Sect. 125 plan...without the plan document :(

[Guest FoolMeOnce]

I recently started working as an administrator for a very small (1 FT/4 PT EEs) religious organization. After processing my first payroll there, I realized that my predecessor in the office (let's call him "J") had been underwithholding and misreporting payroll taxes because he was treating his health insurance premiums as if they were subject to a Section 125 plan for the past several years...only problem is, there isn't one in place.

Background: There are two EEs participating in the district health insurance program. One of them has insurance benefits paid by the employer (which is spelled out in the EE's employment contract); J (a part-time employee) was allowed to participate in the plan provided he paid the entire ins. premium through payroll deduction. Soon after enrolling in the group health insurance, J did a little research and suggested setting up a 125 plan. Apparently the executive board did not follow up on the request, so J just took it upon himself to deduct the insurance premium amount and calculate the FIT/FICA/Medicare on the remaining pay.

BTW, things are further complicated by the fact that J is still employed there (in a non-administrative capacity). J will be coming off the group plan and starting coverage with his new employer in another month. At first I was willing to let this go, thinking that there's only a month remaining (and that we are very unlikely to be audited). But now that I realize I'm supposed to sign off on the Form 941 for this past quarter, I'm having second thoughts.

Can anyone tell me what the potential liabilities are for:

• the employer?
  
• the employee, J?
  
• myself?
  

I'm concerned about going to the board as J is very well-liked and I am...well, new. I want to be sure I have all my ducks in a row before I create what I imagine is going to be a HUGE stink, and a very uncomfortable situation for everyone. Thanks in advance for any advice!

[masteff]

As this will be the last 941 that will be potentially incorrect and as you're new to the position and weren't in charge for the better portion of the quarter, would it be totally inappropriate to simply ask J to sign one last 941 since he's better familiar w/ it than you? "One last one since you ran most of those payrolls, J?" Then you can start signing them in future quarters?

[Guest FoolMeOnce]

That is one of the possibilities I discussed with my supervisor this morning. Of course, in order for me to sign off on the 3QTR 941, we need to take taxes on the full salary amount before deducting the insurance premiums for July. Hopefully, the board will back me up on that one - I know J is going to pitch a fit!

[LRDG]

J should beg you to allow him to sign and quickly and keep very quiet. He's potentially caused a not insignificient problem for his employer.

Penalties that I've seen first hand for one client was in the $90k, but a slightly different problem. However, the IRS assesses at $100's+ per day per EE for certain types of violations. The $90k was for failure to file 5500 for 5+ years.

It's easy for me to say I would refuse to sign the 941, would't sign no matter what, but I'm not sure what I'd do in your situation. It may be wise to not alert J to your concerns about his accounting methods until you have an opportunity to discuss with your sup.

I see back taxes and penalties all around, or at least for J, possibly time in the big house for fraud. It's not like he can claim ignorence, knowledge about such matters is the basis of his job. If there is an audit, and the powers that be have not coninued to ignore J's offence, the IRS has been known to be understanding when ignorence is claimed and the claim is justified.

The $90k was waived by the IRS, btw, but it was approx 8yrs ago, 13yrs since inception of the plan, the signifience of which goes to the fact that 125's were new, at a time when there were unqualified administrators, which was the case with this particular client.

[jpod]

There are no 5500 penalties at issue here.

Can't the 3d Q 941 be fixed by having the employer deposit all taxes due? The taxes attributable to the medical insurance premium for one employee for one quarter can't be a large amount.

[LRDG]

The IRS will not simply ask taxes be paid on the premium, they will assess penalties, sanctions and back taxes for as far back as this has been going on, which seem to be much longer than one qtr.

[jpod]

There is no obligation under the IRC to correct for past quarters. It is a judgment call to be made by the emploeyr with the advice of its accountant or tax lawyer as to whether it will fix via the 941c procedure. The poster was primarily concerned about the pending 941 now that the error has been discovered.

[Guest FoolMeOnce]

Thanks for all the feedback. It was an interesting day at work today.

I would hope the IRS would take into account the size of our payroll...90K seems like a rather extreme penalty, given that the total payroll last year was about 60K. <g> (BTW, jpod, if the board had a tax lawyer or accountant to consult with in the first place, I doubt I'd be dealing with this situation. I'm pretty much the only person giving them any "advice" at the moment. And I've never filled out a 941 before!)

I was able to find some old emails on file from J to a couple board members. From the emails, it is clear to me (and now, my supervisor) that J knew the plan document was required but went ahead without it anyway. After a couple hours digging through files, I determined that J has been doing this for about 2.5 years, with about $1300 in taxes owed by the EE and ER apiece.

I've recommended to my supervisor that this year's 941 forms be amended. (I'm leaving it up to them to figure out what, if anything, to do about 2006 and 2007.) Otherwise, I won't be signing the 941 (or, for that matter, next January's W-3). My supervisor is going to speak with someone on the board and find out how they want to proceed. So it looks like things are going to be resolved, eventually.

But wait...there's more...

J stopped by the office this afternoon to let me know that his accountant (J must have filed for an extension on his 2007 tax return) said he needed a revised W-2 - with the Box 1 wages "corrected" to reflect the salary after the insurance deductions - and that W-2C forms should be arriving in the mail shortly. I'm not sure which is more insulting - that he thinks I'm naive enough to not understand what's going on, or that I would go along with breaking the law (did I mention I work for a *religious* organization? <g>). Needless to say, that's not gonna happen.

