What is a Section 125 Cafeteria Plan and how are the non-discrimination rules applied? This deep dive from Farhat Lectures helps Enrolled Agent (EA) and CPA exam candidates and accounting students understand how these plans let employees choose between taxable cash and non-taxable benefits, plus the rules for Highly Compensated Employees, key employees, family attribution, and what happens when a plan fails non-discrimination testing.

Try it free at farhatlectures.com — interactive exercises, lectures, simulations, cases, multiple choice, and AI tools for CPA, CMA, EA and students.

Video Timeline & Key Concepts:
0:00 — Introduction
1:18 — Why it is called a cafeteria plan
1:40 — Benefits of pre-tax dollar arrangements
4:05 — Common examples: health insurance, HSA, and FSA
5:05 — Illustrative example: an employee and a dental group
6:47 — Non-discrimination rules and IRS requirements
10:47 — Defining Highly Compensated Employees (HCE)
13:03 — Family attribution rules in ownership
15:20 — Defining key employees and the three tests
19:15 — Differences between HCEs and key employees
22:29 — Consequences of failing non-discrimination testing
23:36 — Practice multiple-choice question (MCQ)

Frequently Asked Questions:
Q: What is the primary benefit of a Section 125 Cafeteria Plan for an employee?

A: It allows employees to pay for qualified benefits using pre-tax dollars, reducing their federal income tax, Social Security, and Medicare tax liabilities.

Q: What happens if a cafeteria plan fails the IRS non-discrimination testing?

A: The tax-favored status is stripped away for Highly Compensated Employees and key employees, so they must include the value of the benefits received as taxable income.

Q: How is a Highly Compensated Employee (HCE) defined?

A: An HCE is defined either by owning more than 5% of the company at any time during the current or prior year, regardless of salary, or by meeting a specific compensation threshold set by the IRS.

Q: What are the three tests used to determine if someone is a key employee?

A: A key employee is an officer or owner who meets one of these: a 5% owner, a 1% owner earning more than a set amount, or a company officer with compensation above a specific threshold.

Q: Do family members' shares count toward an employee's ownership percentage?

A: Yes. Under family attribution rules, shares owned by a spouse, children, grandchildren, and parents are treated as if the employee owned them for HCE and key employee testing.

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