POP)

The pretax contributions made by an employee under this type of plan may only be used to pay the premiums for group health insurance.

Flexible Savings Arrangements (FSA)

Pretax funds are saved by employees who participate in an FSA and can be used to pay for certain medical expenses. Such plans have an annual cap on contributions, and any funds left over at the end of the calendar year are forfeited.

Simple Cafeteria Plans

If they offer the same benefit payments to every eligible employee, employers with 100 workers or fewer are exempt from the plan non-discrimination requirements.

Full Flex Plans

Benefits are purchased by qualified employees with company contributions. The employee may use pretax payroll deductions to cover any benefit that isn’t fully provided by the company.

An employer must design and open Section 125 plans. This is employers that include: 

• Government entities
• Sole proprietorships
• C corporations
• S corporations
• Partnerships

Benefits are made available to the employees of a company, their married partners, as well as their dependents when a plan is established. Former employees may potentially be eligible for Section 125 benefits. Although this is dependent on the specifics of the cafeteria plan, this also cannot be the plan’s primary purpose.

However, not every employee who works for the company is eligible to take part in the plan. A section 125 plan is not open to non-employees, including:

• 1099 contractors
• Individuals who hold more than 2% of the S corporation,
• LLC members
• Partnership partners

Benefits to Employer

Section 125 plans have a variety of tax-saving advantages for employers. Employers save money on workers’ compensation insurance premiums, the Federal Insurance Contributions Act (FICA) tax, the Federal Unemployment Tax Act (FUTA) tax, and the State Unemployment Tax Act (SUTA) tax for each member in the plan. 

The Section 125 plan typically pays for itself. This is since the expense of actually opening the plan is cheap when paired with the additional tax savings.

The fact that employees get a rise without the firm having to pay more is an extra bonus. The company is frequently urged to make a contribution to each individual employee’s plan in order to encourage higher participation by individuals who are not yet enrolled in the Section 125 plan, as more members in the plan amount to further tax savings for the employer.

Benefits to Employee

The main advantage for employees is also very much tax-related. Anyone participating in the plan can typically anticipate saving 20% – 40% of each and every dollar invested in the plan.

Each year, the employee must pick how much money to contribute to the plan. Every payment cycle, an automatic deduction for the “election” amount is made from the paycheck of the employee.

If an employee chooses to have $1200 per year withheld from their paycheck and invested in the plan, for instance, and the business has 24 separate pay periods, $50 is automatically and tax-free withheld from each pay period.

The third-party administrator of the plan receives and holds the funds. On request, it is then given out for repayment of acceptable expenses.

Under a Section 125 plan, a wide range of child care and medical expenses are available for reimbursement. Numerous qualified expenses for medical supplies and procedures are eligible for reimbursement.

Expenses that qualify for this include:

• Ambulance services
• Birth control
• Chiropractic care
• Dental and physician fees
• Fertility treatments
• Hearing aids
• Long-term care services
• Nursing homes
• Prescription drugs
• Psychiatric services
• Sterilization
• Wheelchairs

There are also many different qualifying over-the-counter products available such as:

• Prenatal vitamins
• Orthopedic shoes
• Allergy medications
• Cold remedies
• Contact lens solutions
• First aid supplies
• Painkillers
• Pregnancy tests
• Sleeping pills
• Throat lozenges

In summary, the benefits that are included in Section 125 Plan include: 

• Societal health advantages
• Coverage for accidents and disabilities
• Adoption support
• Aid with dependent care
• Term life insurance for groups
• Health savings accounts (HSAs)

A Section 125 plan can be created in a fairly simple manner. An employer is required to carry out nondiscrimination testing, notify workers, and provide the appropriate documents. 

The three nondiscrimination standards that must be passed by Section 125 plans are the:

• Eligibility to participate
• Benefits and contributions
• Concentration tests

These tests are used to assess whether the plan favors employees who earn a high wage or important employees of the company.

Different benefits are offered by cafeteria programmes. Employees may pay their fair share of insurance premiums. This is normally done on a pretax basis under a premium-only plan (POP). The out-of-pocket eligible expenditures can be paid pre tax under the flexible spending account (FSA) version, which is the design of the above-described plan.

The comprehensive plan, known as a consumer-driven healthcare (CDHC) plan, includes a credit system that the employee may utilize at their discretion for permissible costs. Then, employees can use their own funds to complement the CDHC and purchase other perks or coverage.

Employers are required to work with a competent Section 125 third-party administrator that can offer the most recent documents for establishing a plan and keep the employer informed of the most recent compliance requirements.

Typical services provided by third-party administrators to employers include:

• A current plan document
• Summary plan descriptions
• Corporate resolution
• Any customized forms
• Legal review
• Attorney opinion letters
• Discriminatory practices testing
• A signatory-ready Form 5500 if it is required
• Employee education

Except in the case of a qualifying life event, employees who have already enrolled in a cafeteria plan and made their selections often cannot change them. This is normal until the following open enrollment period.

A qualifying life event counts as the following events: 

• Marriage, divorce or legal separation
• Adoption or childbirth
• Involuntary loss of coverage under another plan
• Your employment status changing
• Going past the age limit of a parent’s plan

These circumstances do not suffice in and of themselves to support a special open enrollment. Employees typically need to show proof of their eligibility in the form of a marriage licence, birth certificate, letter from an insurance company, or other legal document.

Today’s workers place a high importance on having a choice of flexible health benefits that enhance their welfare and the wellbeing of their families. Because they enable companies to provide eligible benefits that draw and keep talent while lowering their own and their employees’ tax obligations, section 125 plans continue to be popular.

To choose the best plan for them and make sure they adhere to Affordable Care Act rules, employers should discuss their options with benefits administrators. As well as gain the advice of legal counsel.

FAQS on Section 125

Who needs a section 125 plan.

Pre-taxed employee benefits are required by the IRS. Yes, a Section 125 plan document is required if you’re an employer that wants to permit salary deductions from employees’ pre-tax wages to be used to pay for group health as well as other insurance premiums.

What Is the Difference Between Section 125 and HSA?

Employee contributions to a Section 125 HSA are collected as pre-tax payroll deductions in accordance with the election form filled out during open enrollment. Although monies placed into an HSA are instantly available to cover or repay eligible medical expenses, the yearly election amount is not pre-funded.

Who Is Not Eligible for the Section 125 Plan?

Some of the entities that are ineligible for the Section 125 plan include self-employed people, partners in a partnership, and people who possess more than 2% of a subchapter S corporation.

What Is the “Use It or Lose It” Policy?

It is a requirement of Section 125 plans that you use any remaining monies in the account at the end of the calendar year or forfeit them to your employer. It is possible for plan participants to carry over up to $500 of leftover funds from one year to the next. This is thanks to a carryover provision that was put in place in 2013.

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Taking Another Look at Cafeteria Plans

Benefit choices for health care and caregiving are more important than ever

Cafeteria plans are getting new attention during the pandemic as a way to let employees select—and fund with pretax dollars—optional insurance benefits and spending accounts that meet their health and caregiving needs.

Also called Section 125 plans (after the relevant section of the tax code), cafeteria plans are used to direct employee contributions to group health plans and 401(k) retirement plans. During the COVID-19 pandemic, however, they've received renewed attention as a way to let employees use pretax dollars to fund supplemental health care, such as critical illness insurance . They also channel salary-deferred contributions to health savings accounts (HSAs), health flexible spending accounts (FSAs) and dependent care FSAs (DC-FSAs), sometimes referred to as dependent care assistance programs, as well as life and disability insurance and even mass-transit debit cards.

"Cafeteria plans are a necessity if your employees are making salary-reduction elections so that a portion of their salary, pretax, is directed toward [health or other insurance] premiums" and tax-advantaged spending accounts, said Heather DeBlanc, a partner in the Los Angeles office of Liebert Cassidy Whitmore. "In order for an employee to divert salary to pretax premiums, a cafeteria plan document must be in place and approved by the governing body of the employer," she explained.

[SHRM members-only toolkit: Understanding Section 125 Cafeteria Plans ]

The Big Picture

Employers shouldn't just take for granted that their employees understand the potential benefits of or how their cafeteria plans work, benefits advisors say. Simply offering benefits through a cafeteria plan is never enough to assure appropriate use. Communication and education are must-do's during open enrollment or when onboarding new hires.

"I am a big believer in total rewards," said Jennifer Barton, who heads World Insurance Associates' employee benefits division. Barton recommends that employers do a total rewards gap assessment. "I think now more than ever, that's important for an organization to assess," she said. Employees' benefits-related needs have shifted and changed during the pandemic—employees' priorities are likely to remain different than they were in the past, especially for those continuing to work remotely, she said.

For instance, while commuter benefits may have been popular before the pandemic, they are likely less so now in some cases, Barton said. Meanwhile, the varying needs of employees working from home, including those related to the care of children and others, is likely to spur interest in caregiving benefits such as DC-FSAs.

"I think the most important thing an HR person could do today is to take stock of what they have for their employees, and then go out and talk to employees" about the benefits they value, those they don't see much value in and those they don't have access to but would like to receive, Barton said.

Whether employee input is gathered through surveys, focus groups or some other means, it's important, she added, "to understand what's critical today given the changing dynamics that employees are facing both at home and in the workplace."

[Related SHRM article: Soliciting Employee Feedback for 2022 Benefits Changes ]

Lin Grensing-Pophal, SHRM-SCP, is a Wisconsin-based business journalist with HR consulting experience.

