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Jul 08, 2024 Erin Crowley

CPAs: Protect Your Clients from Risk-The Importance of Section 125 Compliance

CPAs: Protect Your Clients from Risk-The Importance of Section 125 Compliance

If your clients provide employee benefits on a pretax basis, they are likely utilizing a Section 125 deduction, also known as a cafeteria plan. This allows employees to contribute pretax dollars from their gross income to benefit plans.  

These deductions lower taxable income, resulting in lower federal and state income tax and Medicare and Social Security taxes. Employers also receive tax benefits by reducing FICA on wages set aside for Section 125 purposes.  

Payroll service providers can set up pretax salary reductions for a business's employees as requested, but they typically do not require the business to produce a Section 125 plan document to show the plan exists. 

Therefore, many small businesses are out of compliance with Section 125. While the chance of an audit is low, the risk is high if noncompliance unexpectedly results in years of past deductions suddenly becoming subject to taxation. 

This disconnect creates a practice opportunity for CPAs to inform and educate clients about the risks of noncompliance and guide them to acceptable outcomes. 

ConnectPay Can Help You Address This Gap 

We inform clients of the Section 125 documentation obligations and see if their health insurance policy vendor has provided the critical documents.

If they have not provided the documentation, we offer a service that provides compliant Section 125 plans as well as non-discrimination tests for the following plans: 

Section 125 Cafeteria Plan - POP Test   

  • Eligibility Test 
  • Contributions and Benefits Test 
  • Key Employee Concentration Test (utilization) 

Flexible Spending Accounts (FSA) Test 

  • Eligibility Test 
  • Benefits Test 

Dependent Care Assistance Plan (DCAP) - Test

The Dependent Care Plan test is required if the DCAP benefit is offered within the Flexible Spending Account. 

  • Eligibility Test 
  • Contributions and Benefits Test 
  • More-Than-5% Owners Concentration Test 
  • 55% Average Benefits Test 

To be fully compliant with Section 125 regulation, all nine tests from above must be satisfied. The eligibility test above can be satisfied with proper plan design. Your small business clients might also want to consider keeping tabs with the following tests:

  • Key Employee 25% Concentration Test - applies to all pretax benefits provided under the plan. No more than 25% of the aggregate of all non-taxable benefits may be provided to key employees. 
  • Dependent Care 55% Average Benefits Test - applies only to the Dependent Care FSA. This test is passed if the average benefit provided to employees who are non-HCEs is at least 55% of the average benefit provided to HCEs. 
  • 5% Owners Test - applies only to Dependent Care FSA. Not more than 25% of the amounts for dependent care assistance during the year may be provided for shareholders or owners (or their spouses or dependents) who own more than 5% of the stock, the capital, or profits interest in the employer (on any day of the year.)

Does ConnectPay sell insurance?

No, we do not. Unlike larger payroll providers, we do not sell insurance or employee benefit programs, or offer tax advice. 

Our role in the Section 125 process is to help clients set up compliant pretax salary deductions for their employees by reviewing their Section 125 documentation—the Section 125 Plan Document. 

If we already run payroll for your small business clients: 

Instruct your clients to contact their Payroll Specialist directly to ensure their business is compliant with Section 125 requirements.  

If we do not run payroll for your small business clients:

If you have small business clients that need help with payroll or Section 125 compliance, and they are not part of our ConnectPay network, they can call 877-551-0907 to become a customer and receive Section 125 support!

We're Here to Help!

Is it time to move your small business payroll clients to a trusted partner? At ConnectPay, we provide compensation and an ongoing revenue share for organizations providing payroll service for S-Corps and other small businesses. 

Get in touch with us to explore our CPA Partnership program. 

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Published by Erin Crowley July 8, 2024