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Cafeteria plans, often referred to as "125 Plans" or "Flexible Benefit Plans," offer employers a tax-advantaged way to provide benefits to their employees. These plans allow employees to use pre-tax dollars for various benefits, including medical and dental premiums, as well as flexible spending account (FSA) plan benefits. To maintain compliance with the IRS, cafeteria plans must adhere to specific guidelines, including the requirement of that they are not discriminatory, which is evaluated through nondiscrimination testing.
The Purpose of Nondiscrimination Testing
Nondiscrimination testing, specifically Section 125 nondiscrimination testing, serves the vital role of ensuring that cafeteria plans treat all employees fairly. This means preventing any form of favoritism towards highly compensated employees (HCEs) over non-highly compensated employees (NHCEs) when it comes to accessing and benefiting from tax-advantaged benefits offered by the cafeteria plan.
Compliance with Section 125 Nondiscrimination Rules
Employers must conduct various tests and calculations to demonstrate that benefits offered under the cafeteria plan are accessible to all eligible employees on a nondiscriminatory basis. These tests evaluate factors such as plan participation rates, contributions, and benefits received by HCEs compared to NHCEs.
Who Must Test
All employers that allow employees to use pre-tax dollars through cafeteria plans must perform nondiscrimination testing. This includes government plans, church plans, and other plans, even if they are not subject to the Employee Retirement Income Security Act (ERISA).
Consequences of Failure
Failure to comply with nondiscrimination rules can have adverse tax consequences for both employers and participating employees. Potential consequences include plan disqualification, tax penalties, or adjustments to employee contributions to rectify any discrimination issues. Compliance is essential to maintain the tax advantages of cafeteria plans and promote fairness among employees.
Types of Cafeteria Plan Tests
Cafeteria plans undergo various tests, including those for the plan as a whole and specific tests for underlying benefits like FSAs. This article covers the general cafeteria plan testing and testing for FSAs.
Cafeteria Plan Nondiscrimination Testing:
Section 125 Cafeteria Plans allow employees to use pre-tax funds for qualified benefits under the plan. These plans are subject to three nondiscrimination tests:
- Eligibility Test: Assesses whether enough NHCEs are eligible to benefit from the plan. There are three sub-tests reviewing (1) any employment requirement limiting how long employees have to wait before being eligible to participate; (2) any entry date requirement limiting how long an employee who meets eligibility can be required to wait before participation begins; and (3) a two-part nondiscriminatory classification test requiring a bona fide business classification for those excluded from or eligible for the plan and a mathematical calculation comparing the ratio of eligible NHCEs to HCEs.
- Contribution and Benefits Test: Evaluates if contributions and benefits are provided on a nondiscriminatory basis and that HCEs do not disproportionately select more tax-free benefits than NHCEs.
- Key Employee Concentration Test: Ensures that benefits provided to key employees do not exceed 25% of total benefits provided to all employees under the plan.
Depending on the test results, employers may need to make adjustments to plan features, benefits, or contributions.
Flexible Spending Account (FSA) Nondiscrimination Testing:
FSA plans, including Dependent Care Flexible Spending Account (DCFSA) and Health Care Flexible Spending Account (HCFSA) plans, allow employees to put aside pre-tax funds to use to be reimbursed for eligible expenses. the opportunity to save pre-tax dollars and use those dollars to pay for eligible expenses. While these plans provide significant savings, it's crucial for employers to ensure they comply with nondiscrimination rules.
Dependent Care Flexible Spending Account (DCFSA) Nondiscrimination Tests:
A Dependent Day Care FSA enables an employee to set aside pre-tax funds to pay for qualified dependent day care expenses, including childcare or eldercare. To maintain fairness among all employees, DCFSA plans are subject to the following four nondiscrimination tests:
- Eligibility Test: Assesses whether the plan discriminates in terms of eligibility. The percentage of highly compensated employees (HCEs) participating in the DCFSA must not be substantially higher than the percentage of non-highly compensated employees (NHCEs) participating. This ensures that the plan doesn't unfairly favor HCEs.
- Contribution and Benefits Test: Focuses on contributions and benefits provided to participants. It requires that HCEs' contributions and benefits under the DCFSA do not disproportionately exceed those of NHCEs. If HCEs' contribution percentages exceed a certain threshold above NHCEs' percentages, the plan may be deemed discriminatory.
- More than 5% Owners Concentration Test: No more than 25% of the amount paid for the DCFSA during the year may be provided to more than 5% shareholders or owners, or their family members.