[Visit SHRM's resource page on  Open Enrollment .]

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6 Key Components of a Cafeteria Plan

As noted in a recent  SHRM study , employers continue to offer more employee benefits to attract and retain talent. In turn, successfully implementing section 125 strategies is smart business.

In this article, I’ll explain why it’s smart business – and the six key components you need to keep in mind to ensure you’re staying compliant.

What is Section 125?

Cafeteria plans, (often called flexible benefit programs or flex plans) are employer-sponsored benefit programs offering tax advantages under §125 of the Internal Revenue Code. A section 125 plan is the only means that an employer can offer employees a choice between taxable income and nontaxable benefits without the choice causing the benefits to become taxable.

A cafeteria plan allows an employee to pay for certain benefits from gross pay, before federal income taxes, Social Security taxes, and, in most cases, state income taxes are deducted.

A premium only plan (POP), or premium conversion plan:  The employer is simply offering a way to obtain favorable tax treatment on benefits already offered. POPs work in the following ways:

• Employees’ premium contributions are automatically deducted from their salaries before taxes are taken out.
• Taxable income is reduced by the amount withheld, so employees pay less in taxes and have more take-home pay.
• With employee taxable income reduced, employers and employees pay less in FICA payroll taxes.
• Premiums sheltered through premium conversion must be for coverage under certain qualified benefits, such as group health coverage.
• Most companies currently have this set up through their payroll provider. A POP plan is the simplest type of §125 plan and requires little maintenance once it has been established, requiring updates when there are changes to things such as plan eligibility or benefits offered.

Written plan requirement.

When an employer adopts a section 125 plan, it must be in writing. To note, a summary plan description (SPD), certificate of coverage, summary of benefits and coverage and a master contract is not a plan document.

The plan document is a written document that describes:

• The participant’s rights.
• The participant’s benefits.
• The participant’s obligations within the plan.
• The terms and conditions for administering the plan.

Every employer who maintains a Health & Welfare Benefit Plan that is subject to ERISA must have a separate written plan document for each of the IRS and ERISA requirements. Your ERISA documents do not satisfy the IRS’ written document requirement for cafeteria plans.

The tax code does not impose any specific disclosure requirements for participants, however, there is an aspect of informing those who are enrolled under ERISA covered benefits – the participants of your plan.

The Summary Plan Description (SPD) is an important written document that a plan administrator must provide automatically and free of charge to participants of an ERISA covered health benefit plan. 

The SPD is designed to inform participants and their beneficiaries of their benefits and rights under the plan. The SPD explains what coverage the plan offers, how the plan operates, and the rights and responsibilities of participants and beneficiaries. It provides information on when an employee can begin to participate in the plan, how service and benefits are calculated, when benefits becomes vested, when and in what form benefits are paid, and how to file a claim for benefits.

Almost every employee benefits plan is required by ERISA to have an SPD on file and it must be distributed to plan participants in a manner that confirms receipt. It is important to note that even though a Third Party Administrator (TPA) or insurer may produce and distribute the SPD, the distribution of the SPD is the sole responsibility of the plan administrator and not the insurer or TPA.

The Department of Labor (DOL) requires plan administrators to provide participants with an SPD within 90 days of coverage or within 120 days of the plans effective date.

Offer of choice.

Not all types of benefits can be offered under a cafeteria plan. The following is a list of benefits that can be included as part of an overall cafeteria plan.

Plans that can be offered via section 125:

• Wellness plan
• Group voluntary life
• Adoption assistance
• Voluntary life
• Voluntary dependent life
• Voluntary AD&D
• Voluntary LTD
• Voluntary STD
• Voluntary long-term care
• Voluntary critical illness and cancer

Plans that can’t be offered via section 125:

• Spousal or dependent life
• Prepaid legal
• Educational Assistance Programs
• Transit-commuter benefits

Remember, a cafeteria plan is a true choice and that enrollment materials and the SPD are going to outline what those choices are and the eligibility provisions that are going to fall right along with that.

Employee benefit.

An important factor to remember is that these plans are truly an employee benefit.

So, who can participate in a cafeteria plan? Check out this chart below.

* The employee must be a ‘bona fide employee’ and must not be deemed to be self-employed (ex. the employee-spouse must not have invested his or her own assets in the business and must not be an owner under state marital or community property laws).

**LLC may elect to be taxed as any of several entities (ex. partnership or C-corp) an LLC members ability to participate in a cafeteria plan depends on the LLC’s tax election status and is outside the discussion of this article

Prospective elections.

While this component may seem like a no-brainer, it’s still an important one to mention. Generally, you have an open enrollment period that gives employees enough time to make conscientious decisions about their upcoming elections. In the case of cafeteria plans, here are some things to note:

• Plans should communicate election periods.
• Initial elections must be prospective.
• Mid-year election changes must only be prospective except in the case of a birth or adoption of a child.
• Qualifying events – generally 30 days’ notice.

Irrevocable elections.

Under cafeteria plans, another key component centers around irrevocable elections.

Here’s the rule: Once an election is made, a participant may not change the election during the period of coverage. Typically, a plan year is 12 months.

The IRS recognizes certain events as permissible mid-year election changes – meaning allowing an exception to the general irrevocability rule. These events fall into these groups:

• Change in legal marital status,
• Change in number of dependents,
• Change in employment status,
• Dependent satisfies or ceases to satisfy dependent eligibility requirements,
• Residence change.
• For adoption assistance provided through a cafeteria plan, the commencement or termination of an adoption proceeding. 
• Cost or coverage changes: These would take effect at the beginning of a cafeteria plan year and are simply communicated as part of open enrollment. However, in some cases, these changes occur at other times (like mid-year). Enabling participants’ pre-tax salary reductions to go with the flow of their component plan cost and coverage changes is what this group of events is designed to do.
• Other laws or court orders: Under this category would include events that coordinate cafeteria plan election changes with requirements under other, non-cafeteria plan laws (e.g., 401(k) rules, HSA rules, HIPAA, COBRA, and health care reform). Of course, this adds a layer of complexity.

Nondiscrimination testing (NDT).

Although it’s sixth on the list, this component is extremely important. Here are a few things to know about NDT .

What is NDT?

The IRS created a series of tests designed to make sure that certain highly compensated participants don’t use or select more nontaxable (pre-tax) benefits than non-highly compensated employees.

Is NDT required?

Yes. In order to document a plan is in compliance, an annual test must be performed, and the results documented for each plan. Because corrections can’t be made after the end of the plan year, the impact and cost of learning a plan failed nondiscrimination testing in previous plan years can be significant.

What happens if my plan fails the test?

Nondiscrimination tests can’t be passed by making corrections after the end of the plan year.

The total amounts withheld from gross income for any health and welfare benefits that fail are included in gross income for highly compensated participants.

The employer must treat the amount of highly compensated employees’ salary reductions as taxable income for W-2 reporting and for income tax, FICA, and FUTA withholding.

When should plans be tested?

The plan tests must be passed as of the last day of the plan year.

What’s next for employers?

Comply, communicate, and distribute.

Here’s a handy checklist of questions to ask yourself when it comes to your benefits offering to make sure you’re properly complying, communicating, and distributing documents to employees.

• Have you amended your documents and verified your administrative practices are consistent with the document?
• Have you amended your POP to allow for the marketplace and stability period plan changes?
• If you renewed your medial plan early, have you amended your plan documents?
• Have you amended your POP document to include HSA contributions made through pre-tax payroll deductions, if applicable?
• Have you completed NDT for your POP plan?

So, after learning these key components on cafeteria plans – are you in compliance?

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What Is a Cafeteria Plan?

Cafeteria Plan Explained

How a Cafeteria Plan Works

Example of a cafeteria plan, do you need a cafeteria plan, how to get a cafeteria plan, frequently asked questions.

Morsa Images / Getty Images

A cafeteria plan is an employer-sponsored program through which employees can elect to contribute pre-tax dollars to benefit accounts for certain qualified expenses including approved medical, dependent care, and adoption expenses.

Key Takeaways

• Cafeteria plans sponsored through an employer can reduce your taxable income.
• You can use the money in your cafeteria plan to pay for qualified medical expenses, contribute to an FSA, or pay health insurance premiums.
• You can use your cafeteria plan to pay for other qualified benefits, like adoption expenses, accident and health benefits, dependent-care costs, group term life insurance, and health savings accounts.

If your company offers a cafeteria plan, you'll most likely be able to sign up during your company’s open enrollment period. If you decide you want to enroll, you can choose or "elect" how much you’d like to contribute to your plan.

You'll be able to be reimbursed throughout the year from this plan for any qualifying expenses. Keep in mind that you can only change your election if you have a qualifying life circumstance. Qualifying circumstances can include marriage, divorce, or a change in employment.

Cafeteria plans are also called Section 125 plans or flexible benefits plans.

Qualified benefits eligible for cafeteria plans include:

• Health insurance premiums (excluding Archer medical savings accounts or long-term care insurance)
• Accident insurance
• Adoption expenses
• Dependent-care expenses
• Group term life insurance coverage
• Health savings accounts, including long-term care services
• Flexible spending accounts (FSA)

When an expense not covered by your health insurance comes up, you can use your cafeteria plan funds to pay for your expenses. Keep in mind, though, that you may lose any unused money you contribute to your plan. Make sure you know whether or not your money will roll over.

Your employer should provide you with documents that detail the plan benefits and any rules or eligibility requirements you need to know about.

Unless your company’s documentation says otherwise, you will forfeit any unused funds left in an FSA at the end of the year.

