Simple Cafeteria Plan: Section 125 Safe Harbor for Small Employers

A simple cafeteria plan is a Section 125 arrangement designed for employers who averaged 100 or fewer employees in one of the two prior years, letting workers pay for health premiums, flexible spending accounts, and other qualified benefits with pre-tax dollars. What makes it “simple” is the safe harbor: meet the eligibility, participation, and contribution rules, and the plan is automatically treated as passing the nondiscrimination tests that standard cafeteria plans have to run every year. The Affordable Care Act created this option so smaller businesses could offer competitive benefits without the compliance overhead larger employers absorb.¹

Does Your Business Qualify

The core test looks at headcount. Your business must have employed an average of 100 or fewer employees on business days during either of the two preceding calendar years.¹ A brand-new business that didn’t exist during the prior year qualifies based on the number of employees it reasonably expects to have during the current year.

If you grow past 100 after establishing the plan, you don’t lose it right away. The statute lets you keep the simple cafeteria plan even after exceeding the threshold, but that grace period ends once your average headcount reaches 200 or more employees during any preceding year.¹

Related Companies Count Together

You cannot count each of your businesses separately. All employees of companies treated as a single employer under the controlled group and affiliated service group rules are combined when measuring against the 100-employee threshold.² Parent-subsidiary groups, brother-sister corporations, and businesses under common control pool their workers. A company with 60 employees that shares ownership with a company employing 50 counts as a 110-employee employer and would not qualify.

Who Has to Be Allowed In

Every employee who worked at least 1,000 hours during the preceding plan year must be eligible to participate, and each eligible employee must be allowed to choose any benefit the plan offers on the same terms as everyone else.¹

You can exclude three categories of workers if you choose to:

Employees under age 21 as of the close of the plan year
Employees with less than one year of service as of any day during the plan year
Employees covered by a collective bargaining agreement where benefits were the subject of good-faith bargaining

These exclusions are optional. You can set lower thresholds if you want broader participation, but stricter requirements than these will cost you the safe harbor.¹

Owners Who Can’t Participate

The statute defines a cafeteria plan as one where all participants are employees, and the IRS does not treat self-employed individuals as employees for this purpose.¹ That excludes more owners than people expect:

Sole proprietors cannot participate in their own company’s plan.
Partners in general or limited partnerships are treated as self-employed.
S-corporation shareholders owning more than 2% are treated as partners and are ineligible.

C-corporation owner-employees can participate because they are considered employees of the corporation. Entity structure matters here: sole proprietors and partners lose access to one of the most direct tax-saving tools they offer their own workers.

What You Can Offer Through the Plan

A Section 125 plan lets employees choose between cash (their regular pay) and qualified benefits that receive pre-tax treatment. The common options:

Health insurance premiums — medical, dental, and vision coverage paid through what’s sometimes called a premium-only plan
Health care flexible spending accounts, with a federal limit of $3,400 per employee for 2026³
Dependent care FSAs covering work-related childcare or elder care, with a maximum exclusion of $5,000 per year ($2,500 if married filing separately)⁴
Health savings account contributions for employees enrolled in a qualifying high-deductible health plan
Group-term life insurance up to $50,000 of coverage
Accident and disability coverage
Adoption assistance

Long-term care insurance, retirement contributions (other than certain 401(k) arrangements), and scholarships do not qualify.¹ You don’t have to offer every possible benefit. Many small employers start with a premium-only plan or add a health care FSA and expand from there.

What the Employer Has to Contribute

The safe harbor comes with a price: the employer must fund the plan using one of two formulas. Contributions go to “qualified employees,” defined as eligible employees who are not highly compensated or key employees.¹

Nonelective Contributions

The employer contributes a uniform percentage of each qualified employee’s compensation, at least 2%, whether or not the employee contributes anything. For an employee earning $50,000, the 2% minimum equals $1,000 toward qualified benefits, even if that employee elects nothing.¹

Matching Contributions

The employer contributes at least twice each qualified employee’s salary reduction, capped at 6% of the employee’s compensation.¹ If an employee earning $50,000 contributes 2% ($1,000), the employer must contribute at least $2,000 (4% of compensation). Once the employee contributes 3% or more, the employer’s match stays at the 6% ceiling.

