Gavel on book If establishedunder objective business criteria, bona-fide employment-basedclassifications that do not discriminate in favor of "theprohibited group" may be a reasonable classification ofemployees.

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Under federal law, employer provided benefits eligible for taxexclusions are subject to numerous nondiscrimination provisions.These provisions all are based on one important condition: ensuringexecutives, key employees or other highly paid individuals ("theprohibited group") are not treated more favorably than otheremployees.

When to perform testing

Nondiscrimination testing is a necessary function of providing acafeteria plan, and under the 2007 proposedregulations, Code Section 125 nondiscrimination tests are requiredto be performed annually, as of the last day of the plan year.

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Related: Half of world's largest companies fail pay equalitytest

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Although nondiscrimination testing is only required to be doneannually, it's recommended to also test before year-end, soadjustments may be made if needed to avoid adverse tax consequencesand bring the plans into compliance. Once the plan year is over,employers are not able to fix discrimination problems like what ispermissible under the rules for qualified retirement plans.

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Cafeteria plans, self-insured health plans (includes health FSAs& HRAs), and dependent care assistance programs (DCAPs) aresubject to nondiscrimination requirements under the InternalRevenue Code.

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The requirements to pass nondiscrimination testing is complex(e.g. a cafeteria plan with an FSA have 9 required tests) and thedefinition of "the prohibited group" is different for each benefit,however, they share three common elements:

  • Eligibility–confirm a sufficient number ofnon-prohibited group employees are eligible for the benefit
  • Availability–ensure a sufficient number ofnon-prohibited group employees are being offered the benefit on thesame terms as the prohibited group
  • Utilization–confirm enough non-prohibitedgroup employees are participating and the plan isn'tdisproportionately benefiting the prohibited group

Are classes offered different benefits & contributionspossible?

Employers do have the ability to provide different levels ofbenefits to classes of employees. Federal regulations state that "aplan or issuer may treat participants as two or more distinctgroups of similarly situated individuals if the distinction betweenor among the groups of participants is based on a bona-fideemployment-based classification consistent with the employer'susual business practices."

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In other words, if established under objective businesscriteria, bona-fide employment-based classifications that do notdiscriminate in favor of "the prohibited group," as determined bythe IRS, may be a reasonable classification of employees. Examplesinclude: job categories, geographic location, salaried vs. hourly,etc.

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Offering different plans based on bona-fide employmentclassifications complicates the cafeteria plan nondiscriminationtesting. However, in general, reasonable, bona fideemployment-based classifications should be respected upon audit, aslong as those classifications are nondiscriminatory (i.e. classesdo not discriminate in favor of "the prohibited group") asdetermined by the testing.

Common ownership

If the employer is related to another company or organization(based on the rules under Internal Revenue Code §§414(b), (c), (m),and (o)), some of the nondiscrimination tests require thatemployees at those related entities (even when not participating onthe plans) be included too. It's important for the plan sponsor(employer) to determine which employees to include in itsnondiscrimination testing to ensure accurate test results.

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Due to the complexity of the law in this area, consulting with aknowledgeable benefits attorney prior to offering differentbenefits or contributions to different groups of employees, isrecommended.

Why does it matter?

If a plan is found discriminatory (the results which are subjectto audit by the IRS), there may be adverse tax consequences for"the prohibited group." If you haven't considered running yournondiscrimination tests, now would be a good time to test andpossibly detect potential problems that may be resolved before theend of the plan year.

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Michelle Turner, MBA, is compliance managerfor Ardent Solutions, an Alera Groupcompany. 

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