- 55% Average Benefits Test: The average DCFSA benefits provided to NHCEs must be at least 55% of the average benefits provided to HCEs. If highly compensated employees use the plan more than non-highly compensated employees use the plan, this test fails.
A highly compensated employee for DCFSA testing is a more than 5% owner of the company during the current or preceding year, or an individual with compensation during the preceding year over the IRS dollar limit. An employee who earns more than $150,000 in 2023 is a highly compensated employee for 2024. An employee who earned more than $133,000 in 2022 is a highly compensated employee in 2023.
To pass these tests, employers may need to adjust plan features, contribution limits, or communication strategies to encourage broader participation among NHCEs.
Health Care Flexible Spending Account (HCFSA) Nondiscrimination Tests:
Health Care Flexible Spending Account (HCFSA) plans allow employees to set aside pre-tax funds to pay for medical expenses not covered by insurance. To maintain equity in HCFSA plan benefits, the following two nondiscrimination tests apply:
- Eligibility Test: Ensures that HCEs are not disproportionately represented among plan participants. The goal is to prevent discrimination based on employee status. A HCFSA must benefit:
- 70% or more of all nonexcludable employees;
- 80% or more of all employees who are eligible to benefit if 70% or more of all nonexcludable employees are eligible to participate in the plan; or
- the employees qualifying under a classification that does not discriminate in favor of HCIs (nondiscriminatory classification test).
- Benefits Test: Assesses the benefits provided to HCEs versus NHCEs. The contribution percentages of HCEs should not exceed a specified threshold above those of NHCEs. This prevents a scenario where HCEs disproportionately benefit from the plan. This test consists of two requirements. The benefits must be nondiscriminatory on the face of the plan and in operation. This means the benefits provided to a highly compensated individual under the HCFSA must be provided to all other participants. Required contributions must be the same for all benefit levels, and the maximum benefit cannot be based on percentage of compensation, age or years of service.
Adhering to these tests requires employers to carefully monitor contributions and benefits for different employee groups and make adjustments if needed to maintain compliance.
For HCFSA testing purposes, a highly compensated individual is (a) one of the five highest-paid offers; (b) a more than 10% shareholder of the company; or (c) among the highest paid 25% of all employees (other than non-participant excludable employees).
Consequences of Test Failures:
If a 125 Plan, DCFSA or HCFSA plan fails to meet the nondiscrimination tests, there can be significant repercussions. The plan may lose its tax-favored status, leading to employees' contributions becoming taxable. Additionally, corrective actions must be taken swiftly to address the discrimination issue.
Strategies for Compliance:
Employers can take proactive measures to ensure their 125 Plan, DCFSA and HCFSA plans pass nondiscrimination tests:
- Effective Communication: Properly communicate the benefits of these plans to all employees, ensuring that HCEs and NHCEs alike understand the advantages.
- Limiting Contributions: Consider implementing contribution limits to prevent HCEs from disproportionately benefiting from the plan.
- Regular Monitoring: Regularly assess plan participation, contributions, and benefits across different employee groups to identify potential issues early.
- Frequent Testing: Employers may wish to test their FSAs several times during the plan year to ensure they are on track to pass nondiscrimination requirements.
Conclusion
Cafeteria plans, including DCFSA and HCFSA components, offer valuable tax savings to employees. Employers must conduct nondiscrimination testing to prevent discrimination and maintain compliance. By ensuring fairness in plan participation, employers can retain tax advantages and provide benefits equitably to employees across income levels.
BAS can perform nondiscrimination testing for your cafeteria plan and/or FSAs. To find out more, contact your account manager or email solutions@basusa.com.
Benefit Allocation Systems (BAS) provides best-in class, online solutions for: Employee Benefits Enrollment; COBRA; Flexible Spending Accounts (FSAs); Health Reimbursement Accounts (HRAs); Leave of Absence Premium Billing (LOA); Affordable Care Act Record Keeping, Compliance & IRS Reporting (ACA); Group Insurance Premium Billing; Property & Casualty Premium Billing; and Payroll Integration.
MyEnroll360 can Integrate with any insurance carrier for enrollment eligibility management (e.g., Blue Cross, Blue Shield, Aetna, United Health Care, Kaiser, CIGNA and many others), and integrate with any payroll system for enrollment deduction management (e.g., Workday, ADP, Paylocity, PayCor, UKG, and many others).