How Cafeteria Plans Offer a Tax Break

Cafeteria plans tend to reduce your tax liability because your money is taken out pretax. Although the take-home pay initially looks lower, if you're going to need to cover health care costs or dependent care costs, you'll end up saving money by using a cafeteria plan.

“I think that employees often overlook the fact that making an election to contribute to a cafeteria plan will result in a lower tax burden for them,” William Sweetnam, a legislative and technical director for Employers Council on Flexible Compensation (ECFC), told The Balance in an email interview.

“However, since they have to make the salary reduction election at the beginning of the year, an employee may be unaware of the tax benefits that he will have all through the year.”

A health care flexible spending account (FSA) is an example of a benefit offered under a cafeteria plan. A flexible spending arrangement is an employer-sponsored benefit that allows you to contribute pretax dollars to use for out-of-pocket medical or dependent care expenses.

Let’s use a health FSA as an example. During open enrollment, you specify that you want to put $3,050 (the maximum amount allowed in 2023) in your FSA for the year. That amount will be divided by the number of pay periods, and a corresponding number will be withheld from the paycheck every pay period—$117.31 if you’re paid every two weeks.

In the new plan year, the full amount you elected to withhold for the year is deposited into your account by the employer; the employer essentially fronts the account money for the next year.

The money in this account is to be used only for qualified expenses and must only be used within the plan year.

When you incur a qualified expense, you’ll submit proof of payment to the FSA account’s administrators. Reimbursement will come in the form of a check or direct deposit, depending on how your account was set up.

The main benefit of a cafeteria plan is its power to lessen your tax burden by providing benefit accounts for health and dependent-care expenses. If you believe you'll have medical or dependent-care expenses, putting money in this type of plan would most likely help you save.

Determining how much money you want to set aside for the year can be a challenge—one you’ll want to discuss with your benefits administrator. For plans like FSAs, if you don’t use all the money, you’ll lose it, so a cafeteria plan may be a good choice for you if you know you have qualified expenses, and how much they usually cost each year.

Cafeteria plans are available to employees, their spouses, and dependents. If your employer has one, you should be eligible to enroll when hired or during your employer’s open enrollment period.

To find specifics about the program you’re interested in, you can visit your employer’s benefit website or ask your HR representative what might be available.

Self-employed individuals are generally not eligible to set up cafeteria plans.

Employers interested in setting up a cafeteria plan for their employees can begin by adopting a written plan document, making sure employees know their plan elections are irrevocable for the plan year, and satisfying nondiscrimination requirements for the benefits provided.

Is a cafeteria plan the same as a 401(k)?

No. A 401(k) is a retirement account that can be created by an employee or self-employed person. A cafeteria plan is designed to allow employees to pay for medical expenses and dependent care expenses with pre-tax dollars. The money in many types of cafeteria plans will not roll over from one year to the next.

What does a cafeteria plan include?

A cafeteria plan allows employees to put tax-free money into an account that they can use to cover qualifying medical or dependent care expenses. Health savings accounts, health flexible savings accounts , and dependent flexible savings accounts are all types of cafeteria plans.

IRS. " FAQs for Government Entities Regarding Cafeteria Plans ."

TASC. " Section 125 Cafeteria Plan ."

BusinessPlans. " What Happens if There Is Money Left in My Account at the End of the Claim Period After All My Eligible Expenses Have Been Reimbursed? "

SHRM. " 2023 Health FSA Contribution Cap Rises to $3,050 ."

How does my net pay increase by participating in a cafeteria plan?

A Cafeteria Plan is a benefit provided by your employer which allows you to contribute a certain amount of your gross income to a designated account or accounts before taxes are calculated. These accounts are for insurance premiums and medical or dependent care expenses not covered by your insurance, from which you can be reimbursed throughout the plan year or claim period as you incur the expenses. A cafeteria plan allows you to reduce your gross income, thereby reducing the amount you pay in Federal, Social Security and some State taxes – a savings of between 25% and 40% of every dollar you contribute to the plan.

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Cafeteria Plan

Summary Definition: A type of benefits arrangement that allows workers to choose from several pre-tax benefits.

• What is a Cafeteria Plan?

A cafeteria plan is a type of benefit plan offered by employers that allows employees to choose between taxable and non-taxable benefits.

The cafeteria part of the name comes from the plan’s flexibility, which allows employees to pick which benefits they want. Conforming to Section 125 of the Internal Revenue Code (IRC) , cafeteria plans are also sometimes called Section 125 plans or Section 125 Cafeteria Plans.

Introduced in the 1970s, modern cafeteria plans cover several types of elective benefits, the most common of which include medical, dental, and vision insurance, as well as Flexible Spending Accounts (FSAs).

Employee Retirement Income Security Act (ERISA)

Most cafeteria plans are also covered by the Employee Retirement Income Security Act (ERISA) of 1974. As such, they must meet the same documentation, reporting, and administrative requirements as retirement plans, such as 401(k) or 403(b) plans. For example, all cafeteria plan participants must receive a summary plan description (SPD) within 90 days of enrolling in the plan.

Key Takeaways

• Cafeteria plans are a type of benefit plan that allows employees to choose which benefits they want to enroll in, such as medical and vision insurance.
• Plans must comply with IRC section 125 and the ERISA, including certain documentation and filing requirements.
• Cafeteria plans offer employees more control over their benefits, but can be more difficult for employers to administer.

In This Article

How a section 125 cafeteria plan works, pros and cons of a section 125 cafeteria plan.

Essentially, an employer will compile a range of benefit options their employees can choose from and then allow employees to enroll in the ones they want during an open enrollment period. Employees then use voluntary deductions from their paychecks to pay the premiums on those enrolled benefits.

To comply with the IRC, employers must offer their employees at least one taxable and one non-taxable (aka qualified) benefit. Qualified benefits are those that aren’t included in an employee’s gross income, like dependent care assistance and group term life insurance.

Types of Section 125 Cafeteria Plans

Employers have a few options when deciding what kind of plan and benefits they want to offer their employees:

• Health Savings Account (HSA) – These allow employees to contribute pre-tax wages into an account that they can use to cover medical expenses.
• Flexible Spending Account (FSA) – Similar to an HSA, employees contribute pre-tax wages into a savings account and use it to cover medical expenses. However, unlike an HSA, any unused funds still in the account after the end of the plan year are lost.
• Dependent Care Assistance Plan (DCAP) – A more specialized version of an FSA that employees can use to cover the costs of caring for children under 13 or elderly parents, such as babysitting or in-home care expenses.
• Premium-Only Plan (POP) – This allows employees to pay their insurance premiums with their pre-tax wages, thus reducing their taxable income.

Cafeteria Plan Documentation and Filing Requirements

To show compliance with Section 125 guidelines and ERISA, employers should maintain a few plan-related documents: a main plan document, an adoption agreement, and an SPD.

Employers can include an adoption agreement within the main plan document or keep them separate. Regardless, these two documents should cover all the plan’s offerings, benefits, and legal obligations for the employer.

The SPD is a shorter version of the main plan document that’s intended for employee use. All eligible employees should receive an SPD, and it should be refreshed approximately every five years to show any changes or legislative updates.

Finally, the filing requirements for a cafeteria plan can vary based on whether it offers any welfare benefits. If it does, the employer may need to submit a Form 5500 to the U.S. Department of Labor annually.

Learn More: The 14 Best Employee Benefits to Dazzle Your Talent

Related Glossary Terms

• Qualifying Life Event (QLE)
• Affordable Coverage
• Open Enrollment

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What is a Section 125 Employer Health Insurance Plan (Cafeteria Plans)?

Just the Essentials...

• A Section 125 cafeteria plan allows employees to choose between several taxable and non-taxable benefits.
• Employees can save on taxes by setting aside money to pay for these benefits.
• Benefits include insurance premiums, flexible spending accounts, child care assistance, and retirement plans. 
• Plans are only available through employers and must be offered on a non-discriminatory basis.

What is a Section 125 Cafeteria Plan?

A Section 125 plan, also known as a cafeteria plan, is a type of employer-offered flexible benefits health insurance plan . Employees are offered the choice between receiving compensation in cash or as another benefit, such as health insurance. This can lead to substantial tax savings for you and the company. Read on to find out how.

How do Cafeteria Plans Work?

Section 125 plans are called “cafeteria plans” because they allow employees to choose from a list of taxable and non-taxable benefits, much like a cafeteria allows you to choose from a selection of foods. Each year, employees may elect to put a portion of their paycheck into the cafeteria plan in addition to contributions made by their employer. This amount is deducted from their paycheck each month and applied toward one of the plan’s non-taxable benefits.

Cafeteria plans are designed to offer flexibility. In other words, m oney contributed to a cafeteria plan is not taxable income.

The IRS deducts a portion of your paycheck as a tax based on a percentage of what you earned that month. In short, the more you make, the more taxes you pay. That money goes into the system, meaning that while you still eventually benefit from it in the form of Medicare and Social Security, it will not help you right now. 

When you contribute to a cafeteria plan, that money is removed from your paycheck before tax. This means your total taxable income is lower. While the percentage deducted from your paycheck is the same, you’re paying less money overall. Moreover, you can still use the money you set aside just for specific purposes.

What Can a Cafeteria Plan be Used For?

