Non Discrimination Testing
Cafeteria plans are popular because they allow employees to receive health insurance coverage from their employers without
having to pay taxes on it. Intending cafeteria plans to benefit the rank-and-file employee, Congress created rules to ensure that
their tax-favored status would not be used to benefit only or primarily the highest-paid or owners of a company. These rules are
referred to as nondiscrimination testing.
Cafeteria plans are not the only type of benefit plan that receives tax-favored status and must perform nondiscrimination
testing. Self-insured plans, insured plans, Health FSAs, and DCAPs must also undergo testing. Testing for each of these will vary
slightly, but although the details are different, overall concepts are similar.
Nondiscrimination testing is designed to ensure that the benefits are 1) generally available to a company’s employees and are
2) being utilized by a majority of rank-and-file employees. To measure this, testing rules distinguish between rank-and-file and
highly compensated employees and create threshold percentages for rank-and-file participation. Also, “nondiscrimination
testing” usually means that the plan must pass two or three different tests that each address either availability of benefits or
utilization of benefits.
This introductory primer will first highlight some of the concepts that apply to all types of nondiscrimination testing, then detail
testing requirements for each particular plan type (e.g., cafeteria plans, self-insured plans, etc.).
Nondiscrimination Testing Generally
When to test
Although not mandated by any statute, nondiscrimination testing generally should be performed three times a year: 1) prior tothe beginning of the plan year; 2) several months before the end of the plan year; and 3) after the close of the plan year. This
ensures that any elements in the plan that cause it to fail can be corrected before the end of the plan year.
Control groups refer to when two or more companies are so closely related that they should be treated as one employer. For example, if XYZ Company owns 80% of ABC Company, these two companies will be treated as one employer for testing
purposes. Why is this important? As discussed above, the testing is concerned with employees being eligible to participate and
actually participating in the plan. Suppose that in order to pass the testing, 70% of your employees have to be eligible to
participate in the plan. You have 100 employees and all 100 participate. However, if you are joined as a “control group” with
another company that has 100 employees and none of them are eligible to participate in the plan, then you would no longer
meet the 70% threshold. As a result, what “to own” means becomes very important. Constructive ownership rules apply, primarily in relation to stocks.For example, let’s say you own 1 share of stock out of 1000, but have an option to buy the other 999. Under the rules of
constructive ownership, you would be deemed to own 1000 shares even though you don’t actually own them.
What is being tested
It is important to realize that the testing is applied on a plan-by-plan basis; for example, if you have 100 employees and three
separate plans, 70% of all 100 employees must be eligible to participate in each of the three plans. All non-excludable
employees are considered in deciding whether a particular plan passes. So, if you offer one plan for your 10 managers in a
100-employee company and another plan for the 90 other employees, then the plan for your managers will fail unless 60 other
employees are eligible to participate in it (60 + 10 = 70).
The rules are concerned with whether employees are “benefiting” from the plan. “Benefit,” however, is not clearly defined. There
are two approaches available. The more conservative approach, which OCA follows, defines that in order to benefit, an employee must have elected coverage or have been provided with free coverage by plan design. (The more aggressive approach,
on the other hand, says that in order to benefit, an employee only needs to be eligible to elect coverage.)
Not all workers are considered “employees” for nondiscrimination testing. For example, cafeteria plan nondiscrimination testing
requires that part-time employees be counted. Testing for self-insured plans, however, permits part-time or seasonal employees to
be excluded. Some plan types may allow the exclusion of certain employees for certain parts of the test but not others.
Consequently, when discussing the particular tests, reference will be made to “non-excludable” employees. Excluding certain
workers is obviously attractive to employers because it usually increases their chances of reaching the threshold percentage for
Highly compensated employees (HCEs)
These are the employees whom Congress was worried about receiving the lion’s share of the benefits; they are sometimes
referred to as “the prohibited group.” Like excludable employees, the definition of “highly compensated employee” (HCE) will vary
depending on whether we’re looking at a cafeteria plan or self-insured plan; usually however HCE includes the highest-paid
20-25% of employees.This also raises the question of exactly what “compensation” is. The rules allow any reasonable definition of compensation so long as it is used consistently. The time bracket for compensation must also be determined. It usually is the prior year, but the rules provide some flexibility.
What happens if your plan fails the test? Usually that means that the benefits received by the HCEs will no longer enjoy their
tax-favored status. The only exception is for fully insured plans, which receive a different penalty under the Patient Protection and
Affordable Care Act (i.e., health care reform). If a plan fails the test at the beginning or in the middle of the plan year, the plan
can be corrected so as to avoid adverse tax consequences. A plan administrator should have the authority to cut off any
employee’s salary reductions in order to comply with the nondiscrimination rules.
Certain plans can be exempted from certain tests (or from testing altogether) if they meet particular requirements. For example,
if a POP cafeteria plan passes the eligibility test, it does not have to pass the two remaining tests.
Red flags and how to pass
If your cafeteria plan contains the following elements, then you could be in danger of failing nondiscrimination testing (similar
red flags exist for self-insured plans, etc.):
- Separate cafeteria plans for different employee groups, such as one plan that covers hourly employees and a different
plan that covers salaried employees.
- Exclusion of part-time, seasonal, or temporary employees. (Inapplicable for self-insured plans).
- In a controlled group, employees in one division or company are covered, but those in another division or company are not.
- Employment requirements, waiting periods, or entry dates vary for different groups of employees (e.g., a single
cafeteria plan sponsored by a controlled group contains different entry requirements for employees of various entities in
the controlled group).
- Entry into the plan is delayed beyond the first day of the first plan year beginning after the date the employment
requirement is met. This will cause a plan to fail automatically.
- The plan bases employer contributions or benefits on years of service or percentage of compensation.
- Contributions and rates within a single cafeteria plan vary for different groups of employees.
Although perhaps not a palatable business option on its face, the simplest way to pass nondiscrimination testing is to make all
provided benefits available on the same basis to all your non-excludable employees and to make the provided benefits attractive
enough (i.e. affordable) that a majority of your employees actually utilize the offered benefits. Nevertheless, some variation is
allowed, the limits of which are discussed in the following section.