Compliance Testing

Section 125 - POP and FSA Non-Discrimination Testing

If you have a Flexible Spending Account (FSA) or a Premium Only Plan (POP), the IRS requires you to submit to non-discrimination testing once a year.

The reason for nondiscrimination testing is to prevent highly compensated employees from taking advantage of the benefits that these plans provide for employers and employees alike. Such advantages, consist of an increase in take home pay because the dollars spent are pre-tax and a 7.65% savings annually on employers matching FICA tax.

Nondiscrimination testing is a big factor in way of compliance. If employers do not adequately follow all the steps necessary for nondiscrimination testing, or they fall out of compliance with federally mandated regulations while using these plans, all discriminatory benefits are included in the gross pay of highly compensated employees. This also means that employers can no longer take advantage of the 7.65% tax break on their annual employer matching FICA tax. In other words, if an employer fails to comply with IRS regulations and testing procedures, any and all benefits that were received from that employer's FSA or POP plan must be re-paid.

Overall, the greatest concern when filing nondiscrimination testing is that your company is in compliance with all regulations before you begin. As stated above, the initial reason for nondiscrimination testing is to avoid the abuse of these benefits by highly compensated employees.

Section 105(h) - Eligibility and Benefits Non-Discrimination Testing

Benefits under an employer-sponsored health plan generally are not taxable due to a special section of the Code which excludes the value of those benefits from taxation. However, in order to ensure that employers do not improperly discriminate in favor of highly compensated individuals ("HCIs"), Congress created nondiscrimination rules under Code Section 105(h).

Currently, Code Section 105(h) only applies to self-funded health plans. A plan is generally treated as self-funded even if the plan has stop-loss insurance. In addition, the Affordable Care Act ("ACA") provides that non-grandfathered, fully-insured health plans will also be subject to rules "similar" to Code Section 105(h).

The 105(h) Test is designed to verify two things. First, that "enough" non-HCIs "benefit" under the health plan, in comparison to the number of HCIs who "benefit." Second, to verify that the health plan's benefits (e.g., deductible levels and covered benefits) do not favor HCIs.

There are three typical definitions of who is an HCI. First, an "officer" of the employer will be an HCI – but only if the officer is one of the five highest-paid officers. Second, an individual who owns more than 10 percent of a corporation is generally an HCI. Finally, an individual who is among the highest-paid 25 percent of all employees (other than certain excluded employees who are not participants in the health plan), is generally an HCI.

There are two tests which both must be satisfied in order to pass the 105(h) Test.

First, the Eligibility Test focuses on whether enough non-HCIs "benefit" under the health plan. The term "benefit" in our testing means that the employee is actually eligible to enroll. The Eligibility Test includes:

  • 70 Percent Test - is satisfied if the plan benefits 70 percent or more of all employees.
  • 70 Percent / 80 Percent Test - the employer must first verify that 70 percent or more of all employees are "eligible" to benefit under the plan. If so, the plan must actually benefit 80 percent or more of all those eligible employees.
  • Nondiscriminatory Classification Test - is passed if, based on certain "facts and circumstances," the plan does not discriminate in favor of HCI eligibility.

Second, the Benefits Test is generally passed if the same benefits are provided to both HCIs and non-HCIs. The Benefits Test generally would be violated if an employer offered better eligibility terms for HCIs than non-HCIs (e.g., immediate eligibility versus 90-day waiting period). It also would be violated if benefits increase with years of service or compensation (e.g., if an HRA provided $100 in benefits for each year of employment).

Employers should periodically examine their plan structure and actual participation rates in order to verify that they pass the 105(h) Test. Failing to do so can cause HCIs to have some of their benefits become taxable. And, for fully-insured, non-grandfathered health plans, those plans could become subject to certain excise taxes if the test is failed.

Section 414(b) - Controlled Group Analysis

The Internal Revenue Code established its Controlled Groups Provisions as part of the Revenue Act of 1964. They were initially issued as part of a tax reform package intended to encourage small businesses, which operated in the corporate form. Over time some medium and large businesses began taking advantage of the lower tax rates afforded small businesses by organizing their structure into multiple corporate forms.

The Employee Retirement Income Security Act of 1974 (ERISA) added sections 414(b) and (c). These sections required that all employees of commonly controlled corporations, trades or businesses be treated as employees of a single corporation, trade or business. These Code provisions used the statutory definition of controlled groups found in section 1563(a) of the Code. Section 1563(a) provides mechanical ownership tests, which are used in determining if a controlled group situation exists.

Sections 414 (b) & (c) did not cover many of the arrangements devised by employers who attempted to avoid coverage of employees. Congress enacted section 414(m) pursuant to section 201 of the Miscellaneous Revenue Act of 1980.

IRC sections 414(b) & (c) were added to the Code because, in the words of the Senate Committee Report on ERISA: " The Committee, by this provision, intends to make it clear that the coverage and nondiscrimination provisions cannot be avoided by operating through separate corporations instead of separate branches of one corporation."

A plan that is maintained by an employer, within a group of employers that are under common control, must meet the requirements of IRC section 401(a) as if a single employer employed all employees of the group.