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Health care flexible spending account plans (HFSA) and dependent day care flexible spending account plans (DFSA) must not discriminate in favor of highly paid or key employees. Plans may be subject to adverse tax consequences if they fail IRS nondiscrimination requirements.
The nondiscrimination testing rules for flexible spending account plans in the Internal Revenue Code are complex. The rules test three plan components: eligibility, availability, and utilization.
Eligibility: The plan’s eligibility requirements must include a sufficient number of non-highly compensated employees.
Availability: The plan must be available to enough non-highly compensated employees.
Utilization: Enough non-highly compensated employees must actually participate in the plan.
Employers are supposed to test their flexible spending account plans under IRS rules 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.
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. An employee who earns more than $135,000 in 2022 is a highly compensated employee for 2023. An employee who earned more than $130,000 in 2021 is a highly compensated employee in 2022.
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 “reasonable classification.”
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
If a flexible spending account plan fails nondiscrimination testing, the benefits provided to highly compensated and key employees will lose their pre-tax treatment and contributions must be recognized in taxable income.
Employers may wish to review their FSAs several times during the plan year to see if they are on track to pass nondiscrimination testing. Reviewing the plan throughout the year may provide 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.
Employers with flexible spending account plans should be aware of nondiscrimination testing requirements.
