Section 125 Nondiscrimination

Section 125 sets forth the nondiscrimination rules that apply to cafeteria plans. These rules determine whether salary reductions under the plan are taxable. Self-insured medical reimbursement plans that are offered under a cafeteria plan (which is generally the case) must also pass section 105(h) nondiscrimination testing, which determines whether reimbursements made under the plan are taxable.

Under Section 125, highly compensated employees, and key employees are not entitled to receive pre-tax benefits under a cafeteria plan if the plan discriminates in favor of those individuals with respect to benefits or eligibility to participate. If the plans are determined to be discriminatory, the value of the taxable benefit must be included in the gross income of what the regulation defines to be highly-compensated employees. This is referred to as cafeteria plan nondiscrimination testing under section 125 of the IRS code.

Plans Subject to Testing

Section 125 testing must be performed on self-insured benefit programs that are paid on a pre-tax basis as a component of the cafeteria plan. This test is often performed after these programs pass 105(h) testing. The exception is a Premium Only Plan (POP), which is not subject to section 105(h) testing and is covered under a special safe harbor for section 125 testing.

Plans Subject to Section 125 Testing:

• Premium Only Plan (POP) – safe harbor available
• Self-Insured Medical Plan
• Health Flexible Spending Account (FSA)
• Dependent Care Assistance Program (DCAP) FSA (information related to DCAP’s is not covered in Compliancedashboard).

Other benefits paid through a cafeteria plan that are typically subjection to section 125 testing (and not covered in Compliancedashboard – Health & Welfare) include Group Term Life, Adoption Assistance, VEBAs and 401(k) plans. In addition, under the Affordable Care Act (ACA), non-grandfathered, fully insured group health plans must undergo nondiscrimination testing for plan years beginning on or after September 23, 2010. However, the IRS announced that compliance will not be required until the government has issued regulations or other guidance on how the rules apply to insured plans.

Please note that a cafeteria plan will not be discriminatory if it is maintained pursuant to a collective bargaining agreement. If the plan covers both union and nonunion employees, then this exception would only apply to the section of the plan that covers union employees. In addition, simple cafeteria plans, as defined in the ACA, are also deemed to meet the cafeteria plan nondiscrimination rules.

Section 125 Nondiscrimination Tests

Employers must conduct three types of nondiscrimination tests every year.

1. Eligibility Test: Determines whether eligibility to participate in the plan favors highly compensated individuals (HCIs). It includes three requirements.

• Employment Requirement: the new-hire waiting period must apply to all employees and cannot be longer than three years;
• Entry Requirement: employees must be eligible immediately following the waiting period; and
• Nondiscrimination Requirement: the plan benefits employees who qualify under a reasonable classification established by the employer, and the classification of employees is nondiscriminatory.

Testing Group
Generally, all employees must be included in the testing group, with the exception of:

• employees (other than Keys) covered by a collectively bargained plan (if cafeteria plan benefits were the subject of bargaining);
• nonresident aliens with no U.S. source income from the employer; and
• employees participating in the cafeteria plan under a COBRA continuation provision.

In addition, employees who have not met the waiting period under the cafeteria plan may be excluded only if the plan restricts participation to employees who have completed three years of employment.

2. Contributions and Benefits Test: Determines whether contributions and benefits are available on a nondiscriminatory basis and whether highly compensated participants (HCPs) select more nontaxable benefits than non-HCPs. It includes three standards:

• Availability: similarly situated employees must be given the same opportunity to elect benefits;
• Utilization: tax-free benefits available to HCPs must compare favorably with the tax-free benefits of non-highly compensated employees; and
• Nondiscrimination: the plan must ensure it does not discriminate in practice.

Testing Group
Employees who are actually eligible to participate in the plan and make applicable salary reductions to pay for those benefits. Employees covered by a collectively bargained plan may be excluded.

3. Key Employee Concentration Test: This test determines whether key employees (Keys) receive too large a share of total benefits under the plan.

• Key employee benefits under the plan cannot be more than 25% better than all employees’ benefits under the plan.

Testing Group
Plan participants who have elected some qualified (nontaxable) benefit. Exclusions are the same as for the Eligibility Test above.

 Highly Compensated and Key Determination

When determining who is highly compensated and thus in the prohibited group, employers should note that there is a slight variation between Section 125 testing, which is described below, and section 105(h) testing and 401(k) plan testing rules.

Highly Compensated Individual (HCI)

An HCI for purposes of section 125 testing is defined as:

• an officer;
• a 5% shareholder;
• during preceding plan year (or the current plan year in the case of the first year of employment) had compensation from the employer such that he or she would be considered a highly compensated employee for purposes of a 401(k) plan (for example, $120,000 for 2017), and, if elected by the employer, was also in the top-paid group of employees consisting of the top 20% percent of the employees when ranked on the basis of compensation paid during such year (or for the current plan year in the case of the first year of employment); or
• the spouse or dependent of a person described above.

Highly Compensated Participant (HCP)

Employees who are HCIs and eligible to participate in the plan.

Key Employee (Key)

A person is a key employee if he or she is:

• an officer of the employer having an annual compensation greater than the dollar amount specified in the definition of key employee under the rules for 401(k) plans (for example, $175,000 for 2017);
• a 5% owner of the employer, or
• a 1% owner of the employer having an annual compensation from the employer of more than $150,000.

Common Ownership

Because individuals may be included in the testing group because of their relationship with the plan sponsor, common ownership of other companies through stock ownership, a partnership, etc. should be carefully reviewed to ensure accurate testing. For example, all employees of all corporations which are members of a controlled group should be treated as a single employer for nondiscrimination testing.

Timing

Under proposed cafeteria plan rules, plans must determine compliance as of the last day of each plan year. In practice, a plan may find it useful to test prior to the start of the plan year and periodically during the course of the year. This will permit the employer to make any needed adjustments in HCI and Key elections prior to the end of the plan year.

Corrections for a plan year cannot be made after the end of that plan year. With that in mind, the cafeteria plan document should be written to give the plan administrator the authority to change any employee’s salary reductions if it is necessary in order to comply with the nondiscrimination rules.

In addition, for plans subject to section 105(h) testing, section 125 tests are often performed after the plans pass 105(h) testing.

Plan Design

There are several plan design elements that should alert employers to the possibility that their cafeteria plans may not pass nondiscrimination testing. These include plans that:

• are not available to all employees;
• do not provide the same entry dates for all employees;
• provide different benefits to different groups of employees.

Simple Cafeteria Plans

Simple cafeteria plans are deemed to meet the cafeteria plan nondiscrimination rules (as well as those for Health FSAs).

In order to be considered a “simple cafeteria plan”, it must meet all of the following requirements:

• It must be maintained by an employer with an average of 100 or fewer employees in either of the two preceding years. There are aggregation rules for employers in a controlled group. There are special rules for new employers and employers that are growing beyond the 100 employee limit.
• All employees with at least 1000 hours of service in the preceding calendar year must be eligible to participate and elect any benefit offered.
• Employees who are not Keys or HCIs must receive employer contributions of at least 2% of the employee’s compensation for the plan year or the lesser of 6% of the employee’s compensation for the plan year or twice the employee’s salary reductions (even if the employee makes no contributions.)

The IRS has not issued regulations on simple cafeteria plans.