What is nondiscrimination testing?
A cafeteria plan and its component benefit plans enjoy favorable tax treatment by the IRS. As a result, the IRS requires these plans to undergo yearly non-discrimination testing. There are 9 different types of nondiscrimination tests. Which ones apply to an employer’s plans will depend on the structure of the arrangement and which benefits are available. The goal behind the testing is to ensure the plan does not discriminate in favor of highly compensated or certain key employees. The IRS Code offers specific definitions of who is considered a highly compensated, or key employee. These types of employees are defined differently for different component benefits of a cafeteria plan. Plans that must be tested include section 125 cafeteria plans, self-insured health plans, flexible spending accounts (FSA), dependent care FSAs, group term life insurance, self-insured health reimbursement arrangements (HRA), and health savings accounts (HSA).
What do the tests involve?
These plans must pass a series of tests. Some of the tests involve eligibility, which looks at who can participate; benefits and contributions, which considers what benefits are being offered; and utilization, which contemplates who actually uses the benefits and to what extent.
What are the consequences of failing the tests?
Failing non-discrimination testing has negative consequences for all highly compensated and key employees receiving the discriminatory benefits. These employees will lose their ability to receive benefits on a pre-tax basis and will be taxed on any previously paid amounts. Non-highly compensated employees will not be affected.
The plan will not cease to be a qualified plan if it fails testing, however employers may be subject to additional taxes that were underpaid, as well as any accompanying interest and penalties. The employer would also be responsible for amending any employee W-2s.
- Have non-discrimination testing conducted before the end of the year.
For employers on calendar year plans, the end of the year is fast-approaching. Employers need to reach out to their respective vendors to set up nondiscrimination testing. It is recommended the employer leave enough time to make any needed plan changes before the end of the year. Most employers use a third-party administrator (TPA) to conduct nondiscrimination testing.
- Review the results.
If the test fails, there may be time for the employer to remedy the various plans. It is possible that participant elections may be changed or plan design changes may be made to ensure plans are nondiscriminatory.
Sequoia clients: employers should check in with their testing vendor to ensure all testing strategies have been utilized before making plan changes.
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