Many arrangements exist in the Internal Revenue Code (IRC) that allow plans to take advantage of favorable tax treatment.
In offering these favorable arrangements, The Internal Revenue Service (IRS) imposes rules to prevent plans from being designed in such a way that they discriminate in favor of individuals who are highly compensated employees (HCE) or are otherwise key employees in the organization.
Throughout my 13 years in the industry, I have found that many human resource and benefit professionals are not clear on the rules or how the plans are tested. This article provides general summary on this topic.
Each IRC Code Section below has its own testing and number of tests that must be performed before issuing a pass or fail. Failures are more common with regards to the Section 125, 105 and 129, which is what this article will expand upon.
|IRS Section||What||Testing||Safe Harbors||Fail|
|Section 105||Self-funded plans, i.e., HRA or HealthCare FSA||Eligibility test and Benefits test||Yes; if more than 70% of non-excludable employees participate in the plan, you pass OR if more than 70% of eligible employees are non-excludable, and more than 80% of those eligible participate in the plan, you pass||Automatic failure if plan eligibility is NOT based on: job category, exempt status, geographic location or similar business criteria
Fails if there is a higher participation rate among HCIs than among non-HCIs.
|Section 125||Cafeteria Plan aka Premium Only Plan aka the tool that allows an employer to take pre-tax deductions from employees for their cost of premiums||Contributions & Benefit test, 25% Key employee test, & Eligibility test||100% employer-paid components are not included under the regulations.||Automatic failure if the waiting period is shorter for HCIs compared to non-HCIs or if better plans are offered to Executives (HCIs) vs. Non-Executives (non-HCIs)|
|Section 129||Dependent Care FSA||Many tests: Once excluded employees are removed for testing purposes, If average non-HCE election is 55% or less of average HCE election, plan will fail||Avoid failure by prohibiting HCEs from electing, limit HCEs elections below calculated amount (cannot increase elections mid-year if results are better than anticipated), monitor beginning, middle and end of plan year||If average non-HCE election is 55% or less of average HCE election (excluding non-HCEs earning < $25K), plan will fail|
Other IRC Sections of Note that are Subject to Non-Discrimination Rules:
Section 127 – Educational Assistance
Section 137 – Adoption Assistance
Section 79 – Group Term Life
Section 223 – HSA Comparable Contributions Test
Section 117 – Qualified Tuition Reductions
Section 132 – Commuter Benefits
If your company has not tested before, you’re not alone. I encourage all employers to research and be aware of the potential penalties.
In the years since the Affordable Care Act (ACA) became the law of the land, I’ve noticed a common misconception among my peers and those working in HR or concerned with such matters.
Here’s the best way to sum it up:
Myth: My company can pay 90 percent for executives and only 75 percent for non-executives with regards to premium for their group health plan. We allow pre-tax contributions to pay for the coverage. That’s still okay until the ACA rules are finalized, right?
Truth: Section 125 Non-Discrimination regulations prohibit this. If your company has a Section 125 plan, and it is favoring the highly comped, your plan is out of compliance and subject to penalty.
The ACA included a provision (Section 2716) that would subject Section 105(h) non-discrimination testing rules to non-grandfathered, fully insured plans, and that provision has since been delayed until further guidance from the IRS. This set our benefits world afire because many companies were (and still are) classing out executives to receive better benefits for less cost out of their paycheck.
If an employer does not have a Section 125 plan, the non-discrimination rules would not apply as the regulations are still pending. However, the majority of employers have a Section 125, so non-discrimination testing rules already exist.
Section 125 already had non-discrimination regulations, why did the ACA propose Section 105(h) regulations for these plans as well?
Some fully-insured plans do not have a Section 125; therefore, non-discrimination rules would be introduced for the first time through the pending 105(h) regulations. In addition, the 105(h) non-discrimination regulations make it difficult to circumvent the rules unlike the Section 125 regulations.
The simple way to circumvent Section 125 issues is to remove any employee contributions or take those contributions on a post-tax basis. This removes the employee(s) from the testing since they do not participate in the Section 125 plan.
The reason this should be important for your company is three-fold:
- In the event of an IRS audit, the auditor will likely request a copy of the test and results. This is usually done as part of the payroll audit and non-compliance will result in penalties.
- IRS has issued proposed regulations requiring annual testing for the Section 125 and 105. This is still in the proposed status so not required yet, but testing once a year for now is best practice to avoid penalties in the event of an audit.
- Failing the test makes for very unhappy key employees because the highly comped must have the cost of the benefits imputed (back taxes and interest on money owed) to correct the failure.