Can't wait until he comes looking for his revised W-2 next week. (Ack!)

[LRDG]

FoolMeOnce, while I don't wish this kind of problem on anyone, I do hope you throughly enjoy watching J squirm over the next couple of weeks or months.

It must have been a most unpleasent situation to find yourself in, showing up for a new job hoping to make a good first impression, to uncover long standing illegal activity conducted a well liked employee and having to be the barer of bad news. Small religious organizations can make for charged political work environments, without the illegal activity, ironic as it is.

BTW, FMO, I didn't intend confuse you with the $95k example for failure to file as example of liability, but you seem pretty sharp. I figured you'd catch that. Doing accounting work for religious, not for profit organization.

[Guest FoolMeOnce]

A part of me is enjoying watching all this unfold, but at the same time, I feel badly for J - he first asked the board to put the section 125 plan in place in 2002. I'm sure he was very frustrated waiting for the (volunteer) powers-that-be to get moving on it.

And once we have the discussion about his W-2 next week, he's going to be (at the very least) looking at shelling out some significant $$ to get this all straightened out. Not to mention having the entire board made aware of his poor judgment and unethical behavior.

[GBurns]

So the apparent problem is that J made pre-tax salary reductions without a section 125 plan in place.

But what does "a plan" and "in place" really mean. Apparently the concensus is that there has to be some document i.e a plan document. Why ? The answer that I always get is that the Treasury Regs say so. But that raises the question of Which Treas Regs ? The Proposed Treas Regs? If that is the response then the next question is Since when have Proposed Treas Regs ever had the effect of law? Many court decisions including Grande v Allison have pointed out that the bulk of the Treas Regs affecting section 125 cafeteria plans are "merely proposed".

So you are trying to apply something that the law cannot enforce.

Has anyone ever seen or heard of a section 125 cafeteria plan failing an audit for any issue that falls under the Proposed Treas Regs ?

Personally I canot recall even one. Maybe my experience is not wide enough but all cases have been for other issues.

So What is "a plan" under IRC section 125 ? This should be the determining factor for resolving this issue. Is the verbal agreement by the Board (of course recorded in the Minutes of the Board Meeting" along with the general understanding by, and consent of, the participants, sufficient to have established "a plan" Or is a written document with a written Board Resolution needed ?

[J Simmons]

The statute defines a cafeteria plan to be "a written plan under which all participants are employees, and the participants may choose among 2 or more benefits consisting of cash and qualified benefits." IRC Section 125(d)(1).

I think a written Board resolution or minutes would at least need to specify that "all participants are employees" and specify 2 or more benefits consisting of cash and qualified benefits from which the participans may choose.

If the Board merely discussed the possibility, or decided that a plan should be adopted and directed the executive director to sign a written plan--but it never was--you'd not have a written cafeteria plan as required by the statute.

[LRDG]

Being such a small organization, very little money involved, in addition to being a non profit entity may have some baring on how lenient or heavy handed the IRS decides to treat the situation. I wouldn't know first hand as I don't have any experience with groups that small, and I do limited work with non profits. I've been involved in a grand total of two 125 plan audits, in addition to the one I mentioned being written about in the WSJ. I was involved in their core benefits, not their 125 plan.

One of the audits involved a client who's payroll was being audited. It was approximately 1995, I got a call from the client asking what he should do because the auditors were quite concerned about payroll deductions for pre-tax premiums and FSA deductions. The client explained to the auditors that the deductions were to 'pay premiums and fund FSAs under a Cafeteria Plan, you know a Sec. 125 plan'. The 6 or so auditors exchanged glances all around, agreeing none of them have heard of any such 'plan'.

My contact, (a partner in a top law firm, his father is a founder of the company I work for) knows Sec. 125 is actually in the tax code, he's seen it himself when we were discussing plan design. At this point he's hearing theam music from the Twilight zone.

I faxed a copy of Sec. 125 from CCH, mostly stalling for time, because I'm really thinking how wierd it is getting, they ARE the IRS, you're the $600 an hr attorney and you'r asking me? About an hour later I got another call from my contact saying the auditors read the fax, passed it around the conference table and announced their work was done. They proceded to pack up and leave. Another example of our tax dollars at work. Ironic and in hind sight a funny IRS story, of which there are just are never enough. According to the client, the shortest audit in history.

Then there was the time I called the tax exempt and benefits division of the IRS in DC with a question about Cafeteria plans and was told that fast food workers are taxed no differently than anyone else.

I agree with the arguement about the temporary and proposed status of Sec. 125 and treasury regs. If any case did end in litigation, I'm sure it's the argument our legal team and client's would make. But I'm not particularly interested in clients spending their time and resources defending a court case over not having a plan document, litigation that could end unfavorabely even if client did legitamitely defend not having one.

With respect to experiene with 125 plan IRS audits, as long as I've been doing Sec. 125 work, I've only had the failure to file a 5500, and those penalties were waived by the IRS. I wasn't directly involved in the case involving constructive receipt violations. My only other contact with IRS auditors and 125 plans is the case I posted above and there was no violation.

IRS established an audit division dedicated to 125s in about 1998/9. The announcement was in many industry publications, but I haven't heard anything more since that time. The audits I'm familiar with happened before the 125 audit division was established.