Cafeteria plans are most commonly used to pay for health insurance premiums, specifically, premiums for your employer’s group health insurance plan. In this regard, they’re very similar to other employer-offered insurance plans. However, what makes a cafeteria plan stand out is the other things you can use it for. This includes benefits such as:

• Child care assistance
• Retirement plans
• Life insurance
• Disability insurance
• Adoption assistance
• Health savings accounts

Employees are free to tailor plans to their specific needs. For instance, a young mother might be more interested in the child care assistance benefits, while an older employee might devote more money toward retirement. 

The specific benefits vary from plan to plan. Some will only cover premiums with no additional employer contributions. A complete list of benefits that qualify can be found here .

One drawback to cafeteria plans is that benefits are considered “use it or lose it.” Any remaining funds over $500 are forfeited at the end of your benefit year. This sounds scary, but it’s not as bad as it initially seems. Thanks to tax savings, you’ll typically make a net profit even if you have to forfeit some money. Still, it’s best to plan your expenses well to avoid unnecessary forfeiture. Set forth a budget based on your expected needs, and consider consulting with a tax professional to maximize your benefits.

How Do I Qualify for a Section 125 Cafeteria Plan?

Cafeteria plans are only available through employers; individuals cannot purchase these plans from the marketplace. There are also some considerations for individuals who are the sole proprietor of a company, a partner, or shareholders who own more than two percent of the company.

Individuals who meet one of these criteria cannot enroll in a cafeteria plan, though their employees (including family members) can.  Plans must be offered non-discriminatory. This means that all employees must be offered the same benefits under the same terms, without favoring highly compensated employees or executives. 

A cafeteria plan can save you a lot of money on taxes, but it’s still important to look at the insurance to see if it meets your needs. If you need help picking the right plan, contact one of our licensed agents at (800) 318-9984, or enter your zip code to begin your search today!

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Terms and Definitions

What is a cafeteria plan.

Updated: July 3, 2024

Cafeteria plan definition and meaning

A cafeteria plan is an employer-sponsored benefit that meets the requirements of section 125 of the Internal Revenue Code (IRC). The most distinct aspect of a cafeteria plan is that it permits employees to pay for specific benefits on a pretax basis.

More about what a cafeteria plan is and its purpose

Employees who opt for a cafeteria plan must be allowed to choose at least one taxable benefit (for example, cash in the form of salary) and one qualified benefit, such as group health insurance .

To qualify, the benefit cannot defer compensation, meaning it cannot be paid at a later date. Additionally, contributions for the benefit are generally excluded from the employee’s gross income. This means the employer does not withhold certain taxes from the employee’s payment/contribution for the benefit. These taxes would have applied had it not been for the cafeteria plan.

The origin and purpose of cafeteria plans

The Revenue Act of 1978 formally incorporated section 125 into the IRC. While cafeteria plans were available prior to 1978, employees had to pay taxes on employer contributions. The Revenue Act of 1978 resolves this by making both employer and employee contributions nontaxable, provided the amounts stay within the prescribed legal limits. Ultimately, cafeteria plans deliver tax savings to both employees and employers.

Types of benefits offered under a cafeteria plan

Qualified benefits include:

• Dental and vision insurance
• Disability insurance
• Accidental death and dismemberment
• Group-term life insurance
• Adoption assistance
• Health savings account (HSA)
• Health flexible spending account (FSA)
• Dependent care assistance

A cafeteria plan excludes benefits not regulated by Section 125 of the IRC, including educational assistance, commuter benefits , and health reimbursement arrangements.

A cafeteria plan excludes benefits not regulated by Section 125 of the IRC, including educational assistance, commuter benefits, and health reimbursement arrangements.

What employers should know about cafeteria plans

• The employer must establish a written plan document outlining details of the plan, including eligibility rules, benefits offered, and plan administrator and trustees.
• Every eligible participant must receive a summary plan description , which explains their rights, responsibilities, and benefits under the plan.
• Generally, qualified benefits are not subject to federal income tax, Social Security tax, Medicare tax, and federal unemployment (FUTA) tax . However, employers should check state and local laws for applicable tax rules regarding cafeteria plans.
• It’s important to look for exceptions in the tax rules. For example, life insurance coverage that goes beyond $50,000 is subject to Social Security and Medicare taxes, but not federal income tax and FUTA.
• Only common-law employees can participate in a cafeteria plan; it excludes the self-employed.

Pros and cons of cafeteria plans

Advantages:

• Employees and employers save on payroll taxes.
• Employers can secure a competitive edge in the talent marketplace by offering the attractive benefits package that cafeteria plans provide.
• Employees can choose from a suite of benefits based on their individual or family needs.
• The plan must adhere to nondiscrimination rules to ensure it doesn’t favor highly compensated employees.

Disadvantages:

• A cafeteria plan must follow strict rules and regulations.
• The third-party administrator (TPA) charges a fee to establish the plan in accordance with legal compliance standards.
• Employees typically can’t change their cafeteria plan elections until the next plan year begins.
• The “use-it-or-lose-it” rule generally applies to cafeteria plans. This means the employee forfeits unused funds remaining at the end of the year, though certain plans offer carryover and grace period provisions.

Cafeteria plan laws to keep in mind

As mentioned, plan sponsors must comply with IRC Section 125. Other laws affecting cafeteria plans include the following:

• Employee Retirement Income Security Act (ERISA)
• Consolidated Omnibus Budget Reconciliation Act (COBRA)
• Affordable Care Act (ACA)
• Health Insurance Portability and Accountability Act (HIPAA)
• Genetic Information Nondiscrimination Act (GINA)

Additionally, employers should consider applicable state and local laws, including those pertaining to nondiscrimination and wages and hours.

Communicating cafeteria plans to employees

In a 2023 MetLife survey , 50% of employees “say having a better understanding of their benefits would make them more loyal to their employer.”

Therefore, it’s important that employees understand the benefits available to them. Otherwise, it can lead to underutilization of the benefits, resulting in financial waste for the employer. What’s more, employees may lose out if they don’t know about the program or how to properly navigate it.

To prevent these outcomes, employers should clearly communicate the cafeteria plan program to their employees. Below are aspects to cover:

• The purpose of the cafeteria plan
• A general idea of how the plan works
• Advantages for employees and their families
• Potential drawbacks employees should know about
• How employees can sign up (and change their elections)
• Whom to contact for more information about the cafeteria plan

Using cafeteria plan in a sentence

“Joining my employer’s cafeteria plan puts more money in my pocket because I don’t pay taxes on my contributions.”

Terms related to: Cafeteria plan

• Hospital indemnity insurance (HI)
• High-deductible health plan (HDHP)
• Pre-tax deductions
• Summary plan description (SPD)

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Cafeteria Plan – Definition, Benefits, and Everything You Should Know

Remember the 80s when Hollywood hugely glorified the teenage drama? Somehow, every high school struggle found its way into the cantina and determined one’s destiny by where one sat during the lunch break. Well, the term we’re about to analyze thoroughly has very little to do with it (sincere apologies to John Hughes). So, what is a cafeteria plan , and how does it work?

In simple words, it’s a specific type of employee benefit. It usually encompasses a variety of taxable and non-taxable perks provided by an employer. Sounds swell? It sure is! Let’s see what it entails and if there are any downsides to it. 

What is a Cafeteria Plan Provided by an Employer?

A section 125 cafeteria plan (or, simply – cafeteria plan) applies to a kind of employee benefits program . In this scenario, an employer grants employees a couple of different taxable and non-taxable benefits. It is then up to the employee to choose which perks would suit their personal needs.

What about the origin? This program was named after the most initial types of policies that enabled employees to pick between different sorts of benefits . The analogy was quite clear – the plans worked in the same manner as a customer that decides between available meals and beverages in a cafeteria. 

Here is another fact to keep in mind: if cafeteria plans discriminate in favor of highly paid employees, they must report these benefits as income . Still, there’s more to grasp. Let’s find out what else is on the menu. 

How Does it Work?

In order to set a cafeteria plan in motion, employees need to pick one qualified benefit plan and one taxable benefit. What does it mean? Firstly, a qualified benefit is a tax-deferred plan the firm deducts from employees’ gross salary under the IRS’s provisioning code. Some eligible benefits can apply to health saving accounts and other healthcare benefits, adoption assistance, or disability insurance. 

A taxable benefit allows employees to add some money to their salary monthly rather than putting it toward benefits plans. For example, with company-sponsored healthcare coverage, employers finance certain shares of each employee’s premium account. If an employee chooses to back out of the program, they will not get paid for the amount their premiums might have cost.

Also, in section 125 plans, companies can offer their staff the value of the benefits as cash. Then, employees can use that capital to pay for taxable benefits. 

Here’s one last piece of information businesses must grasp: programs that offer only taxable benefits can’t be perceived as section 125 plans. 

What Is an Example of a Cafeteria Plan?

So, if you’re still with us, without being mildly disappointed by the fact that we haven’t mentioned a single delicious dessert, let’s cover a few examples of section 125 employee benefits :

• A POP (premium-only) plan – the employees pay for their health insurance benefits with their pre-tax incomes, 
• HSA (health savings account) – the employees create savings accounts where they put money from their salaries to cover medical costs, 
• FSA (Flexible spending accounts) – the employees use their pre-tax deductions to fund this account throughout the year,
• DCAP (Dependent care assistance plan) – funds used by an employee to pay for child or dependent care. 

Nearly every employee pays their medical and healthcare expenses with their own post-tax money. However, a cafeteria plan enables employees to save money on costs they already paid for. If you pay for these expenses upfront, you can submit a claim and necessary documentation to a plan administrator for reimbursement from your accounts.

