Many employer-sponsored benefit arrangements are subject to nondiscrimination testing (NDT), which is designed to ensure plans do not disproportionately favor highly compensated employees. Common arrangements subject to testing include:

• Section 125 plans (also known as cafeteria plans), which allow pre-tax payroll deductions towards benefits including:
  • Insurance premiums (for employees and/or dependents)
  • Flexible Spending Accounts (FSAs)
  • Health Savings Accounts (HSAs)
• HSA employer contributions
• Health Reimbursement Arrangements (HRAs)
• Self-insured and level-funded medical and Rx plans
• Retirement plans

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What You Need to Do

1. Review your current benefit offerings to identify any plans or arrangements that may be subject to nondiscrimination testing.
2. Confirm who is performing the testing (e.g. payroll provider, tax advisor, FSA/HSA/HRA plan vendor, or third-party vendor).
3. Ensure applicable plans remain compliant with nondiscrimination requirements throughout the year. As a best practice, complete nondiscrimination testing at least annually, and retain documentation of testing results. A conservative approach would include:
   1. Pre-year test (before new plan year elections become effective)
   2. Mid-year test to identify developing issues
   3. Final year-end test using actual plan-year data
4. Address any failed tests or compliance issues promptly, as corrective action may be needed before year-end or before tax reporting is finalized.
5. Let us know if you’ve failed the test so we can evaluate your plan arrangements.

Note: Certain exceptions and safe harbors apply to some plan nondiscrimination tests. Because these tests are so complex, employers should work with their legal counsel or tax advisors when performing nondiscrimination testing.

Why You Need to do It

Nondiscrimination requirements are imposed under various federal tax laws, including the Internal Revenue Code. Failing to satisfy applicable nondiscrimination requirements can create tax and compliance issues for both the employer and certain employees, particularly owners and other highly compensated individuals. Depending on the plan type, failed testing may result in taxable benefits, corrective refunds, or contribution adjustments, loss of favorable tax treatment, or the need for amended reporting.

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Rules Vary by Benefit

There is no universal set of nondiscrimination rules; they vary for each type of benefit. Key concepts that are often involved with nondiscrimination testing include:

• Who is in the prohibited group? This is the group that a plan cannot discriminate in favor of. It generally consists of highly compensated or key employees, but the definitions for these categories vary by benefit.
• What eligibility classification standards apply? This usually refers to the percentage of the employee population that is eligible for or receives a benefit from the plan.
• Which employees can be excluded from the testing population? For the purpose of meeting nondiscrimination criteria, certain employees can be excluded from the employee population count—usually those that have not met age or service requirements or are collectively-bargained.
• What is the consequence of finding discrimination? When discrimination is found, generally the members of the prohibited group will not receive the tax favor for the benefit. Sometimes, though, all employees are penalized and the benefit will be included in everyone’s gross income.

The rest of this article discusses common types of benefits that must comply with nondiscrimination rules, and provides a link to the individual tax code provision for each type of benefit (found on the Cornell University Law School website, which contains a directory of all U.S. laws).

Section 125 / Cafeteria Plans

A cafeteria plan offers two or more benefit choices to employees of either cash (taxable income) or qualified benefits. Usually, according to the constructive receipt rule, a taxpayer receives income when it is made available and he or she is eligible to receive it, not necessarily when the employee actually receives it. However, under a cafeteria plan, the availability of cash or benefits does not equal the receipt of income for tax purposes. This exception is only valid for a particular benefit if that benefit plan does not discriminate in favor of HCIs as to eligibility to participate or benefits offered.

If a cafeteria plan discriminates in favor of HCIs or key employees, each member of the prohibited group will lose the cafeteria plan’s tax advantage. For details on these nondiscrimination requirements, see Code § 125 as well as our NDT Guide on Cafeteria Plans.

Dependent Care Assistance Programs

An employee can exclude up to $5,000 of dependent care benefits from their gross income (if single or married and filing a joint tax return), or up to $2,500 (if married but filing separate tax returns). The plan is considered nondiscriminatory if the program’s eligibility, contributions and benefits provided do not discriminate in favor of HCIs or certain shareholders or owners. If discrimination is found in a dependent care assistance program, these individuals must include dependent care benefits in their gross income.

For details on these nondiscrimination requirements, see Code § 129(d).

HSA Employer Contributions

The specific nondiscrimination rules that apply to an employer depend on whether HSA contributions are made through a Section 125 cafeteria plan. Employer contributions to employees’ HSAs are made through a cafeteria plan when the cafeteria plan allows eligible participants to make pre-tax salary deferrals to fund their HSAs.

• When HSA contributions are made through a cafeteria plan (most common), the employer’s contributions are subject to the nondiscrimination tests for Section 125 cafeteria plans.
• When HSA are not made through a cafeteria plan, the employer’s contributions are subject to the tax code’s comparability rules.

Self-funded Health Plans
Including level-funded plans and Health Reimbursement Arrangements (HRAs)

Self-funded health plans pass the Code § 105(h) nondiscrimination rules if the plan does not discriminate in favor of HCIs with respect to eligibility or benefits. If discrimination exists in favor of HCIs, the excess reimbursements received by those employees must be included in their gross income. For details on these nondiscrimination requirements, see Code § 105(h) as well as our NDT Guide to Self- & Level-Funded Plans & HRAs.

Retirement Plans

Consult your retirement plan advisor.

Group-term Life Insurance

Generally, employer-provided group-term life insurance is excludable from employees’ gross income, up to the face amount of $50,000. A group-term life insurance plan is nondiscriminatory if the plan does not discriminate in favor of key employees as to eligibility to participate and the type and amount of benefits.

If a group-term life insurance plan discriminates in favor of key employees, those employees are not eligible for the $50,000 exclusion and must include the entire coverage amount in their gross income. For details on these nondiscrimination requirements, see Code § 79(d).

Voluntary Employees’ Beneficiary Associations (VEBAs)

A VEBA that is part of an employer plan is tax-exempt if the classification of employees who are eligible for benefits, and the benefits offered, do not discriminate in favor of HCIs. However, benefits may represent a uniform percentage of employees’ compensation, if the rate is equal among all employees. For details on these nondiscrimination requirements, see Code § 505.

Educational Assistance Programs

Employees can exclude up to $5,250 per year from their taxable income for educational assistance received through a qualifying employer program. Effective for taxable years beginning after 2026, this amount will be adjusted for inflation. To be nondiscriminatory, the program must benefit employees who are eligible under an employer-determined classification that is not discriminatory in favor of HCIs. If an educational assistance program violates the nondiscrimination requirements, all participants lose favorable tax treatment for their educational assistance benefits. For details on these nondiscrimination requirements, see Code § 127.

This article is not intended to be exhaustive nor should any discussion or opinions be construed as professional, legal, or tax advice. Most content provided by Zywave, Inc. All rights reserved.

• Category: Compliance