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Stretching Your Benefit Dollars

A largely ignored tax break - flexible spending accounts - may offer growth companies just the edge they need.

By Jill Andresky Fraser

Most entrepreneurs could identify with the hiring difficulties faced by Openplus International, a software development company with 25 employees in its Austin, Texas, headquarters. "As a start-up, it's been very difficult to be competitive in attracting top people -- especially in a job market like ours, where demand is very strong for high-tech talent," former controller Livia Baskin confided a few months ago. "As part of that effort, it's been essential for us to offer good medical benefits. But we need to do that in the most cost-effective way possible, since our biggest priority is investing in the company's future."

Unfortunately, at the very time that many growth-oriented business owners have found themselves in a similar bind, health care premiums have been rising by double-digit rates while dissatisfaction with bare-bones managed-care options has also been on the upswing. Fortunately, there are other solutions for small companies besides paying more to insurers or offering less to employees.

One effective strategy -- known as flexible spending accounts, or FSAs -- has gained widespread acceptance at large corporations since the accounts were first created by the Revenue Act of 1978. (They're also called "cafeteria" or "125" plans.) Openplus International set up its own FSA plan more than two years ago, offering its employees the option of paying for their share of medical premiums and unreimbursed health care costs with pretax dollars. The program is so popular that 90% of the company's staffers participate.

Why would anyone trying to woo employees with a state-of-the-art benefits package waste time on a two-decade-old tax break that the small-business community has largely ignored? It's simple. First, a good many small companies made a mistake when they neglected to investigate FSAs in the past. FSAs offer some great financial incentives for most, although not all, growing companies. (See "Does an FSA Make Sense for Your Company?" below.) Second, times have changed. Thanks to technological advancements and increasing competition among financial services companies, the plans have become cheaper to offer and easier to administer, making their appeal greater than ever.

"Companies seldom have an opportunity to provide a valuable fringe benefit that costs them absolutely nothing," notes Jeffrey W. Evans, a certified financial planner with Evans Capital Management, in Erie, Pa. "But the tax savings associated with these plans are so significant that corporations can often more than cover the expense of setting up and running an FSA." (See "How Tax Savings Play Out," below.)

If you're interested in getting your company involved in efforts to curb employee health care costs, you have some options that are regulated by IRS Code Section 125 (thus the name "125" plans). "The no-brainer is called a 'premium only' plan, or POP, and it makes sense for companies that require their employees to pay a portion of the health care premiums, which most companies do," explains Kelly Ann Boyce, an insurance consultant at Boyce Financial Solutions, in Purchase, N.Y.

With POPs, employees can lower their salaries by the amount necessary to cover insurance premiums, which lessens the bite from the bill, since staffers reduce the amount of federal, FICA, and any state or local taxes that get subtracted from their paychecks. Meanwhile, "from an employer's standpoint, an employee's participation has the effect of reducing taxable payroll without cutting head count," Boyce says. "That's because the company doesn't owe any payroll taxes on any money that goes into the POP."

For Sondra Kurtin, the chief executive of RKC (Robinson Kurtin Communications), a New York City-based designer of corporate annual reports and Web sites, both those advantages have been valuable. "With only 10 employees, we don't have the clout in the marketplace to be able to negotiate very good rates on health insurance," she says. "So we try to make use of as many different helpful strategies as we can. On the one hand, we keep our costs down by requiring staffers to pay 30% of the cost for single-person insurance premiums and 100% of the family coverage fee. But the tax advantages from the POP make that more palatable to our employees and also improve our cash-flow position."

Another option that business owners have is to bring more expenses under the flexible-spending-account umbrella. With this type of FSA, a company's staffers can use their pretax dollars to pay for unreimbursed health care expenses, which include everything from copayments or deductibles to items that might otherwise be omitted from a cost-conscious company's insurance plan, such as eyeglasses and orthodontic work. When this kind of "125" plan is set up, employees may also direct some of their FSA contributions to cover dependent care costs, such as day care bills for the kids or adult care expenses for aged parents, and even commuting-related expenses.

Since those reimbursable categories are designed so broadly, the FSA benefit sometimes winds up being even more valuable to employees than a company initially envisions. At Openplus International, for example, "we have some new employees who came to us with COBRA coverage from their former employers. Normally, one might just expect them to switch to our plan because COBRA can be pretty costly," explained Baskin. "But our company can't afford to offer dental coverage, for instance, whereas those other plans might have included it. So we've seen some new staffers use their FSA contributions -- and all those tax benefits -- to help them pay for COBRA premiums instead of our own. And they've really appreciated the opportunity to make that choice."

Recent developments in the marketplace have made FSAs easier than ever to offer. Whereas in the past many small companies needed to hire an outside accounting firm to administer FSAs, operations are now streamlined so that many plans can be handled by a bookkeeper working with a computerized spreadsheet. (After all, the whole process basically boils down to this: a pretax paycheck gets debited by the same amount each pay cycle; those funds get transferred to a special savings account, typically set up at a bank or investment house; and then the employee submits qualified medical or other bills and is reimbursed from his or her own special account.)