Cafeteria Plan HSA – Health Savings Account

Regardless of whether you work remotely or on-site , healthcare is always a top priority. And when it comes to learning more about cafeteria plan HSA – you’re in for a lot of abbreviations! And advantages, of course. 

Employees can take some money from their paychecks and put it into this savings account to pay for IRS-approved medical and healthcare costs. The employee should add a certain amount of cash into the account each year, up to a maximum limit. To obtain this program, an employee should have an HDHP (high-deductible health plan) to save up for qualified medical costs. This specific type of health insurance plan provides low premiums and high deductibles , which makes it highly beneficial for each employee who chooses it. 

Cafeteria Plan: Advantages and Disadvantages

Like any other program, this one offers quite a few upper hands accompanied by some drawbacks. The best aspects of these plans include:

• Paying fewer taxes and controlling several costs much easier,
• Recognizing and respecting employees’ true needs, which will have a beneficial effect on the retention strategies ,
• Gaining a competitive advantage and boosting the public image, which can help a company turn candidates into brand ambassadors ,
• Promoting diversity in the workplace by having separate plans that cover unique necessities and requirements,
• Having a better understanding of what your staff wants and establishing long-term agenda regarding other benefits packages. 

Now, as for the disadvantages of these programs, they mainly affect the employers. For instance, if a staff member chooses to quit their job before the entire amount they have received for a specific type of coverage is reimbursed, a company will suffer financial damage. 

Still, all these drawbacks are pretty easy to overcome . It all starts with having an honest and open relationship with employees and colleagues. That way, agreements can be made in such a manner that everyone is worry-free. 

How Does a Cafeteria Plan Benefit the Employer? 

Excellent employee experience is always a goal. Still, being genuinely interested in your staff and their individual needs is far more than that. And with a section 125 plan, there are other employers’ perks to take into account. 

These plans also allow companies, and especially small business owners, to cut some costs when it comes to their employees’ benefits. For instance, an employer doesn’t need to pay:

• Federal Insurance Contributions Act (FICA), 
• State and Federal Unemployment Taxes (SUTA and FUTA) 
• Workers’ compensation costs. 

These financial advantages are due to the fact that section 125 cafeteria plans decrease payroll taxes . This further leads to reducing or eliminating the expenses linked to allowing cafeteria plans. Finally, all unused means in employees’ FSAs stay with the firm.

How Does it Benefit the Employees?

Aside from granting wellbeing throughout the entire employee lifecycle within an organization, a cafeteria plan allows employees to save up and maneuver their expenses more smoothly. Here are a few crucial cafeteria plan benefits:

• Employees can pay for insurance coverage and retirement plans without any tax fines and punishments,
• Fewer taxes will be deducted from employees’ paychecks,
• The costs for dependent care expenses will be reduced,
• An employee will be able to invest tax savings into a retirement plan.

Overall, these benefit programs have more pros than cons , and they contribute to employees’ satisfaction. 

Know Your Terms & Set Your Aims

Saving up, improving employee experience , and having a few proven strategies for benefit packages in mind sounds like a superb way to run a business. Considering a cafeteria plan and understanding how it works might easily be a perfect solution. Nevertheless, before starting to enjoy the perks of this practice, it’s essential to grasp the potential negative aspects as well. Ultimately, before implementing any tactic, a business must be completely in the clear regarding its actual needs (and what they’re capable of at the moment). 

And if you need any help with understanding your team and growing it, reach out to professional tech recruiters and fulfill your aims sleekly! 

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How to set up your cafeteria plan for pretax employee benefits

• February 1, 2016

It’s common for employers to require employees to pay a share of premiums for many employee benefits. To take a bite of this cost-sharing requirement, many employers permit employees to pay for their premium share of contributions on a pretax basis through cafeteria plans, which provide a special exception to general federal income tax rules applicable to an employee’s income. “Generally, this choice takes the form of allowing employees to purchase benefits, such as health insurance, with pretax dollars. This allows employees to have more take-home pay,” says Frances Horn, employee benefits compliance officer at JRG Advisors . But when providing this, there are requirements that must be met. Smart Business spoke with Horn about the rules that govern these cafeteria plans. How do cafeteria plans work? Section 125 of the Internal Revenue Code (IRC) governs cafeteria plans. Thus, regardless of whether the cafeteria plan is from a private, government, church or nonprofit employer, it remains subject to the cafeteria plan rules. Although all cafeteria plans must satisfy key Section 125 provisions, not all plans are the same. The simplest form is a premium-only-plan (POP), which permits employees to pay premiums with pretax dollars. An employer can also combine the premium payment feature with account-based plans to create a more robust plan. Account-based plans, or spending accounts, permit employees to set aside part of their salary on a pretax basis for unreimbursed expenses. Cafeteria plans are often referenced by other names — most notably, POP, section 125, pretax plan and flexible benefits plan. Regardless of what employers call it, if they provide pretax benefits to employees, the plan must adhere to the IRC 125 rules. What do employers need to understand about the IRC 125 rules? The IRC rules governing 125 plans are numerous, but the most important one is that the cafeteria plan must be established pursuant to a written plan instrument, known as a plan document. Any changes made to the plan also must be set out in writing. This establishes the terms as to how the plan must be governed and any failure to operate in accordance with the terms or the IRC requirements will disqualify the plan. The rules specifically define what must be included in the plan document:

• Specific description of the available benefits and when they are provided.
• Participation rules.
• Employee election procedures — when they can be made, effective date and that elections are irrevocable except for IRS permissible midyear election changes.
• The manner in which employer contributions may be made.
• Maximum amount of employer contributions available through the plan.
• The plan year.
• Provisions for complying with spending account arrangements, if offered.
• If the plan provides for any grace periods or carry-overs when permitted.

Without a plan document, the IRS takes the position that the employer has under-withheld the taxes for participating employees. Such under-withholding could lead to payroll tax underpayments and IRS penalties for an employer. How does this differ from Employee Retirement Income Security Act (ERISA) plan documents? This requirement shouldn’t be confused with the requirement that a benefit subject to ERISA is required to have a written plan document. Whether the cafeteria plan must meet ERISA’s plan document requirement depends on whether the plan contains an ERISA benefit. For example, this would occur if the cafeteria plan permits pretax salary reductions for a health flexible spending account, because it is a self-insured group health plan and subject to ERISA. What else would you like to share? If there is no cafeteria plan document, if the document doesn’t satisfy the plan document requirements or if the plan fails to operate in accordance with the terms of the plan or Section 125 rules, the plan isn’t a cafeteria plan and an employee’s election between taxable and non-taxable benefits results in gross income to the employee.

Make sure you discuss the proper establishment of cafeteria plans with your employee benefit advisors.

  Insights Employee Benefits is brought to you by JRG Advisors

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FAQ: Are owners eligible to participate in a cafeteria plan if they are also employees?

Not in most cases, which can be an unwelcome surprise to a business owner who also works day-to-day for their business. After all, cafeteria plans are designed for employees and owner-employees are employees too, right? 

Not according to the Internal Revenue Code (the Code), where Section 125 establishes the rules for cafeteria plans (aka Section 125 plans), which limits participation in those plans to “employees,” a term that excludes individuals deemed “self-employed” under the Code, including sole proprietors, partners in partnerships and LLPs, members of LLCs, and more-than-2% owners of S corporations. 

Being employed by the business (for example, as its CEO) does not change this determination because, from a tax perspective, at least, a person who works for a business they own is essentially working for themselves (i.e., they are self-employed). 

At first glance, it might seem unfair to prohibit owners who are also employees from participating in plans designed for employees of their businesses. But these owner-employees derive benefits from these plans in a different way because business entities, such as partnerships, LLCs, and S corporations, are not themselves subject to federal income taxation. Rather, their incomes “pass through” directly to their owners for taxation as individual income only. 

These “self-employed” owners therefore directly benefit as individual taxpayers from the advantages that cafeteria plans provide to their company’s bottom lines, such as the FICA and FUTA savings derived from the salary reductions of participating employees, in addition to the other benefits these plans already offer to employers, such as the ability to provide an array of competitive benefits that attract and retain a talented and productive workforce. 

(In contrast, C corporations are subject to “double taxation” under the Code: Taxation of income at both the corporate level and at the individual (owner) level. Notably, owner-employees of C corporations are eligible to participate in cafeteria plans.) 

It’s also important to remember that owner-employees can still enjoy many of the same (or at least substantially similar) benefits that their company’s cafeteria plans provide to their employees. 

For instance, although owner-employees may not be able to pay health coverage premiums through the cafeteria plan, they may be able to take an above-the-line deduction on their own income taxes for health coverage. Additionally, they may not be able to make “pre-tax” contributions to their HSAs through the cafeteria plan, but if eligible, they may be able to make their own direct contributions to their HSAs, for which they can also take an above-the-line deduction. They may not be able to participate in their company’s dependent care assistance program (aka DCAP or dependent care FSA) through the cafeteria plan, but they may be eligible for a DCAP funded outside of a cafeteria plan, subject, of course, to nondiscrimination rules, or they may be eligible for the dependent care tax credit that is available to most individual taxpayers under the Code. 

All individual tax situations are different, of course, and owner-employees should consult with their own tax advisors as to their own eligibility for the tax deductions and credits described in the above paragraph. The essential point is that self-employed individuals, such as most owner-employees, may not be eligible to participate in cafeteria plans, but they may still be able to enjoy many of the benefits provided to their employees through those plans. However, they will have to do so through means generally available to taxpayers rather than those available only to employees.

