Nondiscrimination and Taxation Considerations

Health FSA Nondiscrimination Testing


Summary

A health flexible spending arrangement (FSA) is generally subject to Internal Revenue Code (IRC) Section 105(h) nondiscrimination testing, since it is usually a benefit that is self-insured by the employer. In addition, since FSAs are generally offered under a cafeteria plan (i.e., on a pre-tax basis for employees), IRC Section 125 nondiscrimination likely also applies to an FSA. Sections 105 and 125 require that the plan satisfy nondiscrimination testing, as outlined below.

Generally speaking, Sections 105(h) and 125 prohibit plans from discriminating in favor of highly compensated individuals (HCIs) with respect to plan eligibility and benefits. The two sections, however, contain slightly different definitions of HCI. Section 105(h) defines an HCI as a top-5-paid officer, a more-than-10-percent shareholder or among the top-25-percent compensated employees. Section 125 defines an HCI as any officer, a more-than-5-percent shareholder or any individual with compensation over $115,000 (for 2012), or certain family members (using the IRC Section 318 attribution rules) of an individual considered an HCI.

That said, this summary focuses primarily on Section 105(h). More information on the Section 125 nondiscrimination rules can be found here. For the most part, Section 105 applies to health FSAs in the same manner as any other health plan sponsored by an employer. Nevertheless, there are several practical differences between health FSAs and other types of self-insured medical plans that affect the application and outcome of the nondiscrimination tests. First, unlike many other self-insured medical plans, health FSAs provide lower dollar amounts of coverage and are not intended to provide primary coverage for a specific benefit. Second, health FSAs often are 100 percent employee-funded with pre-tax salary reductions. If an FSA is funded by an employer, the funded amount is generally small. Finally, health FSAs have a much lower participation rate than most other self-insured medical plans, making it more difficult to pass the nondiscrimination testing under Section 105.

Under Section 105(h), a health FSA must satisfy two nondiscrimination tests: the eligibility test and the benefits test. Under the eligibility test, a health FSA cannot discriminate in favor of HCIs as to eligibility to participate. There are three alternative tests under the eligibility test: the 70-percent test, the 70/80-percent test and the nondiscriminatory classification test.

The 70-percent Test is satisfied if 70 percent or more of all employees benefit from the plan. It is not clear whether “benefit” means to be eligible for the plan or to actually participate in the plan. The cautious approach would be to assume that to benefit means that an individual is actually participating in the plan. A more aggressive approach would be to assume that to benefit means simply to be eligible to elect health FSA coverage. The 70/80-percent test is satisfied if 70 percent of all employees are eligible for the plan, and 80 percent of those eligible to participate in the plan are actually participating in the plan.

Under the nondiscriminatory classification test, a plan may vary eligibility based on bona fide business classifications, so long as the classification is not discriminatory in favor of HCIs. In other words, the plan can vary eligibility based on classifications (such as hourly versus salaried, part-time versus full-time, different geographic locations, different business lines, date of hire, etc.), so long as the classification is designed for business purposes (as opposed to benefit exclusion purposes) and the classification does not favor HCIs. To determine if the classification favors HCIs, you basically take the number of HCIs and compare them with the number of non-HCIs, and then compare the outcome against a table found in the regulations, which dictates whether the plan has the proper ratio to be considered nondiscriminatory.

Under the benefits test, the benefits provided under the health FSA must not discriminate in favor of HCIs. The plan must not discriminate on its face (i.e., in its terms) or in operation. Generally, in order for a health FSA to be nondiscriminatory on its face, it must satisfy the following conditions:

  • The required employee contribution must be identical for each benefit level;
  • The maximum benefit level that can be elected cannot vary based on percent of compensation, age or years of service;
  • The same type of benefits (i.e., medical expenses) provided to HCIs must be provided to all other participants; and
  • Disparate waiting periods may not be imposed.

Whether a plan is nondiscriminatory in operation is more of a facts and circumstances determination. Discrimination in operation may occur where the duration of a particular benefit coincides with the period in which HCIs utilizes the benefit, or where the FSA administrator approves certain claims for medical expenses for HCIs but not for non-HCIs. This could occur through lower substantiation standards for HCIs. Basically, though, if HCIs are the only ones able to actually use the benefits, then the plan may be considered discriminatory in operation.

