Don’t Forget About Discrimination Testing
An employer benefit program is designed to be part of a total rewards package for employees. While it is permissible for an employer to set differing levels of compensation offered, the same discretion is not allowed when it comes to employee benefit plans. The IRS has established guidelines to limit the employer’s discretion when dealing with their benefit programs and employee classes. To prevent an employer from offering more favorable benefits, contributions, or eligibility to highly paid employees, and to retain tax favored status, benefit plans must undergo discrimination testing. The benefits tests measure whether a plan is “offered in a manner that is discriminatory on its face” and whether the plan is operated “in a discriminatory manner”.
There are two sections of the Internal Revenue Code (IRC) that establish discrimination tests.
Section 125 Discrimination Test
Section 125 of the IRC applies to cafeteria plans that offer pre-tax contributions and/or Flexible Spending Accounts. Dependent Care and Medical Care Flexible Spending Accounts must be tested separately if they are offered by an employer. The most common Section 125 benefit offered by employers is the pre-tax contribution for health insurance contributions or Premium Only Plan. Several states mandate that all employee contributions for health insurance be collected on a pre-tax basis. Employers in the states of CT, MA, MN, MO, RI, as well any employer offering a section 125 plan, will automatically be required to demonstrate non discrimination under Section 125.
Section 125 of the IRC applies to cafeteria plans that offer pre-tax contributions and/or Flexible Spending Accounts. Dependent Care and Medical Care Flexible Spending Accounts must be tested separately if they are offered by an employer. The most common Section 125 benefit offered by employers is the pre-tax contribution for health insurance contributions or Premium Only Plan. Several states mandate that all employee contributions for health insurance be collected on a pre-tax basis. Employers in the states of CT, MA, MN, MO, RI, as well any employer offering a section 125 plan, will automatically be required to demonstrate non discrimination under Section 125.
Section 105(h)(2) Discrimination Tests
Section 105(h)(2) prohibits some health plans from discriminating in favor of highly paid individuals. Currently this IRC section applies only to self insured plans. Self insured plans that must be tested include HRA’s and employer funded FSA’s as well as the traditional self funded health and welfare plans. The Affordable Care Act applies the Section 105(h)(2) discrimination rule to fully insured non grandfathered group health plans. The application of this rule is pending the release of additional administrative guidance by the IRS.
Section 105(h)(2) prohibits some health plans from discriminating in favor of highly paid individuals. Currently this IRC section applies only to self insured plans. Self insured plans that must be tested include HRA’s and employer funded FSA’s as well as the traditional self funded health and welfare plans. The Affordable Care Act applies the Section 105(h)(2) discrimination rule to fully insured non grandfathered group health plans. The application of this rule is pending the release of additional administrative guidance by the IRS.
Testing Rules
The benefit plan must pass both the Eligibility and the Contribution and Benefits Test. Before testing begins an employer must identify the requisite group of highly paid individuals. In general these include:
The benefit plan must pass both the Eligibility and the Contribution and Benefits Test. Before testing begins an employer must identify the requisite group of highly paid individuals. In general these include:
- The highest paid officers in the company
- An owner/shareholder of the company
- Highly paid individuals based on compensation that is indexed each year
- A spouse or dependent of one of the above that works for the same employer
Eligibility Test:
The IRS requires fair and reasonable employee eligibility requirements so that a plan made available to highly paid and key employees must be made available to an adequate number of non-highly paid employees. Passing the test requires that the plan:
The IRS requires fair and reasonable employee eligibility requirements so that a plan made available to highly paid and key employees must be made available to an adequate number of non-highly paid employees. Passing the test requires that the plan:
- Cover 70% or more of all non–excludable employees, highly paid and non highly paid AND
- Of the 70% of those eligible to participate , 80% or more must be covered under the plan; AND
- Employees qualify under a classification that does not discriminate in favor of highly paid individuals.
Contribution and Benefits Test:
Each employee must have an equal opportunity to select the non-taxable benefit. Waiting periods, required employee contributions and maximum benefit levels should be uniform for all participants and their dependents.
Each employee must have an equal opportunity to select the non-taxable benefit. Waiting periods, required employee contributions and maximum benefit levels should be uniform for all participants and their dependents.
Not all benefit differences cause a plan to be discriminatory.
Different groups of employees can be offered a different benefits package. These groups must be based on a bone fide business classification. Distinctions such as geographic location, nature of compensation (salary and hourly), and specific job categories are permitted. However, there must be a business reason for each classification and the classifications cannot be weighted to provide favorable benefits to highly paid employees.
Different groups of employees can be offered a different benefits package. These groups must be based on a bone fide business classification. Distinctions such as geographic location, nature of compensation (salary and hourly), and specific job categories are permitted. However, there must be a business reason for each classification and the classifications cannot be weighted to provide favorable benefits to highly paid employees.
Some employee groups may be excluded from testing:
- Employees with less than three years of service
- Employees under age 25
- Part-time or seasonal employees
- Non-resident aliens, without US income
- Collectively bargained employees
In addition, certain persons do not meet the definition of employee and are excluded from discrimination testing. Partners in a Partnership and more than 2% owners in an S corporations (including their spouse and children) cannot participate in a cafeteria plan and do not meet the definition of “employee” for testing purposes under Section 125 and 105(h)(2).
Sanctions differ for discrimination violations of 125 Cafeteria plans and 105(h)(2) plans
Example: Section 125 violations sanction the highly compensated individuals (HCI). The HCI will be required to include the combination of plans with the highest aggregate value in their gross taxable income.
Example: Section 125 violations sanction the highly compensated individuals (HCI). The HCI will be required to include the combination of plans with the highest aggregate value in their gross taxable income.
Example: Section 105(h)(2) violations target the plan or the plan sponsor. A fine of $100 per day for every non-highly paid employee is assessed against the company for each day a plan discriminates. The plan or the plan sponsor may be subject to this excise tax or a civil action compelling the employer to provide non discriminatory benefits.
What should employers do next?
Take a snap shot view of your benefit plans. Employers should establish a system for plan review, check plan eligibility rules, benefit and contribution levels, and look at plans offered to both active and retired or terminated employees. Plans that differ by benefits or contributions should be tested annually to confirm that there is no discrimination. Testing should be done early in the year.
Take a snap shot view of your benefit plans. Employers should establish a system for plan review, check plan eligibility rules, benefit and contribution levels, and look at plans offered to both active and retired or terminated employees. Plans that differ by benefits or contributions should be tested annually to confirm that there is no discrimination. Testing should be done early in the year.
Small Plans
When it comes to flexible spending accounts, small plans cause the most problems. An employer with less than 100 employees can establish a SIMPLE cafeteria plan which eliminates the need for section 125 testing. A SIMPLE cafeteria plan is one that allows employees to purchase certain benefits on a tax-favored basis.
When it comes to flexible spending accounts, small plans cause the most problems. An employer with less than 100 employees can establish a SIMPLE cafeteria plan which eliminates the need for section 125 testing. A SIMPLE cafeteria plan is one that allows employees to purchase certain benefits on a tax-favored basis.
While section 105(h)(2) rules do not currently apply to fully insured plans, now is the time to review plan design and make the necessary changes before the law goes into effect. The delay of this provision means the insured plans will not be affected until 2012 at the earliest. Given this extended time period, companies should examine their plans during the 2011 renewal process and make the changes needed to ensure they will not be discriminatory when the law goes into effect.