Nondiscrimination testing: A high-level overview & reminder

Under federal law, employer provided benefits eligible for tax exclusions are subject to numerous nondiscrimination provisions. These provisions all are based on one important condition: ensuring executives, key employees or other highly paid individuals (“the prohibited group”) are not treated more favorably than other employees.

When to perform testing

Nondiscrimination testing is a necessary function of providing a cafeteria plan, and under the 2007 proposed regulations, Code Section 125 nondiscrimination tests are required to be performed annually, as of the last day of the plan year.

Related: Half of world’s largest companies fail pay equality test

Although nondiscrimination testing is only required to be done annually, it’s recommended to also test before year-end, so adjustments may be made if needed to avoid adverse tax consequences and bring the plans into compliance. Once the plan year is over, employers are not able to fix discrimination problems like what is permissible under the rules for qualified retirement plans.

Cafeteria plans, self-insured health plans (includes health FSAs & HRAs), and dependent care assistance programs (DCAPs) are subject to nondiscrimination requirements under the Internal Revenue Code.

The requirements to pass nondiscrimination testing is complex (e.g. a cafeteria plan with an FSA have 9 required tests) and the definition of “the prohibited group” is different for each benefit, however, they share three common elements:

• Eligibility–confirm a sufficient number of non-prohibited group employees are eligible for the benefit
• Availability–ensure a sufficient number of non-prohibited group employees are being offered the benefit on the same terms as the prohibited group
• Utilization–confirm enough non-prohibited group employees are participating and the plan isn’t disproportionately benefiting the prohibited group

Are classes offered different benefits & contributions possible?

Employers do have the ability to provide different levels of benefits to classes of employees. Federal regulations state that “a plan or issuer may treat participants as two or more distinct groups of similarly situated individuals if the distinction between or among the groups of participants is based on a bona-fide employment-based classification consistent with the employer’s usual business practices.”

In other words, if established under objective business criteria, bona-fide employment-based classifications that do not discriminate in favor of “the prohibited group,” as determined by the IRS, may be a reasonable classification of employees. Examples include: job categories, geographic location, salaried vs. hourly, etc.

Offering different plans based on bona-fide employment classifications complicates the cafeteria plan nondiscrimination testing. However, in general, reasonable, bona fide employment-based classifications should be respected upon audit, as long as those classifications are nondiscriminatory (i.e. classes do not discriminate in favor of “the prohibited group”) as determined by the testing.

Common ownership

If the employer is related to another company or organization (based on the rules under Internal Revenue Code §§414(b), (c), (m), and (o)), some of the nondiscrimination tests require that employees at those related entities (even when not participating on the plans) be included too. It’s important for the plan sponsor (employer) to determine which employees to include in its nondiscrimination testing to ensure accurate test results.

Due to the complexity of the law in this area, consulting with a knowledgeable benefits attorney prior to offering different benefits or contributions to different groups of employees, is recommended.

Why does it matter?

If a plan is found discriminatory (the results which are subject to audit by the IRS), there may be adverse tax consequences for “the prohibited group.” If you haven’t considered running your nondiscrimination tests, now would be a good time to test and possibly detect potential problems that may be resolved before the end of the plan year.

Michelle Turner, MBA, is compliance manager for Ardent Solutions, an Alera Group company.