Section 125 and 105(h) Testing



Section 125 Testing

Because Section 125 Cafeteria plans have favorable tax benefits, they are subject to annual testing to confirm that non-highly compensated participants and non-key employees are not discriminated against in favor of highly-compensated or key employees with respect to benefits or eligibility to participate.  See the reference materials for additional information.

The Cafeteria plan is subject to Section 125 Testing. If the Cafeteria Plan includes a Health FSA plan, the Health FSA is  also subject to Section 105(h) annual testing.  

Section 125 testing applies to:

Employers must conduct three types of non-discrimination tests every year:

1. Eligibility Test:  each plan must meet three requirements.

      1. Employment Requirement:  the new-hire waiting period must apply to all employees and cannot be longer than three years;
      2. Entry Requirement:  employees must be eligible immediately following the waiting period; and
      3. Non-discrimination Requirement:  the plan must ensure it does not discriminate in determining who benefits from the plan.

Safe Harbor test: an employer can pass the eligibility test automatically if all employees are eligible to participate in the plan, all employees have the same waiting period and the waiting period is less than 3 years.

2.  Contributions and Benefits Test:  each plan must meet three standards

      1. availability:  similarly situated employees must be given the same opportunity to elect benefits;
      2. utilization:  tax-free benefits available to highly compensated employees need to compare favorably with the tax-free benefits of the non-highly compensated employees;
      3. non-discrimination:  the plan must ensure it does not discriminate in practice.

3. Key Employee Concentration test:  Key employee benefits under the plan cannot be more than 25% better than all employees’ benefits under the plan.

Failure to meet the Section 125 nondiscrimination requirements will reduce or eliminate the tax-free status of the benefits provided to highly compensated and/or key employees.

Section 105(h) Testing

Section 105(h) of the Internal Revenue Code generally excludes from gross income amounts paid through employer-sponsored health coverage. This exclusion may not apply to benefits provided to highly compensated individuals (“HCIs”) under a self-insured plan if the plan discriminates in favor of these individuals in terms of benefits or eligibility (as defined in Section 105(h).

In addition, the ACA has made fully-insured plans subject to rules “similar” to those that apply to self-insured plans.  However, the Treasury Department announced a delay in the enforcement of the nondiscrimination rules against fully-insured (non-grandfathered) group health plans until it issues further guidance. See the ACA: Nondiscrimination Rules reference material for more information.

Section 105(h) testing applies to the following health plans:

Note: employers should also review severance plans under which a highly compensated individual is offered health coverage (often in the form of a COBRA subsidy) on a more favorable basis than for active employees, e.g, in terms of a subsidized COBRA payment or in the duration of coverage.

A plan must satisfy Section 105(h) tests “for a plan year,” which is interpreted to require the plan to pass on each day of the year.  Employers who believe their plan is in danger of passing must monitor their plan design and participation throughout the year so adjustments may be made to ensure that the tests are passed.  This is especially important if significant changes to workforce occur, such as after a merger or acquisition.

Employers must conduct two tests:

1. Eligibility Test:  A plan will pass if it meets any one of three alternative tests:

      1. 70% Test: Must demonstrate that the plan benefits 70% or more of all nonexcludable employees
      2. 70%/80% Test: Must demonstrate that 70% of all nonexcludable employees are eligible to benefit and 80% of those eligible actually do benefit under the plan. In this context, to “benefit” means to actually participate in the plan.
      3. Nondiscriminatory Classification Test: The plan benefits a nondiscriminatory group (classification) of employees. This requires:
        1. bona fide business classifications for any exclusions (a subjective component), and
        2. a sufficient ratio of benefiting non-HCIs to benefiting HCIs (an “objective”component)

2. Benefits Test:  A plan will pass the benefits test if:

      1. All benefits provided to highly compensated participants under the plan are provided to all other participants. Must be the same type and amount of benefit; and
      2. The plan does not discriminate in actual operation. This tests the benefits available to employees, not actual utilization of those benefits.
If a Section 105(h) plan is determined to be discriminatory in favor of highly compensated individuals, the affected HCIs must include some or all of the value of the benefits received in their taxable income.  This imputed income is subject to federal income taxes (but not to Social Security or Medicare taxes), and potentially to state taxes as well.