A plan can pass every other compliance check and still turn an executive’s benefit into taxable income.
Cafeteria plans and self-funded medical plans must not favor highly compensated or key employees. When a test fails, the plan keeps running but the favored group can lose the tax advantage, often without anyone noticing until year-end. We run the tests early enough to change the result.
Different plans, different tests, one consequence.
Each arrangement has its own tests and its own definition of who counts as favored. We match the test to the plan before we run anything.
Cafeteria Plans
Section 125 looks at who is eligible, who actually benefits and how much of the total pre-tax benefit goes to key employees. A fairly designed plan can still fail on participation, because rank-and-file employees choose not to use it.
Health FSAs
Health flexible spending accounts are tested on eligibility and benefits. An employer contribution only some employees can reach, or a design that favors salaried staff, is where a health FSA tends to slip, so we look at the design first.
Dependent Care Accounts
Dependent care assistance has its own tests, including one that compares the average benefit of non-highly compensated employees with that of highly compensated employees. The result turns on who uses the account, which the employer does not control.
Self-Funded Medical
Section 105(h) applies to self-insured medical reimbursement plans, including level-funded plans and HRAs. When eligibility or benefits favor highly compensated individuals, their excess reimbursements can become taxable, which is why executive-only medical arrangements need a close look.
Testing once at year-end only tells you what already went wrong.
The data that decides a test is the data at the end of the plan year, when there is little room to fix anything. So we test at the start of the year, again mid-year and a final time before the year closes.
Test Early
An early test uses projected elections, so its result is a warning rather than a verdict. It gives you time to adjust the design, or the elections of the favored group, while the plan year is still open.
Correct Going Forward
A common correction is reducing the pre-tax elections of highly compensated or key employees for the rest of the year. We check that the plan document permits it before anyone promises it, because an unauthorized fix creates a new problem.
Keep the Record
A passing test that is not on file is hard to prove in an audit. We keep each test, its data and its date with the plan records, and your CPA confirms the tax treatment wherever a test fails.
Most failed tests start as a data problem, not a design problem.
The tests depend on who is highly compensated, who is a key employee and who owns what. Get those wrong and a passing result means nothing.
Compensation Data
Prior-year compensation drives who counts as highly compensated. We take it from payroll records, not memory, because a single misclassified executive can change the outcome for a small group.
Ownership and Family
Ownership can be attributed between family members, so an owner’s spouse or child can count as a key employee without holding shares. We ask directly, since payroll systems do not track it.
Related Companies
Employers under common ownership may have to be tested together. When a controlled group question is open, we bring in the CPAs and attorneys available through us, since that determination is theirs to make.
What employers ask about testing.
Do fully insured employers need to test?
Yes, if they have a cafeteria plan. The Section 125 tests apply to pre-tax premiums and FSAs whether the medical plan is insured or self-funded; the self-funded medical test is the one that turns on funding.
What happens if we fail?
The plan keeps operating and rank-and-file employees keep their tax treatment. The favored group’s benefit can become taxable, and your CPA decides how that is reported, which is why we involve them early.
We are a small company. Does this really matter?
It matters more. A few owners and managers make up a larger share of a small group, so their elections move the result. That is the reason to test, not a reason to skip it.
Send us your renewal.
We’ll tell you whether it looks competitive, where we see opportunity, and the five questions we’d put to your carrier. No cost, and no obligation to move anything.
The renewal letter
Your current plan summary
Contribution split by tier
Enrolled counts by tier
Four documents — two more if your group is 50 or more. Nothing else; every extra one is a reason to postpone.
An independent employee benefits consulting firm. We look at the entire benefits program — cost, plan performance, risk and administration.
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