Some employee benefits enjoy a tax-favored status under the Tax Code, but such favorable tax treatment applies with respect to certain highly compensated individuals only if the plans satisfy applicable nondiscrimination tests. As one example, if a cafeteria plan discriminates in favor of any highly compensated participant, all highly compensated participants may lose the ability to pay for benefits on a pre-tax basis through the plan. As another example, if a self-insured health plan provides better benefits to highly compensated individuals, those individuals will be taxed on the value of the better benefits.
Failure to pass either the Eligibility Test or Benefits Test will result in all highly compensated individuals who are receiving discriminatory benefits under the plan losing the tax exclusion otherwise available for medical benefits provided under a self-insured health plan with respect to such discriminatory benefits. Consequently, such employees will be taxed on the discriminatory benefits.
Although many employers often overlook nondiscrimination testing requirements, there has been an increased interest in such rules following the expansion of these rules under the Affordable Care Act (“ACA,” a.k.a. the “Health Care Reform Act”) to insured health plans. While the regulators have delayed enforcement of nondiscrimination requirements in the insured context pending the issuance of regulatory guidance, once nondiscrimination is enforced against insured plans, it will have even more drastic consequences since ACA does not merely impose adverse tax consequences on impacted employees, but imposes penalties of $100 per day, per person, on the employer. In view of the recent legislative activity in this area, as well as anticipated additional regulatory activity, we expect enforcement eventually to increase not just with respect to insured plans but with respect to all plans. So, now is the time for employers to get their nondiscrimination testing in order.
Nondiscrimination Testing Self-Insured Health Plans
To avoid adverse tax consequences, an employer’s self-insured health plan must not discriminate in favor of highly compensated individuals as to eligibility or benefits. For purposes of these tests, an “employer” includes all related companies in an employer’s “controlled group.” While determining whether an entity is within a controlled group requires a complex analysis regarding ownership percentages, suffice it to say that it is possible for purposes of performing the nondiscrimination tests, that employees not employed directly by a particular employer may be required to be included in the analysis. (Also, employees employed through a staffing agency may need to be considered.)
As mentioned, self-insured health plans are subject to both an Eligibility Test and Benefits Test. The Eligibility Test requires that an adequate number of non-highly compensated individuals are eligible for, or participate in the plan, or, if that is not the case, that a reasonable classification, as determined by the IRS applying a complex testing scheme, has been implemented for purposes of determining eligibility.
The Benefits Test requires that all participants under a plan be eligible for the same benefits. This determination is made by looking at not only the particular benefits that are available, but also by looking at the contributions made by an employer and its employees with respect to those benefits, or any waiting periods or other limitations that may apply.
Generally, we recommend that all plans be tested on an on-going basis. However, a plan will require more or less nondiscrimination scrutiny depending on that particular plan’s terms and employee demographics. Plans that tend to fail these tests include, for example, those that (i) limit participation to a select group of employees, (ii) have low participation among non-highly compensated individuals, (iii) have unequal waiting periods, and (iv) provide benefits (including employer premium contributions) that vary based on age, service, or compensation.
Nondiscrimination Testing Fully-Insured Health Plans
While the nondiscrimination rules currently are not being enforced with respect to insured plans due to a lack of regulatory guidance, fully insured health plans eventually will be subject to the same nondiscrimination rules as set forth above with respect to self-insured health plans. However, in the case of a discriminatory fully-insured plan, the penalties will be more severe and apply directly to the employer. Once the applicable guidance is issued, we will provide a complete summary of these rules. This likely signals the end of such common practices as supplemental executive health benefit plans.
Nondiscrimination Testing Cafeteria Plans
A cafeteria plan must not discriminate (i) in favor of highly compensated individuals as to eligibility, (ii) in favor of highly compensated participants as to contributions and benefits, or (iii) in a way that concentrates benefits with respect to key employees. Otherwise, highly compensated individuals, highly compensated participants and/or key employees will lose the ability to pay for benefits pre-tax through the plan. The controlled group rules described above apply here as well. So, when being tested, an employer may need to consider other employers and employees within its controlled group.
Cafeteria Plan Eligibility Test
To pass the cafeteria plan Eligibility Test, a plan must pass a nondiscriminatory classification test. This test requires that a plan benefit a group of employees who qualify under a reasonable classification established by the employer through the use of objective business criteria, and that the plan satisfies a complicated mathematical “ratio-percentage” test. For purposes of the “reasonable classification” prong of this test, objective business criteria include, for example, job categories, nature of compensation, and geographic location.
Cafeteria Plan Contributions and Benefits Test
To pass the cafeteria plan Contributions and Benefits Test, a plan must make contributions and benefits available on a nondiscriminatory basis and ensure that highly compensated participants are not selecting more benefits than non-highly compensated participants. In other words, the Contributions and Benefits Test looks to benefit availability and benefit utilization. Benefits and/or employer contributions must be available on a nondiscriminatory basis, and benefits must not be disproportionately elected by highly compensated participants.
Plans more likely to fail the Contributions and Benefits Test are those that vary employer contributions based on, for example, an employee’s division, location, or hours worked. If the same amount of employer contributions is available to similarly situated participants, and the cost of benefits is the same with respect to all participants, a plan will be more likely to pass this test.
Cafeteria Plan Key Employee Concentration Test
Finally, cafeteria plans must pass the Key Employee Concentration Test. The basic rule under this test is that the nontaxable benefits provided to key employees cannot exceed 25% of the total nontaxable benefits provided through the cafeteria plan. This part of the test often is failed by smaller employers. Strategies for passing the test include limiting key employee elections with respect to certain benefit components under the plan and excluding key employees for certain portions of the plan or altogether.
Consequences of Failing Cafeteria Plan Testing
If a cafeteria plan fails to satisfy any of the applicable nondiscrimination tests for a year, all members of the prohibited group (i.e., highly compensated individuals, highly compensated participants, or key employees, as applicable) must include in income any amounts previously paid under the cafeteria plan on a pre-tax basis for that tax year.
Other Nondiscrimination Tests
In addition to the tests described above, employers offering dependent care assistance plans (including those offered through cafeteria plans), group term life insurance, qualified educational assistance programs, and adoption assistance programs should note that these plans are subject to other versions of nondiscrimination testing. Similar to the tests described above, these tests ensure that such plans are not discriminating in favor of highly compensated or key employees, and, if they are, such employees generally lose the tax-favored treatment that might otherwise apply. In the case of a qualified educational assistance program, the entire program will lose favorable tax treatment if it is found to be discriminatory.
When Should Tests be Run and Who is Responsible?
While the party actually performing the tests may be, and often is a third party administrator or another vendor, the employer ultimately is responsible for the testing, as it is responsible for reporting any imputed income resulting from a failed test on employees’ Forms W-2. Health and welfare and cafeteria plans should be monitored, and tests should be run as needed periodically, with more frequent testing recommended for plans that are at greater risk of failing. However, plans may have certain design or demographic features that cause them to be so far from failing a nondiscrimination test that testing only needs to be done once every few years, if at all.
Administering the various health and welfare plan nondiscrimination tests generally is a complex (and sometimes costly) endeavor. However, the most important first step for an employer is simply to be aware of these tests so that the employer can spot potential issues before implementing operational or plan design changes that may lead to testing failures.