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Barbara Weltman

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What a Cafeteria Plan Can Do for Your Business

August 20, 2020 / By Barbara Weltman

A cafeteria plan overview

A cafeteria plan can be very limited, such as to only enable employees to pay their health insurance on a pre-tax basis. Or they can be expansive, where employees select from a broad menu of benefits. In either case, they entail minimal administrative costs and there’s no annual reporting to the IRS or DOL if there are fewer than 100 employees. What’s more, employee contributions are not taxable compensation so there’s no employment tax on them.

Premium-only cafeteria plans

Small businesses that only pay a portion of employee health insurance premiums, or none at all, can help employees essentially reduce their cost by enabling them to pay their premiums on a pre-tax basis. The plan must offer a choice between cash or health insurance coverage. If they choose the coverage, the amount of what they’d pay for premiums withheld from their paycheck doesn’t count as taxable compensation to them. The cash option is always taxable.

Premium-only cafeteria plans can be helpful to small businesses using:

• Qualified small employer health reimbursement arrangements (QSEHRAs) . These plans restrict employer payments of premiums on employees’ individually-obtained coverage up to a set dollar limit ($5,250 for self-only coverage or $10,600 for family coverage in 2020).
• Individual coverage health reimbursement arrangements (ICHRAs) . Employers fix the amount of individually-obtained health coverage they are able to pay (the law doesn’t set a limit); employees pick up the rest.
• Group health plans . Typically, in small businesses offering this type of coverage, the employer pays only so much (perhaps 50% of premiums in order to qualify for the small employer health insurance credit), and employees pay the balance of the premiums.

Cafeteria menu plans

These plans offer employees a choice between at least one permitted benefit that’s taxable (e.g., cash that’s extra salary or other taxable benefit) and at least one benefit that’s nontaxable (i.e., paid on a pre-tax basis), such as:

• Adoption assistance
• Group health plans (but not Archer medical savings accounts or long-term care insurance)
• Group term life insurance
• Dependent care assistance
• Health savings accounts (HSAs)
• Flexible spending accounts (FSAs) to pay out-of-pocket medical costs
• Qualified retirement plan contributions

Compliance issues

Cafeteria plans must be nondiscriminatory, meaning they can’t favor owners, officers, or highly compensated employees. Plans must test for nondiscrimination annually.

Small employers—those with fewer than 100 employees—can adopt a simple cafeteria plan where discrimination testing is automatically met if:

• Participation is offered to employees with at least 1,000 hours of service in the preceding year. (Don’t confuse this rule with other participation rules, such as non-simplified plans having a 3-year service requirement.) AND
• Employers contribute (1) a uniform percentage of compensation (not less than 2%) or (2) the lesser of 6% of compensation for the plan year or twice the employee’s salary reduction contribution. These are minimums; employers can contribute more.

All cafeteria plans must have written documents—a master plan document, an adoption agreement, and a summary plan description. The summary plan description must be given to all eligible employees at least 90 days before their coverage begins. If the plan has not been updated, then the document must be given to participants every 10 years. If there’s been a change, then every 5 years.

Final thought

This has been a brief look at what cafeteria plans are all about, but there’s much more to them. You can learn more about them in IRS Publication 15-B . Cafeteria plans aren’t do-it-yourself benefit arrangements. You need to work with professionals to see that you choose the plan best suited to your situation and that you operate in compliance with the rules.

Small business ideas, business tax news and small business consulting from Barbara Weltman to provide business owners with the information they need to succeed. Visit our small business blog, Idea of The Day®, small business books and articles on small business taxes, small business finance and small business legal advice.

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Cafeteria plan compliance

The choices for employees can be many, but the recipes for employers are exact..

• Employee Benefits

Employees of businesses that offer health care plans have come to expect that their employer will deduct their employee contributions for premiums on a pretax basis and properly manage other benefits under a Sec. 125 cafeteria plan, also known as a flexible benefit plan. Cafeteria plans are so commonplace that the origins of this treatment and the attendant requirements are often ignored, particularly among small businesses. Payroll service providers, which typically don't offer payroll or income tax advice and are not tasked with monitoring Sec. 125 compliance, will set up pretax salary reductions for the employees of a business as requested but typically do not require the business to produce a Sec. 125 plan document to show that a plan exists, or make other inquiries to be sure the client understands the law.

As a consequence, many small businesses are out of compliance with Sec. 125. While the chance of audit is probably low, the risk is high if noncompliance unexpectedly results in years of past salary reductions suddenly becoming subject to taxation. The disconnect in many small businesses creates a practice opportunity for CPAs to inform and educate clients about compliance and guide them toward it.

ORIGINS OF SEC. 125 PLANS

In 1970, dual - earner households made up 31% of two - parent households; that figure has increased steadily and today is 46% ( Pew Research Center ). As increasing numbers of dual earners had no need for duplicate health care, effective pay inequities resulted for the employees who joined their spouse's benefit plan and received no benefits from their own employer. Cafeteria plans, allowing employees to choose between cash or benefits, became popular, but the benefits were taxable. Disproportionate numbers of lower - paid participants chose cash over benefits, leading to uninsured or underinsured employees.

Sec. 125 was passed in 1978 to allow employers to offer cafeteria plans in which certain qualified benefits are not taxable. Employees can pay for benefits with pretax wages, saving the employees both income and payroll taxes and encouraging participation among lower - paid employees. (See the sidebar "Reasons Clients Should Have a Sec. 125 Plan.") The section also requires employers to pass discrimination tests to discourage favoring highly compensated or key employees.

CODE PROVISIONS

Under Sec. 125, employers with a qualified written plan are permitted to offer employees a choice between at least one permitted taxable benefit and at least one qualified nontaxable benefit, without the choice itself triggering taxation.

The permitted taxable benefit can include cash, various types of paid time off, and/or severance pay. Qualified benefits are those that, under the application of Sec. 125(a), are excludable from gross income by express provision of Chapter 1 of the Code, except for Sec. 106(b) Archer medical savings accounts, Sec. 117 qualified scholarships, Sec. 127 educational assistance, and certain fringe benefits under Sec. 132, which are specifically excluded. Therefore, qualified benefits can include such popular items as accident and health plans, group term life insurance, and dependent care assistance programs. Deferred compensation, except for certain exceptions such as Sec. 401(k) contributions, is not allowed. In some cafeteria plans, employers offer their employees "flex credits" expressed as a dollar amount, which can be applied to purchase any of a variety of benefits offered. If the cost of the benefits chosen exceeds the credits, the employee can use salary reduction to pay the difference; if the credits exceed the cost, the employee can take the difference in taxable cash in lieu of the benefit.

All participants in the plan must be current or former employees. Though only employees may participate, spouses and dependents may benefit from the plan. Individuals who are self - employed , such as sole proprietors or partners in a partnership, and individuals who are 2% shareholders in an S corporation, are not employees for this purpose. Detailed rules cover the types of changes in status relating to employment, marital status, dependents, etc., that may be permitted in the plan documents.

Sec. 125 plan document preparation, guidance, and administration are offered by many professionals in benefits administration services throughout the country. Employers may choose to offer premium - only plans, flexible spending arrangements, and an array of other benefits.

PREMIUM-ONLY PLANS

A premium - only plan (POP, also known as a premium conversion plan), defined in Prop. Regs. Sec. 1. 125 - 1 (a)(5), offers only a single choice consisting of either cash or accident and health insurance coverage. Cash is defined in Prop. Regs. Sec. 1. 125 - 1 (a)(2) to include salary reduction, in which the employee elects to decline to receive a portion of his or her pay and directs the employer to use the money to pay the employee's contribution toward a specified benefit. Under the Code, the money, if used by the employer to pay premiums for a POP, is not constructively received by the employee and is not subject to tax. Employers who offer a POP are not required to offer employees any other form of cash, including cash in lieu of benefits, so employees who opt out of coverage receive no benefit, taxable or nontaxable. However, employers may offer cash in lieu if they choose, and if the employee accepts it, it is a taxable benefit (see the sidebar "A Closer Look at POPs").

FLEXIBLE SPENDING ARRANGEMENTS

Flexible spending arrangements (FSAs) permit employees to set aside pretax wages to pay for certain qualified benefits, subject to limits on the amounts set aside. FSAs can be offered alongside POPs. Benefits covered by FSAs include dependent care assistance, adoption assistance, and medical care reimbursements (health FSAs). For employees covered by a high - deductible health plan, employer contributions to a health savings account (HSA) can be included in a cafeteria plan as a qualified benefit, along with a limited - purpose and/or post - deductible health FSA. FSAs require adherence to two rules: Under the "use or lose" rule, costs payable under all three types of FSAs are required to be incurred during the plan year. However, under proposed regulations issued in 2007, the plan may adopt an optional grace period allowing costs to be incurred during a predetermined period after the end of the plan year. The grace period may not exceed 2½ months, and it may cover some benefits and not others, as specified in the plan.

Under the uniform coverage rule, the full amount of reimbursement available under a health FSA (less amounts previously reimbursed for the plan year) must be available throughout the plan year. This rule does not apply to dependent care or adoption - assistance benefits.

DISCRIMINATION RULES

To encourage participation by lower - paid employees, Sec. 125 plans may not discriminate in favor of highly compensated or key employees, and the regulations include tests required with respect to eligibility, contributions, and individual and total benefits. If, under testing, a plan is found to be discriminatory with respect to a plan year, the discriminatory benefits are included in the gross income of the highly compensated or key participants who received them.

