One of the most underused tax saving opportunities for a small business and its employees is outlined in Section 125 of the US tax code - Cafeteria Plans. For employees, a section 125 plan can give them tax savings of 25% or more of the amount they pay into a cafeteria plan and the employer can save money as well!!

What is a Section 125 Cafeteria Plan?
A cafeteria plan is a separate written plan that provides participants an opportunity to receive certain benefits on a pretax basis.

Under a cafeteria plan, your employees can take advantage of three specific flexible benefits:

• A Premium Only Plan (POP) - POP plans allow employees to elect to withhold a portion of their pre-tax income to pay for their premium contribution for most employer-sponsored health plans.
• Flexible Spending Account (FSA) - An FSA allows an employee to fund certain medical expenses on a pre-taxed basis through income reduction to pay for out-of-pocket expenses that aren't covered by insurance (for example, annual deductibles, office co-payments, prescriptions, over-the-counter drugs and orthodontia).
• Dependent Care Flexible Spending Account - The dependent care FSA is an attractive benefit for employees who pay for child-care or long-term care for their parents. Many employees don't take advantage of this benefit and may be unaware of the significant tax savings. Employees may hold back as much as $5,000 annually of their pre-tax income for dependent care expenses.

Remember, you must have a written plan that specifically describes all benefits and establishes rules. This document should outline specific details, such as a description of the employee benefits that are covered through the plan, participation rules, annual limits, election procedures, eligibility and employer contribution. It also defines the plan year.

How does a Cafeteria Plan Work?
A Cafeteria Plans allows your employees to contribute pretax dollars into the plan. Contributions toward plans are not subject to federal, state, or social security taxes. The contributions are placed into an account the employee can use to pay for allowed expenses. Your employees are able to determine what aspects of benefits are important to them - like a menu, hence the name Cafeteria Plan.

Benefits to You - the Small Business Owner
Since your employee's contributions are not subject to social security tax, you do not have to pay FICA or workers' comp premiums on those dollars. In many cases, the savings in payroll expenses can add up to as much as 20 percent of every dollar being passed through the plan. This savings could quickly offset the costs of implementing a cafeteria plan as they cost very little to set up and maintain.

As the Business Owner - Can I Participate?
Yes and No... Sole proprietors, partners in a partnership, S-Corp 2% or more shareholders (and their family), members in an LLC which has elected to be treated as a partnership, and non-employee director can not participate in these plans.

However, there are some exceptions. Dual status individuals are eligible if they are both an employee and provide services to the employer as a director or independent contractor. This is not available for partners or more than 2% S-Corp shareholders. Also, employee spouses of sole-proprietors can participate if they are an employee of the business and not self-employed.

Of course, sole proprietors, partnerships and S-Corps may still sponsor Cafeteria Plans and FSAs for their own employees.