Employers often provide a range of benefits to employees. One such benefit is a Health Flexible Spending Account (Health FSA). These accounts allow employees to contribute pre-tax dollars to be used for unreimbursed medical expenses incurred during the year. Health FSAs are considered self-funded health plans and must not discriminate in favor of highly paid employees.
Employers often believe that having a non-discriminatory eligibility policy allowing all full-time employees to participate if they choose is sufficient to comply with non-discrimination requirements; however, it is much more complicated. An employer’s FSA may violate nondiscrimination requirements, even though every employee is eligible to participate, if highly compensated employees participate in greater numbers than non-highly compensated employees.
Because highly compensated employees typically have more discretionary income and are more likely to look for ways to reduce their taxable income, these employees are more likely to participate in health FSAs than lower-income employees. When a greater proportion of highly compensated employees participate in a Health FSA than low-compensated employees, an employer’s health FSA may violate nondiscrimination rules, even though the employer offered the benefit on a nondiscriminatory basis. The result of the FSA’s discriminatory health care is a loss of tax benefits for highly compensated employees and penalties for employers who fail to tax these highly compensated employees on discriminatory benefits.
To ensure that a health FSA does not discriminate in favor of highly paid employees, employers should have their health FSA provider provide or arrange for non-discriminatory testing. The testing provider will conduct eligibility and benefit tests prescribed by the Internal Revenue Service to determine if a health FSA has a discrimination problem.
This article summarizes the non-discrimination tests applied to health FSAs.
The analysis of whether a Health FSA is discriminatory varies depending on whether the Health FSA accepts pre-tax salary contributions from employees. Health FSAs funded by pretax employee salary contributions must also comply with section 125 plan nondiscrimination rules, which differ from those in 105(h).
For the purposes of this article, we will discuss the nondiscrimination requirements applied to health care FSAs funded through pre-tax participant salary contributions BUT we will assume that these Section 125 Health FSAs can pass the nondiscrimination requirements applicable under Section 125 of the Internal Revenue Code. Thus, our analysis is limited to the applicability of Section 105(h) requirements to Section 125 Health FSAs that have successfully passed Section 125’s nondiscrimination requirements.
The following is general information about Health’s FSA and is intended for educational purposes only and does not constitute legal advice.
Who are the highly compensated individuals against whom the plan cannot discriminate?
The first step in performing the Section 105(h) nondiscrimination test is to determine which are the highly compensated individuals that your plan cannot benefit. “Highly compensated person” is defined as:
- One of the five highest paid employees;
- A shareholder owning more than 10% of the value of the employer’s shares; and
- Among the highest paid 25% of all non-excluded employees.
To determine who your “non-excluded” employees are, you first need to determine who is an “excluded employee.” “Excluded Employees” are any of the following employees to the extent that they are not eligible for a Health FSA:
- Employees who have not completed three years of service,
- Employees who have not reached the age of 25,
- part-time or seasonal employees,
- Collectively Bargained Employees and
- Foreign aliens who do not receive income from a U.S. source.
If there are employees in these categories eligible to participate in the Health FSA, they will not be excludable employees. Your non-excluded employees, for purposes of determining the highest paid 25% of employees and for applying the eligibility tests below, are all employees other than excluded employees.
How do I determine if my Health FSA is discriminatory?
Once you’ve determined who your highly compensated individuals are, you should determine whether your Health FSA discriminates against them in either eligibility for participation or benefits offered. A Health FSA must pass two tests to be non-discriminatory: (a) the benefits test and (b) the eligibility test.
A Health FSA passes the benefits test if there is no discrimination by the Health FSA person or in action. A Health FSA would be prima facie discriminatory if it varied benefits between highly compensated individuals and non-highly compensated individuals.
For example, allowing a certain highly compensated individual to elect up to $2,500 in salary reductions, but allowing everyone else to elect only up to $1,500 in salary reductions. Another example is a waiting period for participation but a waiver of the waiting period for a highly compensated person. Assuming that all eligible employees are treated equally, there should be no discrimination on the part of the Health FSA.
A Health FSA is discriminatory in operation if, in effect, the Health FSA favors highly compensated individuals. For example, if a Health FSA requires substantiation of expenses from participants, but waives that requirement for highly compensated individuals or allows only a highly compensated individual to be reimbursed for a certain type of expense. If the terms of the Health FSA apply consistently to all eligible employees, the Health FSA must not be discriminatory in operation.
Most health FSAs pass the benefits test, but often have trouble passing the eligibility test. The eligibility test determines whether a Health FSA benefits enough people who are not highly compensated. To determine whether a Health FSA passes the eligibility test, the Health FSA must pass one of three alternative tests:
- 70% test;
- 70%/80% test; and
- A non-discriminative classification test
The 70% test requires 70% or more of all non-excluded employees (all employees other than your excludable employees) to participate in a Health FSA. If at least 70% of your non-excluded employees participate in a Health FSA, your plan passes the eligibility test. For example, if an employer has 100 non-excluded employees and 70 of them participate in a Health FSA, the 70% test is passed.
For health FSAs that cannot pass the 70% test, they will pass if at least 70% of all non-excluded employees are eligible to participate and 80% of eligible non-excluded employees actually participate. For example, if an employer has 100 non-excluded employees, at least 70 of them must be eligible to participate in the Health FSA, and at least 56 of the 70 who are eligible to participate must actually be participating in the Health FSA.
A non-discriminative classification test
If the employer cannot pass the 70%/80% test, the final test is the non-discriminatory classification test. There are two versions of the non-discriminatory classification test – the post-TRA fair cross-section test and the pre-TRA fair cross-section test. Because the Pre-TRA Fair Cross Section Test is subjective, most testing services only administer the Post-TRA Fair Cross Section Test and advise employers with health FSAs who cannot pass the test to discuss it with legal counsel.
The post-TRA fair cross section test is satisfied if the employer’s Health FSA eligibility policy is based on a reasonable classification using objective business criteria and the employee pool and ratio of low-compensated Health FSA participants to high-compensated individuals is 50% or more OR if less than 50%, exceeds the safe harbor percentage.
The Safe Harbor percentage is based on the employer’s concentration percentage of nonhighly compensated individuals and should be determined by reference to the table published by the IRS in Treasury Regulation §1.410(b). If the employer cannot satisfy the safe harbor percentage, the nondiscrimination testing service typically advises the employer to seek outside legal advice as to whether it can pass the Post-TRA Fair Cross Section Test or Pre-TRA Fair Cross Section Test.
Then, in the second part of this series, we’ll look at what to do if the Health FSA is discriminatory.