If you use the matching formula, the match rate for highly compensated or key employees cannot exceed the rate you provide to other employees.² You can contribute more than the minimums, but the same proportionality rule applies, which prevents the plan from channeling extra matching dollars to executives.

Compensation for these calculations is defined by reference to Section 414(s), which generally means the pay you report for the employee during the plan year — wages, salary, overtime, bonuses, and commissions.¹ Your plan document can specify a narrower definition as long as it still satisfies Section 414(s), and the definition you pick determines the dollar amount of your mandatory contributions.

The Payoff: No Nondiscrimination Testing

When you meet the eligibility, participation, and contribution requirements, your plan is automatically treated as satisfying the nondiscrimination rules under Section 125(b) and related provisions.¹

A standard cafeteria plan has to pass annual tests proving that eligibility, contributions, and benefits don’t disproportionately favor highly compensated employees or key employees. When a standard plan fails, the pre-tax treatment of benefits elected by the highly compensated group gets reversed. Their benefits become taxable income, and the employer picks up the associated payroll tax liability. In a small company where the owner and a few managers make up much of the plan, failing those tests is a real risk. The simple cafeteria plan removes it. You commit to the minimum contributions, and in exchange no one’s benefits get retroactively taxed for a testing failure.

Setting Up the Plan

A cafeteria plan must exist as a written document. The statute is explicit: no writing, no plan, and no pre-tax treatment.¹ The document has to identify the plan year, the benefits offered, the eligibility rules, the contribution method (nonelective or matching), and the election procedures.

Beyond drafting, implementation involves a few practical steps:

Adopt the plan formally through a corporate resolution or by executing the plan document, signed by an authorized officer.
Build an employee census listing all eligible employees with hire dates and compensation figures. It feeds directly into the contribution calculations.
Coordinate with your payroll provider to set up pre-tax deduction codes so salary reductions are withheld correctly each pay period and employer contributions are tracked.
Notify eligible employees about the plan, the available benefits, and the enrollment window.

Most small employers work with an insurance broker or third-party administrator who supplies template plan documents and handles enrollment logistics. The plan has to be in place before the start of the plan year. Employees generally cannot make retroactive elections.

Mid-Year Election Changes

Once employees make their elections, those elections are generally locked in. The IRS only allows changes outside open enrollment when a qualifying event occurs and the change is consistent with that event.⁵ Common qualifying events include marriage, divorce, legal separation, annulment, or death of a spouse; birth, adoption, placement for adoption, or death of a dependent; a change in employment status for the employee or a spouse; a dependent aging out of coverage or losing student status; a move that affects provider network access; and gaining or losing Medicare or Medicaid eligibility.

Your plan document must specifically permit mid-year changes for each type of event you want to allow. The IRS regulations make these permissive, not mandatory, so if your plan document doesn’t address a particular event, employees can’t use it as a basis for changing their elections.

Records to Keep

The IRS requires employers to keep employment tax records for at least four years after the tax becomes due or is paid, whichever is later.⁶ For a cafeteria plan, that means retaining the written plan document, employee election forms, records of employer contributions, and payroll records showing pre-tax deductions. If the IRS audits the plan and you can’t produce documentation showing it met the simple cafeteria plan requirements, you lose the safe harbor, and potentially the pre-tax treatment of benefits for every participant.

A standalone cafeteria plan does not require Form 5500 filing.⁷ The underlying welfare benefit plans running through it, such as your health insurance, may have their own Department of Labor filing obligations depending on participant count and plan type.

1
Office of the Law Revision Counsel. 26 USC 125 – Cafeteria Plans
2
Office of the Law Revision Counsel. 26 US Code 125 – Cafeteria Plans
3
FSAFEDS. New 2026 Maximum Limit Updates
4
Internal Revenue Service. Child and Dependent Care Credit and Flexible Benefit Plans
5
Internal Revenue Service. Tax Treatment of Cafeteria Plans (TD 8878)
6
Internal Revenue Service. How Long Should I Keep Records
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Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans