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Legality of contributing to cafeteria plan without reasonable expectation of use


LisaLiza
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Can someone point me towards any applicable rules prohibiting cafeteria plan contributions without a reasonable expectation of use?  I feel sure this can't be allowed, but I'm struggling to find specifics.

Obviously, the goal is to increase compensation on paper to allow for a larger profit sharing distribution annually.  The non-ERISA plan funds would typically all be forfeited back to the business each year.  

You could argue that anyone could 'acquire' a dependent any given year, but I wouldn't try to argue that's a reasonable expectation.  It doesn't seem to pass the sniff test, but I can't even find what sniff tests might apply.  Any help would be much appreciated.

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The employees (a parent and several siblings of a C Corp owner employee) would voluntarily elect to fully fund their own DCAPs - $5000 per year - via cafeteria plan salary reduction.  None have dependents, it would be reasonable to expect that all plan balances would be forfeited annually for the foreseeable future.

 

FWIW, they are already doing this with Health FSAs, but those funds are used as intended - with experience gains being allocated appropriately within the plan.

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The primary goal is to allow key employees to stave off voluntary after tax contributions for a larger chunk of time/income - ACP testing wouldn't be welcome.  Additional accrued sick leave for future retiree benefit is an attractive perk.  FICA/SUTA avoidance seems like an obvious benefit, though, which is why I'm pretty convinced it must not be kosher.  

 

And yes, everyone would be on board with the forfeitures because the whole situation is mutually beneficial.  No one is excessively compensated by any measure, the siblings are paid minimum wage for work that runs the gamut from menial to legitimately professional.

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Employee is paid $70,000.  Employer increases pay to $75,000, with $5,000 funding the employees DCAP.  The DCAP isn't used and the $5,000 is forfeited back to Employer. No one benefits from the $5,000 other than using $75,000 rather than $70,000 as compensation for the calculation of profit sharing contributions. Correct?

Are they really avoiding taxes? 

 

 

 

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4 minutes ago, RatherBeGolfing said:

 

Are they really avoiding taxes? 

 

Maybe... we would need to know more. 

If they are really paying very low wages to even people doing professional work this could be part of trying to not pay a reasonable compensation.   This comes up in family owned companies that are S Corps.    You pay a very low pay which causes the company's profits to be higher.   That income flows throw to the families 1040s.   They take S Corp distributions to pay for the taxes and to keep some for themselves.    You don't pay payroll taxes on S Corp distributions.   There are rules against this- the reasonable compensation rules.   So if they are upping their compensation, to make it look like they are paying closer to a reasonable compensation,  but then in effect taking the pay back via the pre-tax elections that forfeit which allows them to pay via S Corp distributions they would be saving taxes. 

If that is what they are doing it sounds like a lot of work for saving hundreds of dollars at best to me.   But I know people who will go through a lot to deny the government $1 in taxes.   

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Employers can exclude from FICA amounts where "its is reasonable to believe" that the employee will be able to exclude the payment or benefit under §129.  In this case, there's a good argument the employer does not have that reasonable belief given it is clear the employees have no eligible eligible dependents (and therefore no qualifying expenses) for the dependent care FSA contributions.

IRC §3121:

(a) Wages.

For purposes of this chapter, the term “wages” means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash; except that such term shall not include—

...

(18) 

any payment made, or benefit furnished, to or for the benefit of an employee if at the time of such payment or such furnishing it is reasonable to believe that the employee will be able to exclude such payment or benefit from income under section 127, 129, 134(b)(4), or 134(b)(5);

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Thank you!  I knew it had to be simple - or it would be done frequently by family businesses.  I knew it wouldn't fly for an S Corp, if only because the owner and parent wouldn't be allowed to participate anyway.  It totalled out to ~$1500 in avoided FICA/SUTA on the profit sharing contributions, plus an extra 10% of sick leave accrual on the additional 'wages.'  I'm unsure whether 'unreasonably' low compensation is a legitimate issue for C Corp employees, but that might be above my pay grade.  Total comp is significantly higher than just wages, which might mitigate that concern.

