Health Flexible Spending Accounts: What to do if your Health FSA is discriminatory



In the first article of this Health FSA series, we covered how to determine if an employer’s Health FSA is discriminatory. In the second and final article of this series, we’ll cover what employers should consider if their Health FSA may be discriminatory and what steps to take for correction.


The analysis of whether a Health FSA is discriminatory varies depending on whether the Health FSA accepts pre-tax salary contributions from employees. Health FSAs funded with employee pre-tax salary contributions must also satisfy the Section 125 plan nondiscrimination rules which vary from those in 105(h).

For purposes of this article, we will discuss the nondiscrimination requirements as applied to Health FSAs funded through participants’ pre-tax salary contributions BUT we’ll assume these Section 125 Health FSAs can pass the non-discrimination requirements applicable under Section 125 of the Internal Revenue Code. Thus, our analysis is limited to the applicability of Section 105(h) requirements to Section 125 Health FSAs that have successfully passed the Section 125 nondiscrimination requirements.

The following is general information about Health FSAs and is intended for educational purposes only and does not constitute legal advice.

What do I do if I am advised by the testing service that my Health FSA may be discriminatory as to eligibility?

A Health FSA may still be found as passing the Post-TRA Fair Cross Section Testif its concentration percentage of non-highly compensated individuals does not fall below an Unsafe Harbor Percentage (found in the same table as the Safe Harbor Percentage) and upon a review of the applicable facts and circumstances, the IRS determines that the classification used by the employer for eligibility is not discriminatory. Your employee benefits attorney can review information regarding your participants, their salary ranges, and your eligibility criteria to determine whether it is likely your plan would pass the Post-TRA Fair Cross Section Test. 

If a Health FSA cannot pass the Post-TRA Fair Cross Section Test, the employee benefits attorney will apply the Pre-TRA Fair Cross Section Test which analyzes the likelihood of the IRS finding the plan discriminatory. Your attorney may determine that the Pre-TRA Fair Cross Section Test could be satisfied if they determine that the:

  • Compensation of the plan participants is substantially the same as those of employees not participating,
  • Health FSA covers employees in all compensation ranges and those in the middle and lower compensation ranges are covered in more than nominal numbers, and
  • Eligibility criteria on its face does not discriminate in favor of officers, shareholders, or highly compensated individuals. If after consulting your benefits attorney it is determined that the Health FSA does not pass the Post or Pre-TRA Fair Cross Section Tests, the Health FSA is discriminatory.

What do I do if the Health FSA is considered discriminatory?

A Health FSA that fails to satisfy the 105(h) non-discrimination requirements must tax its highly compensated individuals on the excess reimbursements they received from the Health FSA during the plan year.

A highly compensated individual’s excess reimbursement is determined by multiplying the total amount reimbursed to the highly compensated individual by a fraction, the numerator of which is the total benefits paid for that plan year to or for all highly compensated individuals and the denominator is the total benefits paid for that year to or for all plan participants. The resulting amount is included in the highly compensated individual’s income.

For example, if the Health FSA paid $25,000 out in reimbursements during the year, and of that $25,000, $20,000 was paid to highly compensated individuals, a highly compensated individual who was reimbursed $2,500 would be taxed on $2,000.

$20,000/$25,000 = .8 x $2500 = $2000

Are there any measures I can take to ensure my Health FSA Plan passes the eligibility test?

If you are concerned with passing the Eligibility Test, there are some strategies you may be able to use to pass. First, you should determine whether the eligibility policy for participation should be revised to include more eligible individuals or exclude individuals (such as part-time employees).

Second, you should ensure your employees understand the various tax benefits of a Health FSA and provide education on those benefits to encourage more individuals to participate. You may also want to consider adopting a carryover provision per the IRS regulations if you do not already have one.

Third, you could increase participation by providing all eligible employees with a “seed” contribution. This requires the employer to place an employer contribution in each eligible employee’s account. This contribution likely needs to be more than nominal in order for all the employees receiving the contribution to be considered participants. There is no definition of “nominal” but $100 or more would seem to qualify.

Finally, if these strategies do not work you may want to consider limiting the participation of highly compensated individuals. You need to ensure your plan document for the Health FSA allows you to limit the participation of individuals within the highly compensated group.

A plan must not be discriminatory on the last day of the plan year. Thus, if you test your plan mid-year you may be able to fix the problem mid-year to avoid the plan from being considered discriminatory. However, any fixes need to be implemented before the end of the plan year. If you wait until late in the plan year to test your plan it may be too late to correct the discrimination and your highly compensated individuals would need to be taxed on their excess contributions.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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