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Health care flexible spending account plans (HFSA) and dependent day care flexible spending account plans (DFSA) are subject to Internal Revenue Code nondiscrimination requirements. Under the Code, HFSAs and DFSAs must not discriminate in favor of highly paid and key employees. There may be adverse tax consequences for plans that fail nondiscrimination requirements.
The actual nondiscrimination testing rules are complex. They aim at evaluating three themes: eligibility, availability, and utilization. The plan’s eligibility requirements must include a sufficient number of non-highly compensated employees. The plan must be available to enough non-highly compensated employees. Enough non-highly compensated employees must actually participate in the plan.
Employers should test their plans and review compliance with nondiscrimination requirements throughout the plan year. Reviewing requirements during the year allows the plan to make adjustments to deferrals before the end of the year if corrections are needed to pass nondiscrimination testing.
Health Care FSA
A health care FSA must pass two tests: the eligibility test and the benefits test. Testing is required by section 105(h) of the Internal Revenue Code.
HFSAs cannot discriminate in favor of highly compensated individuals. For HFSA 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).
- Eligibility Test
A health care FSA cannot discriminate in favor of highly compensated individuals as to eligibility to participate. This means the plan 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
A health care FSA cannot discriminate in favor of highly compensated individuals as to benefits provided under 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 HFSA 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.
If a HFSA fails either the eligibility or benefits test, the favorable tax treatment for highly compensated individuals participating in the plan will be lost.
Dependent Day Care FSA
A dependent day care FSA must pass four nondiscrimination tests. These tests measure eligibility, availability and utilization. Testing is required by section 129 of the Internal Revenue Code.
A highly compensated employee for DFSA 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 ($120,000 for 2016 and 2017).
- Eligibility Test
Eligibility requirements for a DFSA must not discriminate in favor of highly compensated employees and must ensure that a minimum number of non-HCEs are eligible to participate in the plan. This is referred to as the “reasonable classification test.”
- Contributions and Benefits Test
Contributions and benefits that are available to eligible employees under the DFSA must not favor highly compensated employees or their dependents.
- More Than 5% Owners Concentration Test
No more than 25% of the amount paid for the DFSA during the year may be provided to more than 5% shareholders or owners, or their family members.
- 55% Average Benefits Test
The average DFSA benefits provided to non-highly compensated employees must be at least 55% of the average benefits provided to highly compensated employees. If highly compensated employees use the plan more than non-highly compensated employees use the plan, this test fails.
Testing Results
Employers may wish to test their FSAs several times during the plan year to make sure there is time to correct any excess contributions. Some employers choose to test before the beginning of the plan year, several months before the end of the plan year, after the plan year, and upon major business changes. Only testing after the plan year (as is customarily done in retirement plans), does not allow time to correct deferrals for highly compensated employees.
If an FSA does not pass nondiscrimination testing, then benefits provided to highly compensated individuals and key employees may not be excluded from income. In this case, deferrals and reimbursements may become taxable to highly compensated individuals and key employees
Benefit Allocation Systems offers nondiscrimination testing for flexible spending account plans. For more information about this service, contact your account manager or Solutions@BASusa.com.
