Financing 101

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

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.