March 11, 1998

HOW SMALL BIZ CAN DISH OUT MORE BENEFITS: CAFETERIA PLANS

Edited by Dennis Berman

As unemployment rates near their 24-year low, it's becoming difficult for small employers to attract new employees, much less hang on to old ones. To help fight the labor shortage, large companies are piling on employee benefits such as medical insurance, pension plans, and generous vacation time. How can small companies use benefits to recruit top talent -- yet do it without breaking the bank?

It's not an east task. Benefits are now a significant part of compensation packages, averaging approximately 19% of an employee's gross salary.

Why have benefits become such an expensive, and necessary, part of doing business? Three reasons stick out:

1. Employees now analyze their salaries as a total compensation package, which includes the base salary as well as the benefits' total value. What's more, they've come to expect -- and have received --more in the way of benefit options. One prime example: disability insurance. Although disability insurance can still be purchased individually, it is now generally thought of as an employee benefit.

2. Large employers like to take advantage of economies of scale. They, of course, can't do that with cash. A $2,500 raise costs exactly $2,500. But using huge purchasing plans, they can offer a health plan valued at $2,500, at a cost of, say, $1,700.

3. Tax laws look kindly on employers who offer, and employees who accept, certain fringe benefits. Generally, the IRS allows employers to fully deduct these offerings, while also exempting employees from taxes on the benefits. These incentives are available as long as employers comply with the required antidiscrimination and reporting requirements.

One of the best tax-favored benefits is a "cafeteria plan." Under a cafeteria plan, employees can pick from any number of available benefits -- assembling total packages that best suit their needs. Pure, company-funded cafeteria plans are not often used because they are considered too expensive. A common variation is mixing a cafeteria plan with a flexible spending account. Using an FSA, employees still select from a list of benefits, but the cost is deducted from employees' overall compensation. Large employers have offered benefits this way for years, and small employers mistakenly perceive these plans as being too complicated or costly.

In some instances, a small company might actually save money by offering a flexible spending account cafeteria plan. Here's how one might work for you:

Basics

This type of plan gives the employee the option of selecting cash or choosing from a list of employer-selected benefit options. The employee must in effect "pay for" the selected benefits by giving up his rights to cash compensation.

If everything is done right, the employee is not subject to federal income tax on the value of the selected benefits. (Note: Most states now follow the federal law and don't tax, either.) The employer still obtains a full tax deduction for the benefits paid; and neither the employer nor the employee pay Social Security or Medicare taxes on the value of the selected benefits.

Caution: Under what is known as "constructive receipt rules" enforced by the IRS, employers cannot offer their employees the rightto choose either cash or benefits without having a written cafeteria plan in place. The key word in the above sentence is "right." It still is possible to negotiate an individual compensation package, but you cannot offer a set salary and then let the employee unilaterally choose between cash compensation and benefits without falling under the cafeteria plan rules.

Specifics

A written plan document is required. In the past, you'd have to use a private attorney -- often at great expense -- to help you draft the document. Today, serviceable prototypes are now available from law firms, CPA firms, insurance companies, benefit consultants, and even payroll processing companies. The cost for a typical prototype document is usually less than $1,000. In most cases, an individually designed document is not needed, but be sure to have a lawyer give it a final look, just to be safe.

Your document must be very specific about the benefits you plan to offer employees. For instance, the law allows a cafeteria plan to include disability insurance as an optional benefit, but if your plan document does not specifically allow for disability insurance, it will not be available until you update the plan. Fortunately, most prototypes are fairly generic and contain the required guidelines. The most typical benefit options offered in a cafeteria plan are:

1. Cash -- Note that this is a required option and will be treated as fully taxable income if selected.

2. Health insurance -- Includes traditional health coverage, HMO coverage, and dental insurance.

3. Medical reimbursement programs -- This pays, up to a specified dollar limit, for an employee's unreimbursed medical expenses, such as eyeglasses or vision checkups.

4. Dependent care expense -- Covers qualified child and elder-care expenses.

5. Disability insurance -- Either short or long-term.

6. Group term life insurance -- The employees can elect group life insurance coverage up to a face amount of $50,000 without incurring any income tax cost.

What the Law Requires

1. That you make the program available to all employees who have at least three years' service. Note, less than three years is acceptable as a condition to enter the plan.

2. That the plan benefit a fair cross-section of employees. For small employers, this generally means that all employees be offered the chance to participate.

3. Self-employed individuals, including partners and stockholders with more than 2% in S corporations are not allowed to participate in cafeteria plans because the plans are restricted to employees only. In addition, there are special rules that may limit the tax-free benefits to highly compensated individuals.

4. Each year, you must submit a short report to the IRS describing the activity in the plan. Fortunately this is not a complex document for employers with less than 100 participating employees.

5. To pay for the benefits, you will deduct a portion of employees' salaries from the taxable payroll. As such, there will be the need for some record-keeping. Much of it can be done on computerized spreadsheets and, in most cases, is not all that time-consuming even when done by hand.

Examples

Here's the good part -- learning how a cafeteria plan may actually save you and your employees money.

As an example, take an employee with a monthly salary of $2,000 who elects to put $300 per month into a plan for health insurance, elder care, and disability insurance. Now assume that the salary is taxed at a rate of 25%, which combines federal and state income taxes as well as Social Security and Medicare taxes.

Without Flex
$2,00 -- gross pay
(500) -- less 25% taxes
1,500 -- adjusted gross pay
(300) -- less medical premium
$1,200 -- net take-home

With Flex
$2,000 -- gross pay
(300) -- less medical premium
1,700 -- adjusted gross pay
(425) -- less 25% taxes
$1,275 -- net take-home

At $75 per month, that equals $900 per year in employee savings.

Example of employer savings, if 10 employees each put $300 per month into the plan to pay for health insurance and all employees are under the Social Security and Medicare tax limits:

$3,000 -- 10 employees x $300 per month salary reduction
x 7.65% -- Social Security and Medicare tax (employer portion only)
$229.50 -- total savings per month before expenses

At savings of $229.50 per month, that equals $2,754 in annual savings. Subtracting an estimated $1,000 in startup and administrative costs, that yields a net savings of $1,754 in the first year.

With low startup costs, minimal IRS reporting, and relatively small ongoing administrative expense, a cafeteria plan is one way for a small employer to compete with a big corporation in the midst of this tight labor market.

By Jim Vonachen in Denver. Vonachen is a certified public accountant and partner in charge of the tax practice at Clifton,Gunderson LLC in Denver. He's also a frequent guest of BusinessWeek Online conferences concerned with tax planning and filing tips.