Section 125 Plan Requirements: What Must Exist on Paper

A Section 125 cafeteria plan lets employees pay for health insurance and certain other benefits before tax, but only if you meet the written plan document requirement and follow the eligibility, nondiscrimination, and election rules. The IRS does not let you run this on a handshake. Here is what has to exist on paper, what the rules actually say, and what happens if something is missing.

The Four Things That Must Exist on Paper

Section 125 requires a written plan document before the first day of your plan year. The document must state:

1. Which benefits are offered on a pre-tax basis. Health insurance premiums, dental and vision premiums, health FSAs, and dependent care FSAs are the common ones. You cannot list everything your payroll system can withhold and call it a cafeteria plan. Only benefits specifically allowed under Section 125 qualify.

2. Who is eligible and when. The plan must define eligibility by objective criteria: full-time status, hours worked, length of service. "All employees" is valid if that is your rule. "Anyone we decide to include" is not. The eligibility definition has to survive nondiscrimination testing, which we cover below.

3. The plan year. A 12-month period, stated in the document. It does not have to match your calendar year or your fiscal year, but once you pick it, elections lock for that period. Employees can only change elections if they have a qualifying life event and the change matches the event.

4. How and when employees make elections. The document must describe the election process: when new hires can elect, when existing employees can change their elections, what counts as a qualifying event, and how employees submit their choices. If you allow mid-year changes for reasons beyond the IRS minimum, those have to be in the document too.

These four elements are not suggestions. If the written document is missing or incomplete, the plan is not a Section 125 plan, and every deduction you treated as pre-tax becomes taxable income. The IRS has ruled on this repeatedly: no document means no exclusion.

Section 125 Eligibility Rules

You can limit participation, but the limits have to be neutral. Common restrictions:

• Full-time employees only
• Employees who work at least 30 hours per week
• Employees with at least 90 days of service
• Employees in a specific division or location, if there is a business reason

You cannot define eligibility in a way that favors highly compensated employees or key employees. The IRS defines highly compensated employees as officers, owners of more than 5% of the company, employees who are highly compensated based on the facts, and spouses or dependents of any of those people. Key employees are officers making over a threshold, top owners, and the highest-paid employees if they also own more than a certain percentage.

Your eligibility rules face two tests: the Section 125 nondiscrimination test and the underlying benefit tests. If your health insurance itself fails nondiscrimination under Section 105(h) because only executives are offered coverage, wrapping it in a Section 125 plan does not fix it. The cafeteria plan adds a second layer of testing on top of the benefit's own requirements.

Nondiscrimination Rules in Ordinary Language

Section 125 requires three separate nondiscrimination tests. They measure different things.

Eligibility test: The plan cannot require a year of service for rank-and-file employees if highly compensated employees can participate immediately. It cannot require hourly employees to work 35 hours per week if salaried employees are eligible at 20 hours. The rule is that eligibility conditions have to apply the same way to everyone, or the plan has to pass a safe harbor: it benefits a group of employees that is at least 70% non-highly-compensated.

Benefits and contributions test: The plan cannot give highly compensated employees richer benefits or larger employer contributions unless the same benefit is available to other participants. If the company pays the full health premium for executives but only half the premium for everyone else, the plan fails.

Key employee concentration test: Key employees as a group cannot receive more than 25% of all the nondiscriminatory benefits provided under the plan. This one catches plans that are technically open to everyone but funnel most of the value to owners and officers.

If you fail any test, highly compensated or key employees lose the tax exclusion for their benefits. The rank-and-file employees keep theirs. The penalty lands on the people the rules are designed to protect against.

Most small businesses pass these tests without thinking about them because everyone is offered the same health plan and the same employer contribution. The test becomes real when you have tiered benefits, different contribution levels by role, or a concentration of ownership.

Plan Year and Election Change Rules

Cafeteria plan elections are annual. You pick your benefits at the start of the plan year, and those elections stay in place for 12 months unless a qualifying event happens.

Qualifying Life Events

The IRS allows mid-year election changes only if the employee has a change in status and the new election is consistent with the change. Recognized changes in status include:

• Marriage, divorce, legal separation, annulment
• Birth or adoption of a child
• Death of a spouse or dependent
• A change in employment status that affects eligibility (termination, a reduction or increase in hours, a strike or lockout, returning from unpaid leave)
• A dependent gaining or losing eligibility
• A change in residence that affects benefit options
• A qualified medical child support order

The change has to match the event. If an employee gets married, they can add the spouse to their health coverage. They cannot drop coverage entirely just because they got married, unless the spouse has other coverage and the plan allows that as a basis for waiving.

