What is Nondiscrimination Testing?
The Internal Revenue Service (IRS) has various rules in place to ensure that health plans do not discriminate in favor of highly compensated individuals (HCIs), highly compensated employees (HCEs), or key employees with respect to plan eligibility, pre-tax contributions, or benefits. To that end, health plans must undergo nondiscrimination testing each year to determine if a plan is discriminatory and the results may be subject to review upon an audit of your plan.
What Types of Tests Must be Completed?
The health plans in place determine what types of tests must be completed.
Cafeteria Plans (IRC Section 125) (can include the HSA and other component benefits if contributions are provided under the cafeteria plan)
- Eligibility Test
- Contributions and Benefits Test
- Key Employee Concentration Test
Health Flexible Spending Account (FSA) (IRC Section 105(h))
- Eligibility Test
- Benefits Test
Dependent Care Plans (IRC Section 129)
- Eligibility Test
- Contributions and Benefits Test
- More than 5% Owners Concentration Test
- 55% Average Benefits Test
Health Reimbursement Arrangement (HRA) (IRC Section 105(h))
- Basic Test
- Eligibility Test
- Benefits Test
Self-Insured Medical Plan (IRC section 105(h)) (includes medical, dental, vision)
- Eligibility Test
- Benefits Test
Group Term Life Insurance
- Eligibility Test
- Benefits Test
When Should Nondiscrimination Testing be Completed
IRS regulations require nondiscrimination testing to be performed by the last day of the plan year; however, it is recommended that employers conduct a pre-test mid plan year to determine if any corrective steps need to be taken in the event the plan discriminates. For example, the most common failure usually occurs with dependent care FSA plans, as these plans are often more utilized by highly compensated employees. If an employer has failed this test in the past, it is a good idea to test this benefit mid-year. If a discrimination issue is discovered during the plan year, the employer can make adjustments to the plan to ensure that the plans pass the testing at the end of the year. It may be difficult to correct any plan failures that are discovered in the last days of the plan year. This is why we recommend testing the plan before the last month of the plan year. Further, after the plan year has ended, employee salary reductions cannot be re-categorized as post-tax contributions and applicable HCEs or key employees may be taxed accordingly.
What Happens if Nondiscrimination Testing was Not Completed or if a Plan Fails a Nondiscrimination Test?
If an employer fails to perform nondiscrimination testing, then they will lose the opportunity to catch any discriminatory issues that may exist and make the appropriate corrections prior to the end of the plan year. It could also be problematic for an employer who is undergoing a plan audit if they are unable to demonstrate that they complete testing on an annual basis.
Failure to pass nondiscrimination testing will result in all or a portion of the benefits provided to HCIs, HCEs, and key individuals being categorized as taxable. The benefits provided to these individuals may need to be included in their gross income. If the employer has already issued Forms W-2, they will need to issue amended Forms W-2 to report the taxable amounts. A testing failure will not affect non-highly compensated employees in any way.
Employer Action Item:
The vendor assisting with testing your cafeteria plan or self-insured health plans will likely reach out to you during the plan year to obtain information required to complete nondiscrimination testing. As the plan administrator, we advise that you actively contact your vendor to determine the nondiscrimination timeline for the year so you are not rushing to complete testing or gather needed information. We also recommend that a pre-test be completed mid-year for any plans that are new or that have failed testing in the past to ensure that any necessary adjustments can be made prior to the close of the plan year.
The information and materials on this blog are provided for informational purposes only and are not intended to constitute legal or tax advice. Information provided in this blog may not reflect the most current legal developments and may vary by jurisdiction. The content on this blog is for general informational purposes only and does not apply to any particular facts or circumstances. The use of this blog does not in any way establish an attorney-client relationship, nor should any such relationship be implied, and the contents do not constitute legal or tax advice. If you require legal or tax advice, please consult with a licensed attorney or tax professional in your jurisdiction. The contributing authors expressly disclaim all liability to any persons or entities with respect to any action or inaction based on the contents of this blog.