Employer Action

Employers should consider the nondiscrimination rules when designing or amending the health FSA, particularly with respect to eligibility for and contributions to the FSA. Eligibility and contributions, among other things, should be consistent for all employees, and should not favor HCIs.

Employers that sponsor health FSAs should engage a vendor that can perform the appropriate nondiscrimination tests, and those tests should be performed during and at the end of the plan year, to ensure that the plan is operating in a nondiscriminatory manner. Importantly, while corrections to the plan may be made throughout the year, no corrections may be made to the plan after the end of the plan year. Thus, the tests should really be monitored during the year so that any adjustments can be made prior to year-end.

Penalties

If the FSA is considered discriminatory, the non-HCIs will not lose their tax benefits, and the health FSA will not cease to be a valid Section 105 plan simply because it is discriminatory. However, the tax advantages for HCIs will be lost, meaning that the amounts considered to be “excess reimbursements” paid to the HCIs under the FSA will become taxable. The formula for calculating the amount of tax on an excess reimbursement varies based on whether the benefits paid to the HCIs were the result of discriminatory coverage (i.e., a failure of the eligibility test) or of discriminatory benefits (i.e., a failure of the benefits test).

For discriminatory coverage, HCIs are taxed on a pro rata portion of their excess reimbursements. The amount of excess reimbursement for a particular HCI is determined by multiplying the total amount reimbursed to the HCI by a fraction, the numerator of which is the total benefits paid during that plan year to, or for, all HCIs and the denominator of which is the total benefits paid during that plan year to, or for, all participants. The resulting amount will be included in the HCIs’ income. Effectively, this formula causes all HCIs who have received reimbursements under a discriminatory plan to be taxed on a percentage of their benefits. The taxable amount for any particular HCI would be the total benefits paid to that individual for the year, multiplied by the pro rata portion of all benefits paid during the year to HCIs. For example, if HCIs receive 40 percent of plan benefits, then 40 percent of all HCI reimbursements would be taxable.

For discriminatory benefits, HCIs are taxed on the full amount of their excess reimbursements. Thus, if a benefit is available only to an HCI and not to all other participants, then the total amount reimbursed to the HCI for that benefit is includable in gross income. If the benefit is available to non-HCIs but is a lesser benefit, then the amount available to the HCI will be offset by the amounts available to non-HCIs.

There is no income tax withholding required for reimbursements under a health FSA, even when the reimbursements are includible in the employee’s gross income. In addition, excess reimbursements under a discriminatory self-insured plan are not wages for purposes of FICA (Social Security and Medicare) or FUTA withholding.

Frequently Asked Questions

Q1. Are there any exceptions to the FSA nondiscrimination testing for small plans?
A. No. Neither Section 105(h) nor Section 125 provide for a specific size plan. Thus, any-sized self-insured plan, such as an FSA, is subject to Section 105(h) nondiscrimination testing, and any-sized cafeteria plan is subject to Section 125 nondiscrimination testing.

Q2. For a discriminatory FSA, where are the excess reimbursements actually reported?
A. The discriminatory amounts (i.e., the excess reimbursements) are included in the HCIs’ gross income and should be reported on Form W-2, Box 1. If the plan year has already closed and W-2s have already been issued, then the employer must issue amended Form W-2s to the HCIs who received excess reimbursements, and those HCIs would be responsible for filing an amended individual federal income tax return to correct their gross income reported to the Internal Revenue Service (IRS) (assuming the individuals already filed such a return).

Q3. What health FSA plan designs may be used to pass the eligibility test?
A. One plan design that would likely pass the eligibility test would be for the employer to make “seed contributions.” Sponsors can design health FSAs to make a de minimis benefit available to all non-excludable employees (sometimes called a “seed contribution”). If the employer makes a seed contribution, then all these employees would be counted as “benefiting” for eligibility testing purposes. However, making seed contributions would also cause all eligible employees to be participants and might increase aggregate administration costs. In addition, depending on the amount of the seed contribution, the FSA may become subject to obligations under the HIPAA portability rules (it may not be an excepted benefit under these rules) and additional COBRA obligations (it will not be eligible for the special limited COBRA obligation). So keep that in mind.

Additional Resources

Citations

  • IRC § 105(h)
  • Treas. Reg. § 1.105-11(e)
  • Treas. Reg. § 1.125-5.

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