ISSUED 12/18/2020
The Internal Revenue Code’s nondiscrimination rules are designed to prevent plans from discriminating in
favor of individuals who are either highly compensated or otherwise key to the business. The intent is to ensure that rank-and-file employees receive their fair share of the tax benefits and ensure highly compensated or key employees are not receiving disproportionate amount of tax-free benefits.
Cafeteria, or Section 125, plans and certain health and welfare benefit plans are subject to nondiscrimination testing. Different nondiscrimination tests apply to each type of benefit plan. Below is a brief synopsis of the various tests.
Cafeteria Plans
• Eligibility Test: Are enough non-highly compensated eligible to benefit
• Contributions and Benefits Test: Are contributions and benefits available on a nondiscriminatory basis and do highly compensated select more nontaxable benefits than non-highly compensated
• Key Employee Concentration Test: Do Keys receive greater than 25% of qualified benefits
Health FSA, HRAs, Self-Insured Major Medical, Dental, and Vision
• Eligibility Test: Are enough non-highly compensated benefiting from the plan
• Benefits Test: Are all benefits provided for highly compensated the same for all other participants
Dependent Care Assistance Program
• Eligibility Test: Are enough non-highly compensated eligible to benefit
• Contributions and Benefits Test: Are contributions and benefits available on a nondiscriminatory basis
• More-Than-5% Owners Concentration Test: Do more than 5% owners receive more than 25% of the benefit
• 55% Average Benefits Test: Do non-highly compensated receive at least 55% of the average benefits provided to highly compensated
Fully Insured Major Medical and Dental*
• Eligibility Test: Are enough non-highly compensated benefiting from the plan
• Benefits Test: Are all benefits provided for highly compensated the same for all other participants
*Under healthcare reform, fully insured group health plans (other than grandfathered plans) generally are required to satisfy the nondiscrimination rules similar to those for self-insured plans. However, compliance is not required until the IRS has issued regulations or other guidance on how the nondiscrimination rules apply to insured plans. Do note, if offered through a cafeteria plan, fully insured plans are indirectly subject to cafeteria plan’s nondiscrimination rules.
Who is Part of the Highly Compensated and Key Employees Group
The group of employees in whose favor discrimination is prohibited (the prohibited group) is defined differently for each plan and for each test run under the plan. There is not a single definition for all plans and tests.
Cafeteria Plan Highly Compensated Participant
• Officer
• More than 5% shareholder
• Highly Compensated (More than $130K in 2020, more than $130K in 2021)
• Spouse or dependent of above
Key Employee
• Officer making over $185K for 2020, over $185K for 2021
• More than 5% Owner
• More than 1% Owner Making over $150K
Self-Funded Highly Compensated Individual
• Highest paid 25%
• Five Highest Paid Owners
• More than 10% Shareholder
Dependent Care Highly Compensated Employee
• More than 5% Owner
• Highly Compensated (More than $130K for 2020, more than $130K for 2021)
Exceptions and Safe Harbors
Certain exceptions and safe harbors are available to nondiscrimination tests which may provide an alternative way of passing. These include collectively bargained plans, premium-only plans, and simple cafeteria plans. Qualifying for these safe harbors will treat the plan as meeting some of the nondiscrimination tests wherein the absence the plan would fail.
Failing – Now What
Having a discriminatory plan means those part of the prohibited group will lose their preferential tax treatment; benefits may be included in gross income when they would have been nontaxable if the plan had passed testing. The status of the plan will not be impacted nor will the preferential tax treatment for employees who are not part of the prohibited group.
Common Red Flags That May Warrant a Closer Look
• Different employment requirements, waiting periods, or entry dates
• Different employer contributions
• Separate plans for different employee groups
• Exclusion of classes of employees
• Single cafeteria plan with varying benefit contributions and rates for different classes of employees
• Related group of businesses (controlled group and affiliated service groups) covering employees in one business and not another