Cafeteria Plan – Fringe Benefits (IRS Section 125 Guide)

A Cafeteria Plan, also known as a Section 125 plan, is an employer-sponsored benefit arrangement that allows employees to choose between taxable wages and certain qualified, tax-free benefits. These plans are regulated under Internal Revenue Code Section 125 and detailed in IRS publications such as Publication 15-B and Publication 969.

For employers looking for a full step-by-step setup guide, see:
Section 125 Cafeteria Plan – Employer Checklist.

What Is a Cafeteria Plan?

A cafeteria plan is a written benefit plan that allows eligible employees to choose between receiving taxable income (cash) or specific IRS-approved nontaxable benefits. Only employees—not partners, sole proprietors, or more-than-2% S-corporation shareholders—may participate. This requirement is defined under IRC §125 and IRS guidance in Publication 15-B.

Qualified Benefits Allowed Under Section 125

Only benefits recognized by the IRS as qualified benefits can be offered through a cafeteria plan. According to IRS rules, these may include:

• Medical, dental, and vision insurance (Pub. 15-B)
• Health Flexible Spending Arrangements (Health FSAs) — Publication 969
• Dependent Care Assistance Programs (DCAP) — Publication 503
• Group-term life insurance up to $50,000 (IRC §79)
• Health Savings Account (HSA) contributions — Publication 969
• Adoption assistance benefits (IRC §137)

The IRS allows employees to pay for these benefits using pre-tax salary reductions, which lowers taxable income for federal income tax, Social Security tax, and Medicare tax.

Benefits That Cannot Be Offered Through a Cafeteria Plan

Some benefits, although tax-favored under other sections of the Internal Revenue Code, cannot be offered through a Section 125 cafeteria plan. IRS Publication 15-B provides a detailed list, which includes:

• Employer-provided meals and lodging
• Educational assistance programs
• Qualified transportation and parking benefits
• Working condition fringes
• Employee discounts and no-additional-cost services
• De minimis fringe benefits
• Tuition reduction
• Long-term care insurance
• Archer MSAs

These benefits may still be offered by an employer, but they cannot be elected pre-tax through a Section 125 cafeteria plan.

Flexible Spending Arrangements (FSAs)

Health FSA

A Health FSA allows employees to set aside pre-tax dollars to pay for qualified medical expenses as defined in Publication 502. IRS rules from Publication 969 require that:

• Employees elect an annual amount (subject to the IRS limit).
• The uniform coverage rule applies — the full annual election must be available on the first day of the plan year.
• Unused funds must follow the use-it-or-lose-it rule unless the plan adopts:
  • an IRS-approved carryover limit, or
  • a 2½-month grace period.

Dependent Care FSA (DCAP)

Dependent care FSAs reimburse childcare or dependent care expenses necessary for an employee to work, according to IRS Publication 503. These accounts have annual IRS limits and must be used for qualifying dependents.

Eligibility Rules

IRS Section 125 rules specify that eligible participants include:

• Employees
• Former employees (under limited conditions)

However, the following cannot participate in a cafeteria plan:

• Sole proprietors
• Partners in a partnership
• More-than-2% S-corporation shareholders

These restrictions are stated in IRS regulations under Section 125.

Written Plan Requirement

The IRS requires all cafeteria plans to be established through a written plan document. The document must specify:

• Eligibility rules
• Benefits offered
• Election procedures
• Salary reduction agreements
• FSA rules (use-it-or-lose-it, carryover, grace period)
• Mid-year election change rules under Treas. Reg. §1.125-4
• Nondiscrimination testing provisions

Without a written plan, benefits cannot be excluded from taxable income.

Mid-Year Election Changes

Under IRS regulations at Treas. Reg. §1.125-4, cafeteria plan elections are irrevocable for the plan year except in specific permitted cases, such as:

• Marriage, divorce, birth, or adoption
• Change in employment status
• Significant cost or coverage changes
• FMLA-related leave changes

Nondiscrimination Requirements

Section 125 plans must comply with IRS nondiscrimination rules to ensure they do not favor:

• Highly compensated employees (HCEs)
• Key employees

If a plan fails testing, the tax benefits may be lost for the affected employees but remain valid for others.

Employer Responsibilities

• Maintain a compliant written plan document.
• Apply election and FSA rules consistently.
• Ensure proper W-2 tax reporting (e.g., HSA contributions in Box 12, Code W).
• Perform required annual nondiscrimination testing.
• Follow IRS limits and updates published annually.

For a full employer setup guide, visit: Section 125 Cafeteria Plan Employer Checklist.