Nondiscrimination testing: the annual tests that keep owners and highly paid employees from losing tax benefits.
Which tests apply to a cafeteria plan, a flexible spending account and a self-funded health plan, who counts as highly compensated or a key employee, what happens when a plan fails and how small employers can avoid testing. Written for the owner or HR lead.
Tax-Favored Benefits Cannot Favor the Highest Paid
The tax exclusion for many benefits depends on the plan not favoring a defined group of higher-paid or owner employees.
Why the Tests Exist
Congress allowed pre-tax benefit plans on the condition that they do not mainly benefit owners and highly paid employees. For an employer, the practical meaning is that benefit design has to be defensible. A plan that works well for owners but poorly for rank-and-file staff can put the tax treatment at risk for the people it was meant to help.
Plans That Get Tested
Cafeteria plans, health and dependent care flexible spending accounts and self-funded health plans are the usual ones. Which tests apply depends on what you offer, so list every benefit that runs through payroll on a pre-tax basis. Ask your adviser or plan administrator which ones are tested and who is responsible for running them. For the tax effect on owners and highly paid employees, see Self-Insured Plan Nondiscrimination Rules.
Annual, Not One Time
Tests run each plan year, and a change in headcount or elections can change the result. A plan that passed last year can fail this year after a hiring wave, a layoff or a shift in who elects coverage. Put testing on the annual calendar and gather the data in time to act.
Highly Compensated and Key Employees
Different tests use different groups, defined by pay and ownership.
Highly Compensated Individuals
Employees above a pay threshold or in the top paid group, plus certain owners and officers, depending on the test. The definitions differ by test, and the pay thresholds change over time. Ask your adviser or plan administrator which definition applies and what data they need, such as ownership, pay and hire dates.
Key Employees
Officers above a compensation level and certain owners. Cafeteria plans limit how much of the total benefit may go to this group. Because officers and owners are counted by role and by ownership, a small employer may have a larger share of its benefits flowing to this group than it expects. Review who is in the group before the year starts.
Ownership Attribution
Family members of owners can be counted with the owner. Check who is in each group, including spouses. A spouse, child or other relative may be treated as an owner even if they hold no shares. Ask counsel or your plan administrator how family ownership applies, and keep an updated list of owners and relatives on payroll.
What Each Plan Is Tested For
The tests ask whether eligibility, contributions and benefits are available fairly.
Cafeteria Plan Tests
Eligibility, contributions and benefits, and a key employee concentration test generally apply to a cafeteria plan. Each test looks at a different feature of the plan, so passing one does not guarantee the others. Ask your plan administrator for results by test, and keep the documentation with the plan records.
Dependent Care FSA Tests
Dependent care assistance has its own tests, including an average benefits test and a limit on benefits to owners. Because the tests look at who elects and how much, a small number of high earners can affect the result. Have your administrator check results early, and consider limiting elections for highly compensated staff if needed.
Self-Funded Health Plan Tests
Self-insured plans are subject to a rule that bars discriminating in favor of highly compensated individuals on eligibility and benefits. The rules look at eligibility and the benefits provided, so executive-only coverage or richer terms for a select group can raise concerns. Have counsel review the design, and ask your adviser how the rules apply to your situation.
Key Employee Concentration Test
A cafeteria plan fails this test if the qualified benefits provided to key employees exceed 25 percent of the total qualified benefits provided to all employees under the plan. If it fails, key employees lose the tax exclusion for those benefits.
Eligibility Safe Harbor
The tax code treats a participation rule as nondiscriminatory if no employee must complete more than three years of employment to join, the requirement is the same for everyone, and eligible employees start no later than the first day of the next plan year.
Who Counts As A Key Employee
Key employees generally include certain officers, 5 percent owners, and 1 percent owners above a pay threshold the IRS updates each year. Check the current IRS figures with your advisor before testing. Look at the whole plan year, since a person may qualify at some point and not at another. A written list of who is in the group helps testing go faster and reduces errors.
Fully Insured Plans Are Treated Differently
The nondiscrimination rule for insured health plans has not been enforced.