Highly compensated employees are any employees, or spouses or dependents of employees, who are:

• An officer;
• A 5% shareholder;
• An employee with annual compensation in the preceding year exceeding the amount in Sec. 414(q)(1)(B) ($125,000 for plan years beginning in 2019 and $130,000 for plan years beginning in 2020); or
• If the employer elects under Sec. 414(q)(3), an employee whose salary is in the top 20% of all employees.

Key employees are any employees, or spouses or dependents of employees, who are:

• An officer of the company with annual compensation, per Sec. 416(i)(1), of $180,000 for plan year 2019 and $185,000 for plan year 2020;
• A 1% owner with annual compensation of $150,000 or more in the plan year; or
• A 5% owner, without regard to compensation.

SPECIAL RULES FOR BUSINESSES WITH FEWER THAN 100 EMPLOYEES

Businesses with fewer than 100 employees on average on business days during either of the two preceding years may be eligible to adopt a simple cafeteria plan under Sec. 125(j). Provisions for simple cafeteria plans were included in the Patient Protection and Affordable Care Act, P.L. 111 - 148 , and became available in 2011. Under a simple plan, eligible employees include those with 1,000 hours of service in the preceding plan year. Discrimination testing is simplified: Employers can meet nondiscrimination requirements if the plan requires the employer to provide to qualified employees (those who are neither highly compensated nor key employees and are eligible to participate in the plan) qualified benefits that equal either:

• A uniform percentage of each employee's compensation, not less than 2%; or
• The lesser of 6% of each employee's compensation for the plan year or twice his or her salary - reduction contribution.

However, the nondiscrimination requirement will not be met if the rate of contribution with respect to the salary - reduction contribution of a highly compensated or key employee is greater than the rate for an employee who is not a highly compensated or key employee.

SEC. 125 DOCUMENTS

Employers must have written plan documents, to include a master plan document, an adoption agreement (which can be included in the master plan document), and a summary plan description that must be provided to all eligible employees within 90 days of their becoming covered by the plan. The plan documents must be furnished to all plan participants every 10 years, if the plan has not been updated, or every five years, if the plan has been updated.

The plan documents must specify the plan year, and the plan year may be changed only for a valid business purpose, such as to align with the health care provider's benefit year. Other requirements for written plans are at Prop. Regs. Sec. 1. 125 - 1 (c). The plan must require employee elections to be made annually. Elections are irrevocable during the plan year; however, Regs. Sec. 1. 125 - 4 allows employers to permit certain midyear changes due to changes in employee status. Permitted status changes must be listed in the employer's plan documents.

SEC. 125 AND ERISA

Sec. 125 plans are covered by the Employee Retirement Income Security Act (ERISA), which includes requirements for written plan documents, a trust fund to hold the assets, proper recordkeeping, and periodic notices to the participants and the government. If a Sec. 125 plan uses an insurance contract, a trust fund may not be needed, but employees' salary - reduction contributions should be deposited with the insurer on a timely basis in accordance with U.S. Department of Labor (DOL) regulations.

Annual summary plan descriptions and employee eligibility notices and election forms should be provided to eligible employees on a timely basis before the beginning of each plan year. The DOL does not require Form 5500, Annual Return/Report of Employee Benefit Plan , from most welfare benefit plans that have fewer than 100 participants as of the beginning of the year, including Sec. 125 plans, and IRS Notice 2002 - 24 suspended the requirement to file information returns with the IRS. Annual discrimination test results do not need to be submitted to the government, but evidence of testing should be retained with other plan documents.

COMMON ERRORS IN SEC. 125 PLANS OF SMALL BUSINESSES

Many small businesses expect their payroll service provider to guide them through the laws and regulations that govern payroll, but payroll service providers typically don't offer payroll or income tax advice and are not tasked with monitoring Sec. 125 compliance. As a result, many small businesses may not be compliant with the requirements of Sec. 125. While discrimination issues can subject highly compensated or key participants to taxation, the lack of a written plan or operational errors can subject all participants to taxation, in accordance with Prop. Regs. Secs. 1. 125 - 1 (c)(6) and (7). Common errors include:

No plan documents

Some small businesses don't realize that plan documents are required. Plan documents can be prepared and updated annually by professionals in benefits administration services. The client should thoroughly discuss with the benefits administration personnel the details of Sec. 125 requirements, to be sure the client understands them, and read the documents carefully to be sure their process conforms to the plan.

Misunderstanding employee eligibility

Nondiscrimination rules for eligibility require plans to allow employees who have completed three years of service to participate, providing they satisfy other conditions not related to length of service (Prop. Regs. Sec. 1. 125 - 7 (b)(2)). Small employers might confuse that rule with the shorter eligibility testing rule under a simple cafeteria plan described above, which requires eligibility for employees who worked 1,000 hours in the preceding plan year.

Not retaining evidence of a status change

Employees should be required to authorize their elections and any midyear status changes that they are permitted to make under the terms of the plan documents, and evidence of their authorizations should be retained. Both written and electronic elections are permitted by Sec. 125, and employers should maintain systems for retaining employee authorizations and proof - of - eligibility documents required for status changes.

Not taking required parameters into account when calculating salary reductions or flex credits

Sec. 125 parameters for employer contributions should be examined when calculating salary reductions or flex credits. These parameters include the cost of health plan coverage for cafeteria plans and the employee's compensation and salary reductions for simple plans. Employers should be sure that they have met the requirements for contributions to the plan and the benefits offered.

Not testing for discrimination, or not testing on a timely basis

Tests for discrimination involve eligibility, contributions, and benefits. Tests should be made annually as of the last day of the plan year (Prop. Regs. Sec. 1. 125 - 7 (j)). If midyear status changes are permitted by the terms of the plan documents, interim testing might be advisable to watch for any developing issues.

HOW CPA s CAN HELP

Some small business clients may not be aware that they can offer a Sec. 125 plan. Others may not be aware that their plans are not in compliance, risking adverse tax consequences.

CPAs can ask their clients how their benefits programs are handled and initiate a conversation. If a client does not offer a Sec. 125 plan, or if it has a plan and the CPA identifies a concern, the client will appreciate being informed.

Knowledgeable tax practitioners, together with a professional in benefits administration services, can advise the client on creating the required documents and preparing and implementing procedures to establish compliance within the human resources, payroll, tax, and accounting processes of the client's business. Successfully aiding the client in offering a useful, compliant Sec. 125 plan will be a win for the client — especially for its employees.

Reasons clients should have a Sec. 125 plan

Income tax savings for the employee: A Sec. 125 plan is required for employers who want to allow employees to choose the qualified benefits they want and avoid paying income taxes on the amount of wages they contribute to obtain those benefits.

Payroll tax savings for the employee and employer: Since employees' wages contributed to obtain qualified benefits aren't subject to income taxes, both the employee and the employer save on payroll taxes.

Flexible spending account (FSA) benefits for the employee: FSAs can only be offered through a Sec. 125 plan.

Minimal administration: For a premium-only plan (POP), setup and ongoing fees of administration are minimal, no IRS forms are required, and no U.S. Department of Labor forms are required for plans with fewer than 100 participants.

A closer look at POPs

The cost of care has risen precipitously, as shown in the chart "Health Care Costs vs. Wages." Employers have walked a fine line between the needs to offer health care coverage to recruit employees and to control the cost of health care by requiring employees to shoulder more of the cost. Especially among small employers, a premium-only plan (POP) may seem the perfect way to strike that balance — except for employees who opt out.

A POP, as defined in Prop. Regs. Sec. 1.125-1(a)(5), allows employers to offer only a choice between pay and health care benefits (under a salary reduction). Employees who opt in pay no taxes on the portion of their salary used for their share of the health care premium. If the employer does not offer cash in lieu of benefits, however, employees who opt out of the health care benefits get nothing beyond their usual rate of pay and are no better off than if the employer had no Sec. 125 plan or did not offer health care. Employees who opt out might do so because they have coverage through a spouse or partner; they may also need the additional pay, even though it is taxed.

Two possible solutions present themselves: The first, requiring employers with a POP to offer cash in lieu of benefits, burdens employers with the cost of the additional cash in lieu and payroll taxes and would be especially difficult for small businesses to afford. The second, to permit employees who opt out to receive the amount of their salary reduction in the form of nontaxable pay just as opt-in employees do, shifts the burden to the governments that lose payroll taxes on the salary-reduction amounts of opt-out employees. It might also result in more employees opting out of employer health care coverage, a negative social effect. So neither solution is optimal.

It's unlikely that the 95th Congress, which carefully outlined guidelines to discourage discrimination toward highly compensated employees, envisioned that two employees with the same rate of pay could receive widely differing values for their services. Dramatically increasing health care costs have made this scenario a reality.

About the author

Linda Franks, CPA , is controller at B&Z Manufacturing Co. Inc. in San José, Calif.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at [email protected] or 919-402-4434.

AICPA resources

• " Flexible Benefits for Small Employers ," JofA , March 2001

CPE self-study

• AICPA's Annual Federal Tax Update (#746512, text; #163745, online access)
• Auditing Employee Benefit Plans (#733843, text; #153008, online access)
• Employee Benefit Plans, May 4—6, Las Vegas

For more information or to make a purchase or register, go to aicpastore.com or call the Institute at 888-777-7077.

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SEP plan Fix-it Guide - Contributions to the SEP-IRA exceeded the maximum legal limits

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All contributions made to a SEP are employer contributions.

