Employers offering certain employee benefit plans may not discriminate in favor of highly compensated employees (HCEs) and key employees with respect to eligibility, contributions or benefits. OCA’s non-discrimination tests ensure employers remain in compliance!
What is Non-Discrimination Testing?
In order to provide tax savings, cafeteria plans (and their component benefit plans) must not discriminate in favor of highly compensated employees (HCEs) and key employees (Keys). To make sure this does not happen, Congress came up with some requirements that plans must meet. If a plan does not meet these requirements (i.e., if a plan is discriminatory), then some top employees will have adverse tax consequences. Therefore, the reason for non-discrimination testing is to prevent key and highly compensated employees from taking advantage of the benefits that these plans provide for employers and employees alike.
The nondiscrimination tests are complicated, but they can be boiled down to two basic themes:
- Eligibility. Unless enough non-highly compensated employees (non-HCEs) can get into the plan, the plan will fail as being discriminatory. Think of the tax savings as being like a party and ask yourself, “Have enough non-HCEs been invited to the party?”
- Benefit Availability/Utilization. A plan will be discriminatory if the HCEs/Keys can get more benefits than the non-HCEs/non-Keys. Think of the benefits as being appetizers at a party and ask, “Who is being offered appetizers?” (availability test) or “Who is actually taking the appetizers?” (utilization test).
If a plan fails to comply with these requirements, there may be adverse tax consequences for these highly paid and key employees.
Self-insured plans, Health FSAs, and DCAPs should undergo testing.
Testing for each of these will vary slightly, but although the details are different, overall concepts are similar. To measure this, testing rules distinguish between rank-and-file and highly compensated employees and create threshold percentages for rank-and-file participation.
If employers do not adequately follow all the steps necessary for nondiscrimination testing, or they fall out of compliance with federally mandated regulations while using these plans, all discriminatory benefits are included in the gross pay of highly compensated employees. This also means that employers can no longer take advantage of the 7.65% tax break on their annual employer matching FICA tax. In other words, if an employer fails to comply with IRS regulations and testing procedures, any and all benefits that were received from that employer’s FSA or POP plan must be re-paid.
OCAs Non-Discrimination Testing Services
Section 125 – POP and FSA Non-Discrimination Testing
If you have a Flexible Spending Account (FSA) or a Premium Only Plan (POP), the IRS requires you to submit to non-discrimination testing once a year.
The reason for nondiscrimination testing is to prevent highly compensated employees from taking advantage of the benefits that these plans provide for employers and employees alike. Such advantages consist of an increase in take home pay because the dollars spent are pre-tax and a 7.65% savings annually on employers matching FICA tax.
Nondiscrimination testing is a big factor in way of compliance. If employers do not adequately follow all the steps necessary for nondiscrimination testing, or they fall out of compliance with federally mandated regulations while using these plans, all discriminatory benefits are included in the gross pay of highly compensated employees. This also means that employers can no longer take advantage of the 7.65% tax break on their annual employer matching FICA tax. In other words, if an employer fails to comply with IRS regulations and testing procedures, any and all benefits that were received from that employer’s FSA or POP plan must be re-paid.
Overall, the greatest concern when filing nondiscrimination testing is that your company is in compliance with all regulations before you begin. As stated above, the initial reason for nondiscrimination testing is to avoid the abuse of these benefits by highly compensated employees.
Section 105(h) – Eligibility and Benefits Non-Discrimination Testing
Benefits under an employer-sponsored health plan generally are not taxable due to a special section of the Code which excludes the value of those benefits from taxation. However, in order to ensure that employers do not improperly discriminate in favor of highly compensated individuals (“HCIs”), Congress created nondiscrimination rules under Code Section 105(h).
Currently, Code Section 105(h) only applies to self-funded health plans. A plan is generally treated as self-funded even if the plan has stop-loss insurance. In addition, the Affordable Care Act (“ACA”) provides that non-grandfathered, fully-insured health plans will also be subject to rules “similar” to Code Section 105(h).
The 105(h) Test is designed to verify two things. First, that “enough” non-HCIs “benefit” under the health plan, in comparison to the number of HCIs who “benefit.” Second, to verify that the health plan’s benefits (e.g., deductible levels and covered benefits) do not favor HCIs.
What Are the Specific Tests to Conduct?
There are nine different tests that can be applicable to benefits provided under an Flexible Spending Account (FSA) and/or Dependent Care Account (DCA). Some tests are related to eligibility and availability of benefits, and other tests are based on actual benefits elected (utilization).
The Section 125 Cafeteria Plan
1. Eligibility Test
2. Contributions and Benefits Test
3. Key Employee Concentration Test (utilization)
4. Eligibility Test
5. Benefits Test
Dependent Care FSA (DCAP)
6. Eligibility Test
7. Contributions and Benefits Test
8. More-Than-5% Owners Concentration Test
9. 55% Average Benefits Test (utilization)
Three Most Common Reasons Non-discrimination Tests Fail
• Dependent Care FSA – 55% Average Benefits Test (utilization)
o Because HCEs typically participate in the DCAP at a much higher rate than non-HCEs, it is not unusual for a plan to fail the 55 percent average benefits test. The test also includes all employees even those not participating which can negatively impact the average calculated in the test. To reduce the likelihood of failure, an employer may consider capping HCE DCAP elections at an amount below the $5,000 maximum.
• Medical and Dependent Care FSA – Benefits Tests
o HFSAs and DCAPs that have disparate waiting periods for a single cafeteria plan tend to favor the highly compensated causing the test to fail. To reduce the likelihood of failure, tax the individuals that can enter the plan immediately until the remaining employees can enter the plan.
• Eligibility in the Plan – Eligibility Tests
o Unless enough non-highly compensated individuals are eligible, the cafeteria plan will fail the Eligibility Test. To reduce the likelihood of failure, make sure enough non-highly compensated are able to benefit from the plan.