Section 125 – Eligibility Requirements
In order to qualify for tax advantages, a Section 125 plan must satisfy the requirements of Code Section 125 and underlying IRS regulations, as summarized below.
- A description of the benefits available through the plan, including the periods of coverage;
- The plan’s rules for employee eligibility;
- The procedures governing employees’ elections under the plan, including when elections may be made, when they are effective, and any exceptions to the irrevocability rule;
- The manner for making contributions (for example, pre-tax employee contributions, employer contributions or both) and the maximum amount of contributions; and
- If the plan includes a flexible spending arrangement, a description of the special rules that apply to these accounts (for example, the uniform coverage and use-or-lose rules for health FSAs).
The plan document for a Section 125 plan may be comprised of more than one document. For example, the Section 125 plan document may incorporate by reference benefits that are offered through separate written plans, such as a health FSA, without describing these benefits in full. Also, other Code sections require plan documents for certain qualified benefits, including a health FSA, DCAP and adoption assistance. These requirements can be satisfied by including these benefits in the Section 125 plan document.
A Section 125 plan may be amended, or changed, at any time during a plan year. However, amendments must be made in writing and can only be effective for periods after the later of the adoption date or the effective date of the new amendment, unless otherwise permitted by the IRS.
Any employer may sponsor a Section 125 plan for its eligible employees. This includes private sector businesses, including corporations, partnerships, limited liability companies and nonprofit organizations, as well as public sector employers.
Also, as a general rule, an employer may allow any common law employee to participate in its Section 125 plan. In addition, former common law employees (for example, COBRA participants receiving severance pay) and leased employees, as defined under Code Section 414(n), may participate in an employer’s Section 125 plan.
While only employees are allowed to make elections under a Section 125 plan, a Section 125 plan may provide non-taxable benefits for an employee’s spouse, dependent child who is under age 27 or tax dependent. A “spouse” means an employee’s spouse as defined under federal tax law, including same-sex and opposite-sex spouses. This definition, however, does not include domestic partners. Thus, a Section 125 plan cannot provide non-taxable benefits for an employee’s domestic partner who is not a tax dependent.
Additionally, although individuals who are not considered employees, such as self-employed individuals, partners in a partnership and more than 2 percent shareholders in a Subchapter S corporation, can sponsor a Section 125 plan for their employees, these self-employed individuals cannot participate in a Section 125 plan on a tax-favored basis. Likewise, directors of a corporation who are not also employees cannot participate in a Section 125 plan on a tax-favored basis.
Next Part 3- Qualified Benefits
Many of the benefits that may be provided through a Section 125 plan are subject to the Employee Retirement Income Security Act (ERISA). ERISA includes its own set of requirements for written plan documents and SPDs, which are different from the Section 125 plan document requirements. Employers should confirm that their employee benefit documents comply with both sets of requirements, as applicable.
Impact of Noncompliance: According to the IRS’ 2007 proposed regulations, if there is no written plan document in place or if the written plan document does not comply with the content or timing requirements, employees’ elections between taxable and nontaxable benefits will result in taxable income to the employees.
Relationship to Health Plan Eligibility: An employer’s group health plan may be designed to cover individuals who do not qualify for tax-free health coverage (for example, children who are older than age 27, grandchildren or domestic partners). Under the Section 125 rules, an employee may only pay pre-tax for coverage of a spouse, a child under age 27 or a tax dependent. As a general rule, coverage for other individuals should be paid for on an post-tax basis.