
Public agency employers in California are facing increasing pressure to offer competitive, flexible, and legally compliant employee benefits. But there is one foundational document many agencies still overlook or perhaps do not fully understand—the Section 125 cafeteria plan. Without it, certain popular and tax-advantaged benefits cannot be offered, and agencies may inadvertently run afoul of federal tax law.
In this post, we break down what a cafeteria plan is, why it is legally necessary, and what risks public agencies could face without one.
What Is a Cafeteria Plan?
A cafeteria plan is a written plan that allows employees to choose between: (1) receiving their full wages in cash on their paycheck; and (2) setting aside some of their wages (known as a “salary reduction”) to pay for qualified benefits on a pre-tax basis. The plan takes its name from Section 125 of the Internal Revenue Code (“IRC”). For public agencies, this written plan is essential to offering a range of employee benefits in a compliant and tax-efficient manner.
Paying for Benefits With Pre-Tax Salary Reductions Must Be Done Through a Cafeteria Plan
The key feature of a cafeteria plan is that it allows employees to reduce their salaries on a pre-tax basis to pay for their share of health insurance premiums and other qualified benefits. Without a cafeteria plan, employees’ premium contributions must be taken on an after-tax basis, which can:
- Increase employees’ taxable income,
- Decrease their take-home pay,
- Reduce the perceived value of your public agency’s benefits package, and
- Take away the public agency’s opportunity to save on payroll taxes tied to the pre-tax portions of employee salaries.
Some Benefits Can Only Be Offered Through a Cafeteria Plan
Some of the most valuable and popular benefits—like Health Flexible Spending Accounts (Health FSAs) and Dependent Care Assistance Programs (DCAPs) – can only be offered through a cafeteria plan. Without a formal cafeteria plan:
- Employees cannot contribute pre-tax dollars to a Health FSA to cover eligible medical expenses.
- Employees cannot contribute to a DCAP to pay for child care or elder care expenses with pre-tax income.
This means that without a cafeteria plan in place, a Health FSA or a DCAP would be taxable benefits. As a result, your public agency may be denying employees access to critical tax savings—or offering benefits in violation of IRS rules if a Health FSA or DCAP are treated as a pre-tax benefit—when there is no cafeteria plan.
Offering Cash in Lieu of Health Insurance? Your Public Agency Needs a Cafeteria Plan
Many public agencies offer a “cash in lieu” or “opt-out” payment to employees who waive agency-provided health insurance because they have other group health insurance (such as coverage through a spouse). Cash in lieu should be offered through a cafeteria plan to avoid triggering the constructive receipt doctrine. When the constructive receipt doctrine applies:
- The IRS could determine that employees had the choice to receive either cash in lieu or benefits and, therefore, should be taxed on the value of the cash in lieu regardless of their election.
- The cash in lieu payments will be considered taxable income—even if the employee does not elect to take the cash.
This can result in surprise tax liabilities for employees and compliance issues for the public agency.
Compliance with the CalPERS Equal Contribution Rule
Public agencies that provide health insurance through the Public Employees’ Medical and Hospital Care Act (“PEMHCA”) must comply with the equal contribution rule. The equal contribution rule generally requires employers to provide the same contribution amount toward health benefits for all employees and retirees in a group or class. Gov. Code, § 22892(b).
A cafeteria plan provides a structure where a public agency can provide a cafeteria plan contribution to active employees to pay for health insurance, without offering the same contribution to retirees, while maintaining equal treatment under the CalPERS rules. Failure to use a cafeteria plan could inadvertently result in inequities in employer contributions, potentially putting your public agency at odds with the CalPERS regulations.
Other Cafeteria Plan Benefits
Beyond legal compliance, adopting a cafeteria plan provides:
- Flexibility: Employees can elect and customize their cafeteria plan benefits based on the needs of themselves and their family members.
- Cost Savings: Both employers and employees save on payroll and income taxes.
- Competitiveness: Public agencies offering pre-tax benefits are more attractive in today’s competitive public sector job market.
Has Your Public Agency Properly Adopted a Cafeteria Plan?
In order to take advantage of all of the benefits offered by having a cafeteria plan, it is essential that a public agency ensure that it has completed all the steps to adopt a valid one. There are two key requirements. First, Section 125 requires the cafeteria plan to exist in the form of a written plan, which is usually called a plan document. A cafeteria plan document specifies the operational terms of the cafeteria plan, including what benefits are offered, the term and structure of each benefit, eligibility requirements, and a description of employer contributions and employee salary reduction agreements.
Second, the cafeteria plan must be adopted by an employer and should be effective on or before the first day of the cafeteria plan year to which it relates. (Prop. Treas. Reg. § 1.125-1(c)(1).) The Proposed Treasury regulations provide guidance and the IRS’s stance on the administration of cafeteria plans. While the Proposed Treasury regulations do not specify how an employer must adopt a cafeteria plan, the generally acceptable method is for the governing body of a public agency to adopt it. If a cafeteria plan is not formally adopted by the employer, there is a risk that the employer does not have a valid cafeteria plan in place and as a result, employees who are electing to pay for their share of their benefits by a salary reduction must do so on an after-tax basis.
Trusted legal counsel can assist public agencies with:
- Assessing whether a public agency has adopted a valid cafeteria plan.
- Drafting Section 125 cafeteria plan documents and customizing them to the public agency’s benefits.
- Reviewing existing plans for compliance with IRS and CalPERS regulations.
- Advising on plan implementation and employee communications.
Key Takeaway: Implementing a compliant Section 125 cafeteria plan is not optional—it is a necessary legal safeguard and a smart benefits move. If your public agency does not have a cafeteria plan—or if your current plan has not been reviewed in the last few years—now is the time to act.