We all know at a fundamental level that discrimination is a bad thing. So, non-discrimination testing must naturally exist to verify that you are not discriminating against employees. First reactions might be…”Non-discrimination testing? We don’t need that. We treat all employees the same regardless of gender, race or other protected classes.” Unfortunately, when it comes to pre-tax plan compliance, discrimination has nothing to do with protected classes. Instead, it’s all about the money.
So, what is non-discrimination testing and why is it important?
(We will get back to what if means to be “sniffed”).
What is non-discrimination testing?
The legal answer: The IRS requires that cafeteria plans, self-insured health plans (including health flexible spending arrangements), and dependent care assistance programs must not favor highly compensated or key employees.
The common language answer: Employees that make the most money in the company and who are in the highest positions should not receive more benefits than employees who are paid less.
What is required to have a compliant pre-tax benefit plan?
The legal answer: The Federal government has established regulations that specify requirements for each type of benefit plan governed by IRC Section 125 and IRC Section 129. In order to document compliance, plans must pass annual tests to ensure that they meet specified eligibility, benefits, and utilization requirements—with results subject to audit by the IRS. If requirements are not met, highly compensated (HCE) and other key (KEY) employees would face increased taxable income.
The common language response: Test your Medical FSA and Dependent Care plans to make sure they do not favor highly paid or key employees.
What are the required tests for non-discrimination testing?
Non-discrimination tests can be complicated but it boils down to three basic themes:
Who is offered the benefit? Make sure your benefit is not restricted to highly paid or key employees. If too many “regular” employees are excluded from participation in the plan, then it will be discriminatory.
2. Availability of Benefit
Are the benefits better for highly paid/key employees? The plan will not pass if highly paid/key employees can access more or better benefits than the rest of employees. This is sometimes called a Contributions and Benefits Test.
Eligibility and Availability of Benefits are managed by proper plan design. Once you have established eligibility and the availability of benefits in a non-discriminatory manner (e.g. all benefits are equally available to all employees and any exclusions fall within allowed parameters) then you should be able to pass those tests automatically each year.
What employees are using the benefits? This can be the real catch. A plan will not pass the non-discrimination tests if the highly paid / key employees actually elect more benefits under the plan. This is sometimes called a Concentration Test or 55% Average Benefits Test.
The utilization tests are based on actual benefits elected by employees and must be conducted annually to ensure compliance.
When are compliance tests performed?
This is where the “sniff” comes in.
From a legal perspective, cafeteria plan tests should be performed as of the last day of the plan year and take into account all individuals who were employed throughout the year. However, from a practical perspective, employers may have a “sniff test” completed at the beginning or middle of the year.
A “sniff test” tries to determine if there are any likely issues, typically regarding utilization. If there are issues, employers can perform pre-tax adjustments. The key is to have adjustments made before the end of the plan year.
The most common discrimination issue tends to be for Dependent Care FSA utilization. Highly paid employees may often have higher election amounts, causing plans to fail the Concentration Test. The good news is that if these issues are caught before the plan year ends, adjustments can generally be made to maintain the benefit for the majority of employees.
If your plan year is coming to an end, it may be time to complete your compliance testing. As you prepare for a new year, a “sniff test” might be just what you need to avoid any last minute problems or changes.