The penalty for failing to comply with Cafeteria Plan rules identified in Internal Revenue Code Section 125 can be severe. The penalties can include the application of income taxes against participants who otherwise thought they were electing non-taxable benefits, the application of employment taxes against participants and the employer, and penalties for failing to withhold and report taxes appropriately, among other things.

Although the Internal Revenue Service (IRS) reserves the right to impose the maximum penalties for failing to comply with Cafeteria Plan rules, what the agency will actually do is likely based on the unique facts and circumstances of each situation. It is also contingent upon whether there is a qualification mistake, operational mistake, or nondiscrimination mistake.

A qualification mistake occurs when a Cafeteria Plan fails to be a qualified Cafeteria Plan. For example, if an employer fails to have a formal Cafeteria Plan document adopted. Under such circumstances, the IRS may impose the maximum penalties which are to treat the Cafeteria Plan as if it did not exist (resulting in the likely back payment of taxes and other potential penalties).

An operational mistake occurs when an employer formally adopts a Cafeteria Plan, but they violate one or more of the Cafeteria Plan rules. For example, failing to properly substantiate claims under a Health Flexible Spending Account (FSA) would be an operational mistake. In this type of scenario, the IRS is likely to evaluate if the operational mistake is an isolated incident or part of an ongoing pattern. The IRS may also try to determine if the failure was intentional. Those operational mistakes that are a part of an ongoing pattern or that are intentional are likely to receive harsher penalties than those that are isolated and/or unintentional.

A nondiscrimination mistake occurs when an employer allows highly compensated employees and/or key employees to participate in a Cafeteria Plan to the fullest extent when one or more nondiscrimination tests are failed. In this scenario, the IRS is likely to include in gross income the benefits elected by the prohibited group (i.e., highly compensated employees and/or key employees), and they may impose tax liability and penalties on the employer. However, non-highly compensated employees and non-key employees should be unaffected.

Employers who discover a mistake should try to fix the mistake to bring their Cafeteria Plan into compliance. Employers should also try to reverse past errors to the extent possible. These reasonable, good faith efforts should be viewed favorably by the IRS when determining the penalties that apply for mistakes, if any.