The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Gerald S. Deutsch, Esq.
Glen Head, NY
The Internal Revenue Code defines a “Cafeteria Plan” as a written plan under which all participants are employees, and the participants may choose among two or more benefits consisting of cash and “qualified benefits.” A “qualified benefit” is a benefit which is not includible in the gross income of the employee. It's a good tax advantage for the recipient - instead of getting taxable cash, the employee is getting a non-taxable benefit. In addition, the cost is deductible by the employer.
A cafeteria plan is subject to certain rules and restrictions, including that it cannot discriminate in favor of highly compensated employees.
Of course, a partner in a partnership cannot be covered by a cafeteria plan because a partner is not considered an employee. If, however, the partner's wife works for the partnership, she would be an employee, and she could participate in the plan. But what about a shareholder's wife in an S corporation, who is also an employee of the corporation?
The cafeteria plan regulations that were released in 2007 make it clear that more than 2% shareholders in an S corporation cannot be covered under their corporation's cafeteria plan. Those regulations define a more than 2% shareholder by using the strict attribution rules that consider stock owned by spouses, children, etc. as being owned by the “employee.”
These regulations affirmatively provide that participation in a cafeteria plan is one of the fringe benefits that the Internal Revenue Code where the partnership rules restricting fringe benefit for partners will also apply to a more than 2% shareholder of the S corporation. In addition, the attribution rules specifically will apply, which regard stock owned by spouses, children, etc. as being owned by the employee.
Note that no such attribution rule exists for partnerships. The wife of a partner is not considered to be a partner. For some reason - or perhaps no reason - S corporations are being treated more harshly than partnerships here.
So if a partner in a partnership has a wife that is an employee of the partnership, and the partnership establishes a cafeteria plan, it would appear that the wife would be able to participate in that cafeteria plan based on her being an employee.
If, however, the entity is an S corporation, and the husband, instead of being a partner was a more than 2% stockholder in the S corporation, his stock ownership would be attributed to his wife. Under the cafeteria plan regulations, she thus would not be eligible to obtain the advantages of the cafeteria plan. If she participated in the plan, the benefits would be taxable to her.
This seems to be another example of where an LLC might be a better vehicle than an S corporation, especially if it is contemplated that family members of a 2% owner will be employed in the business.
For more information, in the Tax Management Portfolios, see Raish, 397 T.M., Cafeteria Plans, and in Tax Practice Series, see ¶5940, Cafeteria Plans.
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