Internal Revenue Code Sections 402(h) and 415 limit the amount of contributions made to an employee’s SEP-IRA to the lesser of dollar limitation for the year $66,000 for 2023 ($61,000 for 2022; $58,000 for 2021; $57,000 for 2020; $56,000 for 2019 and $55,000 for 2018) or 25% of the employee’s compensation. The  amount of compensation taken into account is also limited $330,000 for 2023 ($305,000 for 2022; $290,000 in 2021; $285,000 in 2020; $280,000 in 2019 and $275,000 in 2018). If your SEP plan document specifies lower contribution limits, then the lower limits control.

There are special rules if you're self-employed, such as a partner or an owner-employee. When calculating the deduction for contributions made to your own SEP-IRA, compensation is your net earnings from self-employment, which takes into account both the deduction for one-half of your self-employment tax and the deduction for contributions to your own SEP-IRA. For this reason, you determine the deduction for contributions to your own SEP-IRA indirectly by reducing the contribution rate called for in your plan. For more information on the deduction limitations for self-employed individuals, see Publication 560, Retirement Plans for Small Business (SEP, SIMPLE, and Qualified Plans) .

Employer contributions to a SEP-IRA won't affect the amount you can contribute to a Roth IRA or a traditional IRA. However, it may preclude you from receiving a tax deduction for contributions to a traditional IRA. See Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs) , for details.

How to find the mistake

Calculate 25% of each employee’s compensation limited to $330,000 in 2023 ($305,000 in 2022; $290,000 in 2021, $285,000 in 2020, $280,000 in 2019 and $275,000 in 2018) and compare the total contribution made for the employee to the lesser of that amount or the dollar limitation for that year $66,000 for 2023 ($61,000 for 2022; $58,000 for 2021, $57,000 for 2020, $56,000 for 2019 and $55,000 for 2018). Review the special calculations in Publication 560 for self-employed individuals.

How to fix the mistake

Corrective action.

There are two alternative methods to correct a failure to limit employer contributions to employees.

The amount in excess of the annual limit, adjusted for earnings through the date of correction, should be distributed from the affected employee’s SEP-IRA and returned to the employer. The distributed amount is not included in the income of the affected employee, but is reported on Form 1099-R with a taxable amount of zero. If it isn’t feasible to determine what the actual investment results would’ve been, you may use a reasonable rate of interest, such as the interest rate used by the Department of Labor’s  Voluntary Fiduciary Correction Program Online Calculator .

Alternatively, if a submission is made under the VCP program, the excess amount may be retained in the SEP-IRA, but only if the plan agrees to enter into a closing agreement and pay an additional amount to the IRS via an imposed sanction that is equal to at least 10% of the excess amount, excluding earnings. Note that the additional compliance fee will not apply if the excess amount is under $100. 

Under both correction methods, the plan sponsor is not entitled to a deduction for the excess contributions.

Employer I maintains a SEP plan. For the 2018 year, the contributions made for two employees, T and U, exceeded the limit in IRC Section 415. Employee T had an excess of $3,000 and U had an excess of $300. The failure is discovered in 2019.

Generally, Employer I would have to get employees T and U to take the excess money, adjusted for earnings, out of each SEP-IRA by taking distributions and returning the funds to the plan sponsor.

Correction programs available

Self-correction program.

The example illustrates an operational problem because the employer failed to follow the plan terms by improperly exceeding the 402(h) and 415 limitations provided for in the plan document and the Internal Revenue Code. If the other eligibility requirements of SCP are satisfied, Employer I might be able to use SCP to correct the mistake. Employer I would have to determine whether:

• Practices and procedures were originally in place to facilitate compliance with requirements regarding maximum contribution limits.
• The failure is insignificant . If the failure is significant then correction would have to occur by 12/21/21.

Voluntary Correction Program

Under VCP, correction is the same as described above under “Corrective action.” If the plan is not under audit, Employer I may make a VCP submission via the Pay.gov website following the procedures set forth in Revenue Procedure 2021-30 PDF , Section 11. Consider, using Form 14568, Model VCP Compliance Statement PDF , including Form 14568-C, Model VCP Compliance Statement - Schedule 3: SEPs and SARSEPs PDF . User fees for VCP submissions are generally based upon the current value of all IRAs that are associated with the SEP plan. For example, if the value is between $0 and $500,000, the user fee is $1,500 if the submission is made in 2019. User fees may change in subsequent years. If the value of all IRAs exceeds $500,000, the user fee will be higher.

If the mistake includes excess amounts contributed to the employees' IRAs associated with the SEP, the employer must use VCP if the employer wishes to allow the excess amounts to remain in the affected participants’ IRAs. If this correction method is used, a special additional payment of at least 10% of the excess amount will apply. This is in addition to the VCP submission user fee.

Audit Closing Agreement Program

Under Audit CAP, correction is the same as described above under “Corrective action.” Employer I and the IRS enter into a Closing Agreement outlining the corrective action and negotiate a sanction that is not excessive, considers facts and circumstances, and bears a reasonable relationship to the nature, extent and severity of the failures, based upon all relevant factors described in section 14 of Rev. Proc. 2021-30 .

How to avoid the mistake

After the initial calculation of allocations based on the terms of the SEP plan document, you should check to make sure none of the proposed allocations would violate Internal Revenue Code Sections 402(h) and 415. If there’s a problem, you can adjust it before you transfer the money into the SEP-IRAs.

SEP Fix-it Guide SEP overview EPCRS overview SEP checklist PDF IRA-based plans additional resources

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Since 1930, Publix has grown from a single store into the largest employee-owned grocery chain in the United States. We are thankful for our customers and associates and continue remaining deeply dedicated to customer service and community involvement, and being a great place to work and shop.

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Toll Brothers plans luxury townhomes at aging, 72-year-old Chase Manor apartment site

Jeff Clabaugh | [email protected]

August 6, 2024, 12:21 PM

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One of the first garden-style apartment communities in Chevy Chase, Maryland, will be redeveloped as luxury townhomes.

The Chevy Chase Land Company has sold the former Chase Manor Apartments to luxury homebuilder Toll Brothers, which will redevelop the 4-acre site into a townhome community called Chevy Chase Crossing. Toll Brothers did not immediately respond to a request for more details about the planned development or its timeline.

It will include a total of 63 townhomes.

Chase Manor Apartments, east of Connecticut Avenue just off Jones Bridge Road, was completed in 1952 and was home to 67 garden-style apartments, appealing to individuals and families looking for a location near shopping and transportation. The last tenants moved out earlier this year.

“It is somewhat bittersweet to sell the site of a former 72-year-old community that holds so much history for the many locals of Chevy Chase, but with an aging infrastructure and increasing demand to live in this area, it was time to allow for its redevelopment,” said The Chevy Chase Land Company Chief Executive John Ziegenhein.

The Chevy Chase Land Company remains active in the Chevy Chase area. It codeveloped Chevy Chase Lake, anchored by The Ritz-Carlton Residences, has plans for a Phase Two Chevy Chase Lake West project across the street, and is adding new tenants to The Collection, a strip of higher-end retail and restaurants just across the D.C.-Maryland line on Wisconsin Avenue.

The company has developed about 10 million square feet of office, retail and residential projects.

Toll Brothers is an active luxury homebuilder in 24 states, including Maryland, Virginia and D.C.

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Jeff Clabaugh has spent 20 years covering the Washington region's economy and financial markets for WTOP as part of a partnership with the Washington Business Journal, and officially joined the WTOP newsroom staff in January 2016.

• @wtopclabaugh

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30 million student loan borrowers could be eligible for relief in latest forgiveness plan

• Published: Aug. 01, 2024, 10:39 a.m.

MLive file photo

• Matt Durr | [email protected]

As President Joe Biden continues to push various plans to provide student-debt relief, the Department of Education announced Thursday it will begin reaching out to borrowers about the options going forward to receive relief. All borrowers who have at least one outstanding federally held student loan will be contacted via email and provided with the options still available to them, the DOE said.

The DOE was clear however that the email does not guarantee the borrower will be eligible for relief.

Along with providing the options available, the email will also include information on how borrowers can opt out of the relief plans by contacting their servicer by Aug. 30. If a borrower elects to opt out of the plans, they will not be able to opt back in.

“These latest steps will mark the next milestone in our efforts to help millions of borrowers who’ve been buried under a mountain of student loan interest, or who took on debt to pay for college programs that left them worse off financially, those who have been paying their loans for twenty or more years, and many others,” said U.S. Secretary of Education Miguel Cardona. " The Biden-Harris Administration made a commitment to deliver student debt relief to as many borrowers as possible as quickly as possible, and today, as we near the end of a lengthy rulemaking process, we’re one step closer to keeping that promise.”

In April, the Biden administration released a draft set of rules that would allow the DOE to forgive student-loan debt for millions of borrowers who qualify. Those rules have not been finalized, but would make an estimated 30 million borrowers eligible for relief if approved.

The rules would allow for the partial or full forgiveness of student-loan debt for borrowers who:

• Owe more now than they did at the start of repayment.
• Have been in repayment for decades.
• Are otherwise eligible for loan forgiveness but have not yet applied.
• Enrolled in low-financial value programs.

The update comes after the 8th Circuit Court of Appeals last month granted a motion for an administrative stay which halted Biden’s most recent plan to lower payments or forgive student debt for millions of borrowers.

Since the Biden administration first introduced student-debt relief options, the DOE says 4.8 million borrowers have benefitted from the $168 billion in relief that’s been approved.

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