If you're comparison shopping among insurers or benefits specialists, there's a new twist worth investigating: Med-i-Bank Inc., a company based in Birmingham, Mich., has come out with a card similar to a debit card that speeds up the employee reimbursement process. Staffers can swipe their cards at their doctors' offices and immediately pay themselves back for out-of-pocket expenses. (That's great because it also removes the need for employers to process paperwork or issue payment checks themselves.)

Like everything connected with the world of health care, FSAs are, of course, not perfect. In return for tax advantages, there are financial risks. From an employee's standpoint, the big one is "use it or lose it": if, by the end of the year, the total withheld from the paycheck is more than the employee (and his or her family) has needed to cover premiums, unreimbursed medical bills, and other FSA-appropriate expenses, the employer gets to keep whatever's left in the savings account.

That's an intimidating enough prospect to prevent many of the employees who could participate in corporate FSA plans from getting involved. (Statistics suggest that fewer than 20% of the employees who can sign up do so.) And that's a problem, since companies need good participation levels if they're to earn significant payroll tax savings and keep their plans in compliance with IRS rules (which prevent top-heavy participation by only higher-paid staffers). But by educating people about the ways that the benefits can outweigh the risks, entrepreneurs can enhance participation levels.

"The truth is, 'use it or lose it' forces people to be conservative when they make their projections about how much they want to shelter from taxes. If they're cautious when making projections, they seldom face any real risk," explains Valerie Robbins, a partner at the Washington, D.C., accounting firm Beers & Cutler. "And fortunately, if a participating employee experiences a significant family change, which might include a birth, death, divorce, or loss of the spouse's job, FSA contribution levels can be adjusted, which also helps minimize risks."

From a business owner's vantage point, the big problem is simply this: The company must cover any discrepancies between the amount an employee has promised to contribute during the course of the whole year and whatever funds actually have been set aside at the time he or she submits a bill for reimbursement. There's the rub. After all, if a staffer promises to contribute $1,500 but has set aside only $100 by the time a family member suddenly needs a pricey root canal procedure that is not covered by health insurance, the company must ante up the $1,400 difference -- and hope that the employee doesn't quit before year-end. (If the employee does quit, IRS rules state that the company must eat the loss.) "The way to get around that," explains Evans, "is for a company to set conservative limits itself when it comes to how much its employees can contribute to these plans."

Federal guidelines don't put a cap on the amount that staffers can contribute to FSA plans for noncovered health care expenses, but companies typically set the limit between $500 and $1,000, at least when they're first getting started and need to gain confidence. Different rules govern the "premium only" and "dependent care" options, but in both cases, companies face no additional financial risk.

One final caveat: As with pension plans, businesses must prepare a series of forms -- some of which may need to be filed with the federal government -- describing their FSAs at the start-up phase and updating developments at the end of each plan year. Those forms can be time-consuming and can cause serious financial penalties if they are overlooked or prepared incorrectly. "If you make a mistake on your annual Form 5500, for example," warns Amit Ahluwalia, an FSA expert at MHM Business Services Inc., based in Kansas City, Mo., "the IRS could determine that your company was out of compliance and penalize you by up to $15,000 per year. That's in addition to the fact that the company and its employees would owe back taxes and interest on any tax savings that had been granted in the past."

So it's worth consulting an expert. Once your FSA is up and running it should cost your company less than $200 per employee. Compare that with how much you might otherwise spend on health care benefits, and you'll probably just take two aspirins and sign up.

Jill Andresky Fraser is Inc.'s finance editor.

Unless your company is so cash rich that it can afford to pay 100% of the costs for a top-quality health insurance package for its employees, a flexible spending account -- especially the POP variety -- will probably make sense. But there are some exceptions worth pointing out:

Owners lose out. If you're a sole proprietor, partner, member of a limited liability company, or owner of more than 2% of the shares of an S corporation, you yourself can't participate in an FSA, which means you won't receive any personal tax savings. Of course, your company does still stand to benefit on the payroll tax front, so long as you have other employees who can sign up.

Young staffers don't join. Here's a simple fact: it doesn't pay to set up an FSA plan if no one is going to participate in it. So if the bulk of your employees are young (which means they probably won't anticipate big medical bills or need help with dependent care costs), you might as well pass.

Transient workforces need not apply. If you expect heavy staff turnover, you'll be better off skipping an FSA. That's because your company's financial risks rise along with the likelihood that staffers won't stay around long enough to make 52 weeks' worth of salary contributions to their accounts.

Tiny staffs are a question mark. The more workers you have, the likelier it is that your company's participation level will be great enough to have payroll tax savings outweigh administrative costs. But if most of your employees are partners or owners (and thus can't participate), an FSA may not work.

Let's consider a company with 10 employees and an annual payroll of $300,000. With Social Security taxes at 7.65%, the company should owe $22,950. What if enough employees signed up for an FSA plan to subtract $24,000 from the taxable payroll? That company would save $1,836 in taxes.

Here's the impact on a single employee, whose annual salary is $30,000. Assuming that she chooses to contribute $2,400 to an FSA, her taxable income drops to $27,600. With taxes at 30.65% (based on rates of 20% federal, 7.65% FICA, and 3% state), she would increase her yearly take-home pay by $736.

"Assuming that all 10 employees achieved the same results, this company and its staffers would save a total of $9,196 during the course of a year because they participated in an FSA plan," calculates Kelly Ann Boyce. Not bad.