Nondiscrimination testing: Simplifying the core concepts

Nondiscrimination testing is a crucial part of sponsoring employee benefits as required by the IRS. In a world of constantly changing rules and regulations, it is crucial that employers remain up to date on how these tests impact their benefits. Nondiscrimination tests work to satisfy the Golden Rule, which dictates that highly compensated employees cannot receive a higher benefit than other employees.

Basics of Nondiscrimination Testing
There are three major tests you should have an understanding of as a plan sponsor Cafeteria Plan testsDCAP FSA tests and Health FSA tests. All the three categories include eligibility tests, which is where we see the Golden Rule at play.

Timeline for When to Conduct Tests

Testing must be done every year, however, there is no formal guidance by the IRS for when to test. In order to ensure you have a complete picture of utilization, Sentinel often recommends plan sponsors conduct testing as close to the end of the plan year as possible. Completing testing close to the end of the year helps avoid further complications. If you are concerned about your plan being in danger of failing at the end of the plan year, you could try conducting testing mid-year instead. The results of this rest would allow you to predict, based on enrollments, where your plan may stand come year end.

Testing Preparation

You will be asked to conduct a census of your population prior to testing. This census must include everyone who was an employee during the year of testing, even if they have since been terminated. The only exclusions apply to those who are included in collective bargaining, nonresident aliens with no U.S. source of income, and COBRA individuals who were terminated prior to the start of the plan year being tested.

Consequences of Failing a Test

When conducting nondiscrimination testing, there is a possibility that your plan will fail. If a problem is discovered before or during the plan year, changes are still permissible to be made. However, after the plan year ends, you are no longer allowed to make any changes. In the case of a failed test, there are certain remedies that can attempt to solve the problem. The general rule is to make assumptions about where you think the plan will end up at year end and scale back the elections made by the group of highly compensated individuals (HCIs). By cutting back elections to the HCI group, the goal is to have the plan pass by end of year.

Three Major Nondiscrimination Tests

  1. Cafeteria Plan Tests
    If your organization sponsors a Section 125 or Cafeteria Plan, you will be required to run the following three tests.

    1- Eligibility Test
    The purpose of the eligibility test is to ensure enough non HCIs are benefiting from the plan. You must successfully meet three different requirements in order to pass.

    The employer requirement states that no employee should be required to wait more than three years before being eligible to participate in your plan, and the requirement must be the same for all employees.

    The entry requirement states that entry into the plan must be no longer than the first day of the first plan year beginning after the employer requirement is met. You must remain within these time frames to be compliant.

    The nondiscriminatory classification test measures the number of HCIs who are allowed to benefit from the plan vs the number of non HCIs who are allowed to benefit.

    2- Key Employee Concentration Test
    This is a utilization test used to determine if key employees are receiving too much benefit from the plan. The test in operation states that key employees may only account for 25% or less of all benefits paid through the cafeteria plan.

    3- Contributions and Benefits Test
    This utilization test compares the benefits in the plan as a percentage of population to determine whether the percentage of benefits compared to compensation for HCIs is proportionate to that of the non HCIs. The test measures whether your high earners are receiving more benefit than others in your organization.

  2. Health FSA Tests Health
    FSA tests are generally less rigorous than the Cafeteria Plan tests.

    1- Eligibility Test
    There is an eligibility test component, however, you only need to pass one of the three tests. As long as your eligibility for Health FSA is aligned with your eligibility for the Cafeteria Plan, you will subsequently pass the following tests.

    2- Benefits Test
    This test ensures the plan is inherently fair on paper and in practice. The goal is to ensure all aspects of your Health FSA are the same for all employees. Different waiting periods for different people could be a trigger for failing the test. As long as the provisions are the same across the board, you will pass this test.

  3. Dependent Care FSA Tests
    There are four distinct tests for a Dependent Care FSA.

    1- Eligibility Test
    This remains in line with the eligibility tests for Cafeteria Plans and a Health FSA. Are you allowing enough individuals to participate by allowing them to be eligible in the plan? If you met this test in the Cafeteria Plan, you will pass here as well.

    2- Contributions and Benefits Test
    This is a plan design benefits test – not a utilization test. The test seeks to ensure the benefits you are offering are the same for all employees. As long as the contribution maximum and waiting period are the same, the plan will pass the test as a result.

    3- More-Than-5% Owners Test
    This is a unique test that is not normally seen in Cafeteria Plan or Health FSA testing. There are many situations where more-than-5% owners cannot participate in Cafeteria Plan or FSA benefits, dependent on the owners, organization or taxation rules. However, in some situations they are allowed to participate in these plans.

    The rule of this test is that those more-than-5% owners, if participating, cannot make up more than 25% of the DCAP benefits. As long as there are enough contributions from other employees, the plan will pass this test.

    4- 55% Average Benefits Test
    This is the test most often failed, as it can be challenging to pass regardless of the number of participants. This test was designed to ensure enough non-HCIs are benefiting from DCAP.

    The 55% Average Benefits Test is a utilization test that measures the average contribution to dependent care across HCIs and non-HCIs. If the average DCAP benefit for the non-HCI group is at least 55% of the average DCAP benefit for the HCI group, then the plan will pass the test.

    You are not just looking at who enrolls in dependent care – you are looking at the entire organization, regardless of how much of your population is using the plan.

    All individuals are included in the calculation for this tests, excluding those who are included in collective bargaining, nonresident aliens with no U.S. source of income, and COBRA individuals who were terminated prior to the start of the plan year being tested. There is another special exclusion unique to this test, and that is anyone who earns less than $25,000 in the testing year. This helps the average contribution go up for the non-HCIs.

    If you know there may be complications with your organization and this test, try to get ahead of the curve with projections or midyear testing before the problem is harder to manage at year end.

For more details on nondiscrimination testing, visit
Scott Riordan, Head of Health & Welfare, [email protected]

Cat Torres, Health & Welfare Consultant, [email protected]

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