Introduction to Section 125 Plan Compliance

A Section 125 cafeteria plan provides valuable tax advantages for both employers and employees, but failing to comply with IRS regulations can lead to penalties, tax liabilities, and plan disqualification. Employers must understand the most common compliance mistakes to ensure their plan remains valid and benefits all employees fairly.

This guide outlines the most frequent Section 125 compliance errors and how to avoid them.

Mistake 1: Not Having a Formal Written Plan Document

The IRS requires that every Section 125 plan have a written document detailing plan rules, eligibility, benefits, and compliance procedures. Without it, the plan is not legally valid, and tax benefits may be disallowed.

How to Avoid It:

• Ensure the plan document is comprehensive and up to date.
• Work with a third-party administrator (TPA) to draft a compliant plan document.
• Regularly review and update the document to reflect regulatory changes.

Learn more in What Employers Need to Include in a Section 125 Plan Document.

Mistake 2: Failing Non-Discrimination Testing

Section 125 plans must pass IRS non-discrimination tests to ensure that tax benefits are not disproportionately favoring highly compensated employees (HCEs) or key employees.

Common Non-Discrimination Tests:

• Eligibility Test – Ensures fair access for all employees.
• Benefits & Contributions Test – Confirms that contributions do not favor HCEs.
• Key Employee Concentration Test – Prevents key employees from receiving more than 25% of total plan benefits.

How to Avoid It:

• Conduct annual non-discrimination testing.
• Adjust plan contributions or eligibility requirements if necessary.
• Seek legal or TPA guidance to ensure compliance.

For more insights, read How Section 125 Plans Affect Social Security and Medicare Contributions.

Mistake 3: Misclassifying Employees

Only W-2 employees are eligible to participate in a Section 125 plan. 1099 contractors, partners, and S-corp owners cannot receive tax advantages through a cafeteria plan.

How to Avoid It:

• Verify that all participants are eligible employees.
• Exclude owners and independent contractors from pre-tax benefits.
• Consult legal or tax advisors to confirm employee classifications.

For more information, see Do Section 125 Plans Work for 1099 Contractors and Freelancers?.

Mistake 4: Not Keeping Proper Records

Employers must maintain accurate records of plan documents, elections, and compliance reports to meet IRS auditing requirements. Poor record-keeping can result in penalties and tax liabilities.

How to Avoid It:

• Store all plan documents, enrollment forms, and compliance reports securely.
• Keep records for at least seven years in case of an audit.
• Use a TPA or benefits software to automate tracking and reporting.

For guidance, refer to the IRS Section 125 Guidelines.

Mistake 5: Not Filing Required Documents

Employers offering FSA or dependent care benefits under a Section 125 plan must file IRS Form 5500 annually if they meet specific participant thresholds. Failure to do so can lead to penalties and plan compliance risks.

How to Avoid It:

• Determine if your company is required to file Form 5500.
• Submit all required IRS documentation on time.
• Work with a TPA or accountant to ensure compliance.

Mistake 6: Poor Employee Communication and Enrollment Processes

Many compliance issues stem from employees not understanding their benefits or failing to properly enroll in the plan. Employees need clear instructions and timely enrollment periods.

How to Avoid It:

• Provide detailed plan explanations during open enrollment.
• Send reminders about deadlines and benefit changes.
• Offer HR or TPA support to answer employee questions.

For more best practices, see How Employers Can Use Section 125 Plans to Stay Competitive in Hiring.

Ensuring Long-Term Section 125 Plan Compliance

Avoiding these compliance mistakes ensures that employers maximize payroll tax savings while maintaining a legally valid cafeteria plan. Regular audits, documentation updates, and expert guidance can prevent costly errors and protect employee benefits.

Next Steps for Employers

• Review your Section 125 plan document for compliance.
• Schedule annual non-discrimination testing.
• Consult a Section 125 expert to manage compliance risks.

For expert guidance, visit www.elevate-benefits.com 

or email contact@elevate-benefits.com.