Section 125 cafeteria plans offer significant tax advantages, but they are also heavily regulated. Many employers lose the tax benefits not because of bad intent, but because of poor administration.
Understanding Section 125 compliance is critical to protecting both the employer and employees.
Why Section 125 Compliance Matters
A Section 125 plan only works if it meets IRS requirements. If the plan is non-compliant, the IRS can disqualify the plan entirely.
When that happens:
- Employee benefits become taxable
- Payroll tax savings are reversed
- Employers may owe back taxes and penalties
Compliance is not optional. It is foundational.
The Most Common Section 125 Compliance Issues
No Written Plan Document
One of the most frequent violations is failing to maintain a formal plan document. A Section 125 plan must be documented in writing and reflect how the plan operates.
Operating without a document puts the entire plan at risk.
Outdated or Incorrect Documents
Even if a plan document exists, it must be kept current. Changes to benefits, eligibility, or administration require updates.
Using boilerplate documents that do not match real-world operations is another common mistake.
Failure to Conduct Nondiscrimination Testing
Section 125 plans cannot disproportionately benefit owners or highly compensated employees.
Employers must test annually to ensure the plan meets nondiscrimination rules. Skipping this step is a compliance failure.
Improper Election Changes
Employee elections are generally locked in for the plan year unless a qualifying life event occurs.
Allowing mid-year changes without a valid event violates IRS rules and can invalidate pre-tax treatment.
Poor Recordkeeping
Employers must be able to prove elections, changes, and plan administration.
Missing records can be just as damaging as missing documents.
Premium Only Plans Are Not Exempt
Many employers assume Premium Only Plans are exempt from compliance requirements. They are not.
Even a simple POP requires:
- A written plan document
- Annual elections
- Proper payroll handling
POP plans are simpler, but they are still Section 125 plans under the tax code.
Who Is Responsible for Compliance?
Ultimately, the employer is responsible for Section 125 compliance, even if administration is outsourced.
Third-party administrators can help, but liability does not transfer.
This is why employers should:
- Understand the basics of compliance
- Work with experienced administrators
- Review plan operations annually
How to Reduce Compliance Risk
Employers can significantly reduce risk by:
- Maintaining accurate plan documents
- Aligning payroll systems with plan rules
- Conducting annual nondiscrimination testing
- Training internal teams on election rules
- Performing periodic compliance reviews
Proactive management is far less costly than fixing a failed audit.
Final Thoughts on Section 125 Compliance
Section 125 plans are powerful, but only when handled correctly.
Compliance is not about paperwork for its own sake. It is what protects the tax benefits that make these plans valuable in the first place.
For employers willing to do it right, Section 125 remains one of the most effective benefit strategies available.