HIPAA Special Enrollment

The plan must also allow changes when the employee or dependent loses other coverage or becomes eligible for premium assistance under Medicaid or CHIP. This is a HIPAA requirement that overlays on top of the Section 125 rules.

What Happens If You Allow Changes Outside These Rules

Some employers think flexibility helps morale. The IRS thinks it destroys the plan. If employees can change their health elections whenever they feel like it, the plan is not a Section 125 plan. The salary reductions are taxable. The reasoning is that letting people adjust coverage based on anticipated claims turns the arrangement into a reimbursement, not an insurance election, and reimbursements do not get the pre-tax exclusion unless they meet the rules for a health FSA or HRA.

Employers who want more flexibility than the IRS allows sometimes write it into the plan document anyway. That does not make it legal. It makes the document evidence that you are not operating a compliant Section 125 plan.

Consequences of Missing Each Requirement

No written plan document, or a document that does not include the required elements: Every deduction you treated as pre-tax is taxable wage income. You owe the employer share of FICA on that income. The employee owes the employee share, plus income tax, and you will have to file corrected W-2s. If the IRS finds this on audit, you will also owe interest and possibly penalties for late deposit of employment taxes.

Eligibility rules that fail nondiscrimination testing: Highly compensated or key employees lose the exclusion. Their benefits become taxable. Everyone else is unaffected. The employer still owes its share of FICA on the now-taxable benefits. You find out you failed when you run the test, which is supposed to happen annually. If you did not run the test, you find out on audit.

Allowing election changes outside the qualifying event rules: Same result as having no plan document. If the plan does not operate according to the election rules in Section 125, it is not a Section 125 plan, and the exclusion is lost.

Failing to adopt the plan document before the plan year starts: You cannot backdate a plan document. If you signed the document in March and tried to make it effective in January, the plan does not exist for January and February. Any deductions taken during that period are taxable.

The unifying principle is that the tax exclusion is a trade. Employees give up the ability to change their minds in exchange for the ability to pay before tax. The IRS will not give you the tax benefit if you are also giving employees the flexibility of after-tax pay.

How to Know Your Plan Meets the Requirements

If you are not sure whether your plan document exists, ask whoever set up your cafeteria plan to produce it. If no one can find a written, signed document that was executed before your current plan year started, you likely do not have one.

If you have a document, check that it includes the four elements at the top of this article. Many template documents do, but templates have to be filled out. A document that says "eligibility: __________" with a blank line is not a compliant document.

For nondiscrimination testing, ask your third-party administrator or benefits consultant whether the tests were run for the most recent plan year and what the results were. If the answer is "we don't do that," you have a process problem. The tests are required. Not running them does not mean you passed.

What is a Section 125 plan? explains the structure itself. How to set up a Section 125 plan walks through the setup sequence, including when to adopt the document and how to coordinate it with your plan year. Both are worth reading if you are building this from scratch or trying to fix a plan that was set up incorrectly.

FAQ

What happens if we have been running a Section 125 plan without a written document?

Every pre-tax deduction you took is taxable income. You owe corrected W-2s, back FICA taxes, interest, and potentially penalties. The exposure grows each year you operate without a document. The answer is to adopt a compliant plan document now, going forward, and consult a tax professional about how to handle the prior years.

Can we limit Section 125 participation to salaried employees only?

Only if you can pass the nondiscrimination tests with that restriction in place. An eligibility rule that excludes hourly workers will fail unless the salaried group itself is at least 70% non-highly-compensated and meets the other safe harbor conditions. Most of the time, hourly-versus-salaried breaks down along compensation lines, and the plan fails. You can do it, but you have to run the numbers first.

Do the nondiscrimination tests apply every year, or just when we set up the plan?

Every year. You run the eligibility test, the benefits and contributions test, and the key employee concentration test annually. If your workforce changes or your benefit offerings change, the results can shift. A plan that passed last year can fail this year if you hired three new executives and your employee mix is now different.

If an employee has a qualifying life event, can they make any election change they want?

No. The change has to be consistent with the event. If they have a baby, they can add the baby to coverage or increase dependent care FSA contributions. They cannot drop all coverage or elect a benefit unrelated to the event. The consistency requirement is in the Section 125 regulations and is not optional.

Where This Matters Most

The written plan document requirement and the nondiscrimination rules exist because Section 125 is a tax exclusion, not an entitlement. The IRS will give you the benefit if you operate within the boundaries. If you treat the plan as a payroll preference instead of a legal structure, the exclusion goes away.

If you are setting up a cafeteria plan or trying to determine whether your existing plan is compliant, the eight things to look for when hiring help will tell you what questions to ask and what answers should worry you. A provider that does not mention the written plan document or the annual testing is not doing the work.

Educational only, not tax or legal advice. Confirm anything you rely on with your CPA.