 

This begs the question, though, are they asking for trouble maxing out their health FSAs, if they aren't making a concerted effort to spend it down annually?  It's used appropriately, to cover all incurred medical expenses, but I don't think there's ever been a year where they were able to make the full $2750 contribution each after allocation of prior year funds.  It seems to me that this is the very definition of a self funded insurance plan, but it still might not pass muster up against 'reasonable belief.' 

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Certainly I have some factual questions about this arrangement, but it clearly doesn't pass the smell test. 

Although the questions about FICA/SUTA, compensations, etc., are valid, it seems that the first question is whether the individual is actually eligible to participate in a DCAP.  There seems to be some doubt about that.

To participate in any tax-favored benefit plan, the individual must first be an employee.  Owners or partners may or may not be employees.  If they are determined to be employees, they must also be eligible to participate in the plan.  However, an employee must also be eligible to participate a tax-favored benefit plan, and based on the facts described, these individuals aren't eligible to contribute to a DCAP.  

IRC sec. 129 "Dependent care assistance programs" (DCAP) provides the rules for this program.  The purpose of the DCAP is to exclude from gross income amounts for dependent care with respect to dependent care services not exceeding $5,000.  IRC 129(a)(2)(A). 

Dependent care and dependent care services are defined in IRC sec. 21 "Expenses for household and dependent care services necessary for gainful employment."  Dependent care is limited 1) to qualifying individuals; so that 2) the employee may have gainful employment.  An individual who doesn't satisfy these 2 elements isn't eligible for the exclusion and, therefore, participation in a DCAP.

A generic cafeteria plan doc that we use states:  Dependent care expenses are defined as expenses incurred for the care of a qualifying individual. A qualifying individual is either: (i) a dependent who is under age 13, or (ii) the Participant's spouse or dependent who lives with the Participant and is physically or mentally incapable of caring for himself/herself. However, these expenses are dependent care expenses only if they allow the Participant to be gainfully employed.

Next, the right to an exclusion from gross income doesn't actually accrue until expenses for dependent care are paid or incurred.  IRC 129(a)(2)(A).  If the individuals do not pay for dependent care services, they cannot make a claim for the exclusion.  The COVID crisis illustrated this principle.  Families who were at home didn't incur expenses, so, through their no fault of their own, were in danger of forfeiting amounts already contributed to their DCAP.

In addition to potential forfeiture, IRC 129(a)(2)(B) requires that amounts that exceed the amounts actually used must be included in gross income in the taxable year in which the dependent care services were provided. 

The Code slaps the hand reaching into the cookie jar for a second (or third) cookie.  The worst case scenario is that the plan appears to have intentionally allowed ineligible individuals to participate and could be disallowed because of the employer's bad faith and lack of compliance.  Disqualification could be retroactive for the period that these ineligible employees contributed to the DCAP.  All funds contributed would then be subject to taxation.

Because these individuals weren't ever eligible to participate in the plan, it's possible that the plan could refund the amounts contributed.  However, if the terms of the plan require forfeiture, it's also possible that the funds would be forfeited.  Either way the amount of the contributions must be included in the employee's gross income for the tax year in which the contributions were made.

Because most tax-plans don't reconcile until after the end of the tax year, the employer would have to send the employee an amended W-2 (or other applicable doc) to account for the excess.  If an employee has already filed their Form 1040, they must then file an amended return.  If taxes aren't paid on excess contributions for that tax year, the taxpayer and/or the plan administrator may be subject to stiff excise taxes.   

This type of process applies to any number of tax-favored employee benefit programs, such as HSAs, 401(k)s, IRAs, SARSEPs, etc.

As for the FSA, I'd apply the same analysis.  So long as the individuals are employees and eligible to participate in the FSA, they can contribute up to the maximum amount.  There is a broad range of medical expenses for which their FSA funds could be used, so the blatant abuse of the statute isn't readily apparent.  If they don't use their FSA contribution, it's forfeited.   

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