How to Avoid Benefits Discrimination Penalties

Many types of health plans are required to pass tests insuring that they don't discriminate in favor of highly paid employees. Here's what you need to know.

Most corporate executives know that cafeteria plans, self-insured health plans and dependent care assistance programs (DCAPs) are subject to nondiscrimination requirements under the Internal Revenue Code. But executives are not necessarily up to speed on the details of the requirements or the consequences of noncompliance.

The requirements are generally intended to prevent the plans from discriminating in favor of highly paid and key employees. If a plan fails to comply with these requirements, those employees may have adverse tax consequences. For example, if a cafeteria plan is discriminatory, the employees may have to pay taxes on their salary reductions that pay for the plan.

A picture of the author, Susan Monkmeyer

Susan Monkmeyer

The Affordable Care Act also establishes nondiscrimination requirements for fully insured (funded through insurance) health plans. Failure to comply with these requirements (which are expected to be similar to the requirements for self-insured health plans described below) may result in excise taxes, civil money penalties or a civil action to compel the employer to provide nondiscriminatory benefits. However, compliance is not required until after the government has issued regulations or other guidance on the new requirements. And there is no official word on the timing for the guidance. See IRS Notice 2011-1 for more information.

Below are the rules currently in place for cafeteria plans, self-insured health plans and DCAPs.

There are three nondiscrimination tests for cafeteria plans:

Eligibility test — a cafeteria plan can’t discriminate in favor of highly paid employees as to eligibility to participate.

Contributions and benefits test — a cafeteria plan can’t discriminate in favor of highly paid employees as to contributions and benefits.

Key employee concentration test — nontaxable benefits provided to key employees under a cafeteria plan can’t exceed 25% of the nontaxable benefits provided for all employees under the plan.

If a self-insured health plan is added, two more tests will apply:

Eligibility test — a self-insured health plan may not discriminate in favor of highly paid employees as to eligibility to participate.

Benefits test — the benefits provided to highly paid employees under a self-insured health plan must be provided for all other participants.

The two self-insured health plan tests apply to self-insured major medical, dental and vision plans, as well as health flexible spending arrangements (FSAs) and health reimbursement arrangements (HRAs).

If a DCAP is added, there will be four additional tests:

Eligibility test — a DCAP must benefit employees who qualify under a classification that does not discriminate in favor of highly paid employees or their dependents.

Contributions and benefits test — contributions and benefits provided under a DCAP must not favor highly paid employees or their dependents.

More-than-5-percent owners concentration test — no more than 25 percent of the amount paid for dependent care assistance during the year may be provided to more-than-5-percent shareholders or owners, or their spouses or dependents.

55 percent  average benefits test  — the average DCAP benefits provided to non-highly paid employees must be at least 55 percent of the average benefits provided to the highly paid employees.

Although the nine tests are varied and complicated, they boil down to three common themes: eligibility, availability and utilization. Imagine that you are planning a party, with the benefits under your company’s plan being the appetizers. The nondiscrimination tests essentially ask, “Have enough non-highly paid employees been invited to the party?” (eligibility), “Are enough non-highly paid employees being offered the appetizers?” (availability), and “Are enough non-highly paid employees actually eating the appetizers?” (utilization).

The prohibited group (those in whose favor discrimination is prohibited) is defined differently for purposes of the various nondiscrimination tests that apply to each plan, so the individuals who are actually considered highly paid or key may vary from one plan or test to the next.

Employers should monitor compliance with testing criteria during the plan year. This is because, unlike under the rules for qualified plans, employers cannot fix discrimination problems after year-end. Furthermore, the group of employees included in the testing can change during the year, so the final results cannot be known until year-end.

Susan Monkmeyer, J.D., is a senior editor of EBIA products at Thomson Reuters. She has more than 20 years of experience in the field of employee benefits law. She has also taught employee benefits at William Mitchell College of Law.

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