Enforcement Is on Hold
The IRS has delayed enforcement of the insured plan rule pending regulations, so it is not currently tested. The delay does not mean the issue has been resolved. Rules could change, and design choices made now may be reviewed later, so ask counsel before building a plan that favors executives.
Other Rules Still Apply
Insurance law and the ACA have their own nondiscrimination requirements for fully insured coverage. Fully insured plans also face carrier requirements and rules on eligibility, such as those about waiting periods and class of employee. Confirm with your carrier and adviser that your plan design fits these rules.
Check with Your Adviser
Plan design for owners, such as extra coverage for executives, deserves a review before it is adopted. Bring the design to your adviser before announcing it, including who would be covered, at what cost and on what basis. Early review is usually easier than undoing a benefit employees have already come to rely on.
Consequences and Fixes
A failed test does not end the plan, but it does change who is taxed.
Loss of the Exclusion
Highly compensated or key employees can lose the tax exclusion for some or all of their benefits, and their income increases. This can result in additional taxable income for the affected employees and extra reporting for the employer. Ask a tax adviser how a failed test would be handled, and discuss it before the issue arises.
Corrective Options
Employers can reduce elections for the favored group, increase contributions or change eligibility, within the plan year. Correction usually has to be done in line with the plan document and the rules, and timing matters. Talk with your plan administrator and tax adviser before changing elections, and communicate with affected employees clearly.
Early Testing Helps
Run a mid-year check so there is time to correct before year end. A mid-year run lets you see where the plan is heading, while there is still time for corrective steps. Use current census and election data, and repeat the check if enrollment shifts significantly.
Safe Harbors Can Avoid the Tests
Smaller employers often qualify for a design that skips testing.
Simple Cafeteria Plans
Employers with 100 or fewer employees can adopt a simple cafeteria plan that satisfies the tests by making required contributions. The size rules and conditions are specific, so check eligibility with counsel or your plan administrator before adopting. Employers should also understand the trade-offs involved, including the required employer contribution.
The Trade-Off
The safe harbor requires a minimum employer contribution, a plan document and coverage of eligible employees. For some employers, the predictability is worth the cost; for others, regular testing is more flexible. Compare both approaches with your adviser using your own census, and review the choice if headcount or pay patterns change.
Owner Rules Remain
Owners of some entities, including certain S corporation shareholders, are limited in how they take part in a cafeteria plan. Entity type affects whether an owner can join the plan and how benefits are taxed. A tax adviser should review each owner’s situation before enrollment, because errors here can be costly to fix.
The questions that come from testing.
Six questions employers bring us about nondiscrimination testing.
Do all employers have to run these tests?
Plans that are subject to them do, unless a safe harbor applies. Many small employers use one.
Who is a highly compensated employee?
It depends on the test. The definition looks at pay and ownership, and the pay threshold changes yearly.
Does a fully insured plan need testing?
The insured plan health rule is not currently enforced. Cafeteria plan and FSA tests may still apply.
What happens if we fail?
Highly compensated or key employees can lose the tax exclusion for certain benefits.
Who runs the tests?
A cafeteria plan or FSA administrator often does. Confirm that it is part of the service.
When should we test?
Run a check mid-year and again before year end, so corrections can be made in time.
Ready? Send us your renewal, or talk it through with someone first. No cost, no obligation.
General information about nondiscrimination testing, not tax or legal advice. Compensation thresholds change yearly, so confirm current figures and your plan’s results with your administrator or tax adviser.
Related guides.
Employee Contributions and Plan Assets
Why withheld premiums must reach the plan promptly, and the controls that keep them in step.
Section 125 Cafeteria Plans
How pre-tax premium plans work.
Dependent Care FSA Guide
Rules for child and dependent care benefits.
Owner and S Corporation Coverage
How owners fit into employer plans.
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Enrolled counts by tier
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Laws and rules referenced
26 U.S.C. § 125 — Cafeteria plans: pre-tax premium payments, plan limits and nondiscrimination rules.
26 U.S.C. § 129 — Dependent care assistance programs.
This page is general information, not legal or tax advice. Rules change and facts matter, so confirm your situation with counsel or a qualified advisor.
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