What are Section 125 Cafeteria Plans and how do the non-discrimination rules work? In this in-depth guide, Professor Farhat helps Enrolled Agent (EA) and CPA exam candidates and accounting students understand how these plans let employees choose between taxable cash and non-taxable qualified benefits, plus the rules for Highly Compensated and key employees, family attribution, simple cafeteria plans, and the tax consequences of plan failure.

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Video Timeline & Key Concepts:
0:00 — Introduction
0:35 — Definition of Section 125 and the requirement for a genuine choice between cash and benefits
1:22 — Why it is called a cafeteria plan: picking from a menu of qualified benefits
1:39 — Tax advantages: paying for benefits with pre-tax dollars
4:09 — Common examples: health insurance, HSA, and FSA
6:47 — Overview of non-discrimination rules and why they exist
7:43 — Defining Highly Compensated Employees (HCE) and key employees
8:18 — The 25% threshold rule for benefit concentration among key employees
9:44 — Simple cafeteria plans for small employers (100 or fewer employees)
11:03 — The 5% ownership test for HCE status, regardless of compensation
11:57 — Compensation thresholds and how inflation adjustments affect HCE status
13:05 — Family attribution rules: how ownership is assigned to spouses and children
15:32 — The three tests for identifying key employees
21:30 — Comparing HCE vs. key employee status in large corporations
22:30 — Consequences of plan failure: how benefits become taxable only for the top group
23:41 — Practice multiple-choice question: analyzing tax consequences of a failed plan

Frequently Asked Questions:
Q: What happens if a cafeteria plan fails the IRS non-discrimination test?

A: The tax-favored status is stripped away only from the highly compensated and key employees, who must include the value of their benefits in gross income. Non-key employees are not penalized and keep their tax benefits.

Q: Does an employee need to earn a high salary to be considered a Highly Compensated Employee (HCE)?

A: Not necessarily. Under the ownership test, anyone who owns more than 5% of the company at any time during the year is an HCE, even if their salary is zero.

Q: Can a family member of an owner be considered a key employee even if they don't own shares?

A: Yes. Under family attribution rules, shares owned by a spouse, child, grandchild, or parent are treated as if the employee owned them, which can trigger key employee status.

Q: What is a simple cafeteria plan?

A: It is a plan for small employers with 100 or fewer employees that automatically passes non-discrimination testing, eliminating the need for complex annual tests.

Q: What are the three tests used to identify a key employee?

A: A key employee meets at least one of these: a 5% owner, a 1% owner earning over a set amount, or a company officer earning above the inflation-adjusted threshold.

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