The increasing pressure on HR Managers when it comes to compliance is not easing up. With the majority of the focus on ACA reporting, it is easy to overlook the frequently ignored and misapplied nondiscrimination tests for cafeteria plans.
The consequences of failing the nondiscrimination tests vary, but they could have negative tax implications for an employer’s most important employees and/or lead to penalties being assessed against the employer. Additionally, misapplying one area of the law will only peak the auditor’s interest in what else you may be implementing incorrectly.
In general, a cafeteria plan must satisfy three separate nondiscrimination tests to provide beneficial tax treatment to all of the plans participants. Eligibility, benefits available and contribution and benefits tests ensure that employers offer all benefits to an adequate number of employees and benefits do not discriminate in favor of highly compensated or key employees.
The Eligibility Test
The first nondiscrimination test, the “eligibility test”, examines whether enough non-highly compensated individuals (non-HCIs) are eligible to participate in the plan. An HCI for cafeteria plans is an officer of the employer, a five percent shareholder of the employer, or an individual who for the preceding plan year had compensation from the employer in excess of $120,000. Additionally, a spouse or dependent of an individual described in one (or more) of the three categories above is counted as an HCI. A non-HCI is an individual who is not an HCI.
The first part of the eligibility test requires a cafeteria plan to benefit a group of employees who qualify under a reasonable job classification. Additionally, the eligibility test requires that either a “safe harbor test” or an unsafe harbor facts and circumstances test (“unsafe harbor test”) be satisfied using a table published in the Internal Revenue Code. The “unsafe harbor test” also requires an IRS finding that the classification is nondiscriminatory based on relevant facts and circumstances.
The Contributions & Benefits Test
The second test, the contributions and benefits test, is designed to measure the contributions and benefits available to highly compensated participants to ensure they do not select more nontaxable benefits than non-highly compensated participants. A highly compensated participant is an HCI who is eligible to participate in the cafeteria plan. A non-highly compensated participant is a participant who is not a highly compensated participant. A cafeteria plan must give each similarly situated participant a uniform opportunity to elect qualified benefits (the “availability test”) and the actual election of qualified benefits through the plan must not be disproportionately made by highly compensated participants (the “benefit utilization test”).
The Concentration Test
Last but not least, the key employee concentration test prohibits the benefits provided to key employees under the plan from exceeding 25 percent of the aggregate of such benefits provided to all employees under the plan. A key employee is different from an HCI. For 2015, a key employee is (1) an employee who is a five percent owner of the employer; (2) an employee who is a one percent owner of the employer and whose annual compensation from the employer exceeds $150,000; or (3) an officer having annual pay of more than $170,000.
When conducting nondiscrimination tests, keep in mind that the amount of HCI participants cannot exceed 25% of all non-HCI participants. Also, ensure that you properly identify “excludable” employees:
- Employees who have not completed three years of service
- Employees under age 25
- Part-time or seasonal employees
- Non-resident aliens with no U.S. source income.
However, if you don’t exclude all employees in an excludable category, then no employees in that category are considered to be excludable. For example, an employer could not exclude some employees who have less than three years of service but not others, and it could not exclude some employees who are under age 25 but not others.
As you can see, the various nondiscrimination rules may apply differently depending on the course of action an employer selects. Make sure not to neglect or misapply the rules since they often overlap, need to be applied concurrently, and in light of the fact that the government has increased audit efforts.
For more information on cafeteria plans such as FSAs and HRAs, please contact us to find out how Paypro can assist you in eliminating any manual inputting of your FSA elections, new hires and terms as well as putting an end to manually reconciling your FSA data with payroll information.