The Internal Revenue Service (IRS) requires certain health and welfare plans to undergo annual non-discrimination testing to ensure that plans do not discriminate in favor of highly compensated or certain key employees. The non-discrimination test that must be performed depends on the type of plan and how the plan is structured.
Compliance Snapshot:
- Employers must perform non-discrimination tests on certain health and welfare benefit plans annually;
- Employers should reach out to their non-discrimination testing vendors to perform testing before the end of their plan year;
- If a plan fails non-discrimination testing, employers should ensure all testing options have been exhausted and may need to include the benefits provided to the plan’s highly compensated or key employees in their gross income.
Which plans must be tested?
Plans that must be tested include:
- section 125 cafeteria plans (all pre-tax benefits);
- self-insured health plans;
- flexible spending accounts (FSA);
- dependent care FSAs;
- group term life insurance;
- self-insured health reimbursement arrangements (HRA); and
- health savings accounts (HSA).
There are 9 different types of nondiscrimination tests; which ones apply to an employer’s plans will depend on the structure of the arrangement and which benefits are available.
What do the tests involve?
The various component benefit plans must pass a series of tests. Some of the tests involve eligibility, which looks at who can participate; benefits and contributions (which considers what benefits are being offered); and utilization, which contemplates who uses the benefits and to what extent.
When should nondiscrimination testing be completed?
IRS regulations require nondiscrimination testing to be performed by the last day of the health and welfare plan year. It is recommended that employers conduct a pre-test mid plan year to determine if there are any corrective steps that should be taken, especially when an employer offers different benefits to different employee classes. If a discrimination issue is discovered during the plan year, the employer can adjust the plan to ensure that the plans pass the testing at the end of the year. It is recommended that employers actively contact their non-discrimination testing vendor to determine the testing timeline for the year.
What are the consequences of failing the tests?
Failing non-discrimination testing has negative consequences for the highly compensated and key employees receiving the discriminatory benefits. These employees may lose their ability to receive benefits on a pre-tax basis. Non-highly compensated employees will not be affected. If the discrimination problem is discovered after the plan year has ended, employee salary reductions cannot be re-categorized as post-tax contributions and applicable highly compensated or key employees should be taxed accordingly.
The plan will not cease to be a qualified plan if it fails testing, however employers may be subject to additional taxes that were underpaid, as well as any accompanying interest and penalties. The employer would also be responsible for amending any employee W-2s.
Employer Action Items:
- Have non-discrimination testing conducted before the end of the plan year. Employers should reach out to their respective vendors to set up nondiscrimination testing. Employers should perform testing a few months prior to the end of their plan year to allow for enough time to make any needed plan changes before the end of the plan year. Most employers tend to begin working on testing in October or November for a calendar year plan.
- Review the results. If a plan fails NDT, employers may have time change participant elections or plan design to ensure plans are nondiscriminatory. Employers should also check in with their testing vendor to ensure all testing strategies have been utilized before making plan changes or taxing benefits.
The information and materials on this blog are provided for informational purposes only and are not intended to constitute legal or tax advice. Information provided in this blog may not reflect the most current legal developments and may vary by jurisdiction. The content on this blog is for general informational purposes only and does not apply to any particular facts or circumstances. The use of this blog does not in any way establish an attorney-client relationship, nor should any such relationship be implied, and the contents do not constitute legal or tax advice. If you require legal or tax advice, please consult with a licensed attorney or tax professional in your jurisdiction. The contributing authors expressly disclaim all liability to any persons or entities with respect to any action or inaction based on the contents of this blog.
