by Blake London
on February 2, 2016
The main idea behind a cafeteria plan is to provide a tax advantage to a business’s rank-and-file employees, as opposed to their key employees or executives. One particular group to consider in the administration of a cafeteria plan, then, is a business’s owner or group of owners. Here, we will briefly cover the rules regarding the participation of owners in a cafeteria plan.
- Cafeteria plans are to be offered to employees; the IRS does not consider a self-employed individual to be an employee, therefore, such are ineligible to participate.
- The IRS’s definition of “self-employed” extends to individuals in various owner or owner-like positions, which are each discussed in detail below.
- In nearly all cases, spouses or other relatives of owners can participate in the cafeteria plan as long as they are bona fide employees of the business and are not also considered self-employed (though participation of these individuals may affect compliance of certain non-discrimination tests).
- A sole proprietor who owns the entirety of a company, where no distinction is made between that person and the business, is considered self-employed and may not participate in a cafeteria plan offered to his/her employees, if any.
- A sole proprietor may still be able to deduct the amount paid for health insurance for themselves, their spouse, or their dependents.
Partners in a Partnership
- Partners in a general or limited partnership are considered self-employed, and may not participate in a cafeteria plan.
- Partners may have the ability to make a tax deduction outside of the cafeteria plan for the amount of their medical and long-term care expenses.
- Partnerships that have “limited” partners will want to consult with legal counsel regarding the eligibility of their limited partners to participate.
Subchapter S Corporations
- More-than-2% shareholders of an “S-Corp” cannot participate in a cafeteria plan, as they are treated by Code 125 the same as partners and are considered self-employed.
- The limiting percentage extends to either the amount of the person’s ownership of stock or the amount of voting power granted to that person by their stock ownership.
- The “entire year” rule is in effect here: a person will be considered self-employed for testing if at any point during the year they went above 2% in shareholding
- Unlike the other business types, spouses, children, parents, and grandparents of more-than-2% shareholders may NOT participate in the cafeteria plan.
- Like partners in a partnership, more-than-2% shareholders may be able to make a tax deduction outside the cafeteria plan for medical and long-term care expenses.
Subchapter C Corporations
- No regulations exclude shareholders of any percentage in a “C-Corp” from participating in a cafeteria plan. However, excessive participation of these individuals in the cafeteria plan may cause the failure of certain non-discrimination tests.
Limited Liability Companies (LLC) and Limited Liability Partnerships (LLC)
- Generally, members of LLCs or LLPs are treated as partners for tax purposes and, as such, are also not allowed to participate in the cafeteria plan.
- If an LLC or LLP member is also an employee of the business and is not treated as a partner or self-employed for tax purposes, they could potentially participate.
- If the sole owner of an LLC is another corporation, the employees of that LLC should be able to participate in the cafeteria plan.
- Ultimately, the IRS does not recommend LLC or LLP members participate in a cafeteria plan unless it has elected to be taxed as a Subchapter C Corporation.
What happens if an ineligible owner participates in the plan?
Allowing self-employed individuals as described above to participate in the cafeteria plan could cause the entire plan to be disqualified as a cafeteria plan, which would cause all benefits payments made under the plan for all participants (owner or not) to be taxable. At the very least, those who are ineligible would be taxed for their benefit payments made under the cafeteria plan.