Guidance requested for cafeteria plans, please!

[Guest cease]

The following facts were presented to me:

A person is a 1% owner in a LLC and as a results receives a K-1.

The same person is a common law employee in the same LLC and receives a W-2.

The amount reported on the W-2 is sigificantly larger (70 times more than) than the amount reported on the K-1.

The question is whether this person can participate in the companies cafeteria plan.

I am a retirement plan practioner and would appreciate any guidance as to what additional information is needed, or guidance that allow or doesn't allow this person to participate.

Thank you for your assistance.

[Ron Snyder]

From the Proposed Regs. under Section 125:

"A-4: The term "employees" includes present and former employees of the employer. * * * The term "employees" does not, however, include self-employed individuals described in section 401© of the Code."

Revenue Ruling 91-26 clarifies that 2% shareholders are such self-employed individuals. If a deemed self-employed individual participates in the plan the premiums or reimbursements must be passed through to the 2% shareholder as taxable income.

Please note, however a shareholder who owns 1% is not a 2% shareholder. The employee may participate in the 125 plan.

[401 Chaos]

Vebaguru,

Do you read Rev. Rul. 91-26 to extend the 2% S-Corporation exception to less than 2% members of an LLC? Assuming the LLC has elected to be taxed as a partnership, I have heard others interpret this as being governed by the regular partnership rules. Thus, any LLC member-employee, no matter how small of a membership interest they hold, would be considered self-employed and therefore ineligible to participate in a cafeteria plan. I don't think that is fair, particularly given the rise in LLCs in recent years and the trend to award employees nominal membership interests but I have generally understood there to be a bright-line prohibition if the individual receives a K-1 from the LLC. Thanks for any guidance you can provide.

[Guest jfp]

cease, you have a couple of issues floating around here.

First, is the LLC taxed as a partnership for tax purposes, or as a corporation that has made an S election?

Assuming it is taxed as a partnership, the "2% rule" is irrelevant. No partner can participate in the plan. It is inconsistent with the IRS' position that a partner can receive a W-2 for any portion of his or her compensation. All of the partner's compensation should have been reported on the k-1, so the fact that the compensation was reported - incorrectly, in the IRS' view - on a W-2 cannot be used to allow the partner to participate in the 125 plan.

If the LLC is treated for tax purposes as a corporation and has made an s election, the individual would be an employee and can participate in the 125 plan, as long as he/she is not a "2% shareholder."

[GBurns]

cease

I am curious as to this person's reasons for wanting to participate in the Cafeteria Plan? Is is so as to be able to pre-tax an employee portion of insurance premium, or FSA or for DCAP?

[Guest cease]

Just to provide a quick update.

jfp - you were right. After further discussions, it appears that compensation has been paid to this person incorrectly. All earnings should have been reported on a k-1, not a combination of k-1 and W-2.

Thanks once again for the feedback!