By Andrew J. Goldberg
In an effort to reduce costs without laying off employees, some businesses are drastically cutting back on employee benefits. A significant risk in reducing employee benefits is that companies may find themselves at risk for violating the non-discrimination rules of Section 125 of the Internal Revenue Code. The result of failing to meet the Section 125 requirements is that employees may have to pay additional taxes on their benefits, as well as penalties and interest.
Section 125 is the umbrella provision of the Internal Revenue Code that allows an employee to choose between tax-free benefits OR receiving the same amount as taxable compensation. Such benefits include disability insurance, life insurance, health insurance, medical reimbursement accounts, and dependent care reimbursement accounts. One would think that an individual employee’s selection to receive benefits or compensation should have no bearing on the rights of any other employee, but the IRS says otherwise. Specifically, where the non-taxable benefits selected by employees are provided disproportionately to highly-compensated employees, the plan will fail the IRS non-discrimination requirements and all benefits will be taxable compensation to the highly-compensated employees.
Under Section 125, discrimination can occur as to eligibility where highly-compensated individuals are favored over other employees, or where the plan discriminates in favor of highly-compensated individuals as to contributions and benefits (both benefits available and utilized). The impact of this requirement is that as more lower-compensated employees are laid off, it becomes more likely that the highly-compensated employees will disproportionately benefit from non-taxable benefits available under Section 125.
The penalties for violating the non-discrimination requirements of Section 125 can be significant. Importantly, only highly-compensated employees are subject to the penalty provisions. If the non-discrimination requirements are not met, the highly-compensated employee must include in gross income the maximum amount of the benefit he could have elected to receive (even if the employee elected less than the maximum permitted value). There are multiple consequences resulting from this penalty provision:
- there would likely have been under-withholding of State and Federal income tax by the employer;
- there would have been inadequate payroll taxes withheld and deposited by the employer;
- the employer and/or employee may have to pay penalties and interest on top of the additional taxes;
- the company probably issued incorrect W-2s and will have to issue amended W-2s; and
- the highly-compensated employee may have to file an amended individual income tax return.
In addition to complying with the non-discrimination requirements, the taxpayer must have a written plan document that complies with Section 125. Without a written document, the plan fails, even if in its application it complies with Section 125. At the end of each plan year, there must be specific testing to determine whether the plan meets the non-discrimination rules. Failure to test, and have evidence of the test, can invalidate the entire plan. The current regulations do not allow for even minor errors, nor do they provide any method to retroactively correct minor errors. Therefore, “strict compliance” is required.
For further information regarding these matters, please contact Mr. Goldberg at 248.528.1111 x664 or click here to send an email.
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