Nondiscrimination Testing – The Basics

Individuals enjoy a favorable tax advantage when their benefits are part of a cafeteria plan. As a result, nondiscrimination testing rules were created by the IRS to prevent plans from discriminating in favor of individuals who are either highly compensated or otherwise key to the business (referred to as a "Prohibited Group"). Testing shows whether tax-advantaged plans are discriminating in favor of highly compensated employees or key employees. All employers that provide a cafeteria plan must complete this testing by the last day of the plan year. 

Each type of benefit under the cafeteria plan is subject to its own applicable nondiscrimination testing rules as well as the general nondiscrimination rules under a cafeteria plan. Rules for the cafeteria plan, flexible spending accounts (FSA), and dependent care assistance programs (DCAP) testing are found under IRS Code Sections 125, 105(h) and 129, respectively. When an FSA or a DCAP is offered through a cafeteria plan, they are subject to the Section 125 cafeteria plan testing provisions, as well as their respective sections. These code sections lay the foundation for nondiscrimination testing rules and define terms that are used in performing such testing. 

The members of a Prohibited Group can be different depending on the benefit being tested. They can be Highly Compensated Employees (HCE), Key Employees, and 5% owners in the business.

Nondiscrimination tests are performed on a plan and benefit basis. The testing covers three basic themes – eligibility, benefits, and utilization – all of which are involved in protecting employees that are not in the Prohibited Group:

  • The eligibility test looks at whether there are enough non HCEs that are eligible to participate. A good way to visualize this is a party where the benefit test question is, “Have enough non HCEs been invited to the party?”
  • The benefits test looks at whether there are enough non-HCEs offered the majority of benefits. This can be visualized as appetizers with the question, “Who's being offered appetizers at the party?”
  • The utilization test assesses how many non-Key Employees are participating. This can be visualized with the question, “Who's actually taking the appetizers?”

When a plan fails nondiscrimination testing, employers may think they must cancel the plan and no one can participate but this is not true.  Plans can do testing at different times of the year to help avoid failing the test. If the test is performed at the beginning of the year, problems can be discovered and resolved. At midyear, the employer can account for new hires, election changes, and terminations. Participants in the non-Prohibited Group may continue their election and participation, even if the plan fails nondiscrimination testing.

If a plan is found to be discriminatory before the end of the plan year, the employer can make corrections starting with FSA contributions, then DCAP contributions, followed by HSA contributions, and finally looking at premiums. Adjusting contributions does not mean that the individual cannot participate on an after-tax basis, but they may not be able to contribute all of their FSA, HSA or premiums on a pre-tax basis. Alternatively, if a plan is found to be discriminatory and corrections were not made by the end of the plan year, the entire Prohibited Group will lose their ability to make pre-tax contributions for the plan year, and the contributions made would become taxable compensation. 

Our team is here to support you in staying compliant with cafeteria plan nondiscrimination testing. As a reminder, employers that decide to perform their own testing will need to indicate that at the start of the plan year. As always, we recommend that all parties consult with an advisor and carefully review their situation.