Tax Services Nondiscrimination Testing for Cafeteria Plans
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As we head into the fourth quarter of the year and with Halloween approaching, it’s time to review the scary topic of cafeteria plan nondiscrimination testing. While employers may test their cafeteria plan at any time during the plan year, the IRS requires the cafeteria plan to have passed testing on the last day of the plan year. Therefore, most employers wait until the final quarter of the year to perform the initial cafeteria plan nondiscrimination testing. If you have forgotten about the testing or if you haven’t done so already, now is the time!

Cafeteria plans are subject to a number of nondiscrimination tests to ensure that all employees receive proportional benefits. If certain prohibited groups of employees receive disproportionate benefits, then those employees must have their cafeteria plan benefits reduced before year-end in order to pass the nondiscrimination tests. Waiting until after year end should not be considered an option since there is no way to adjust payroll after December 31. This inability to adjust payroll will result in additional taxable income for the full amount of the elected benefit to the prohibited group if testing is not done until after the end of the calendar year. Completely ignoring the nondiscrimination tests can result in the IRS disallowing all pretax benefits, creating a payroll tax nightmare.

There are fourteen nondiscrimination tests that can apply to a cafeteria plan and its separate benefits.

Cafeteria Plan Tests:

  • Eligibility test
  • Contributions and benefits test
  • Concentration of benefits test

Group Term Life Tests:

  • Eligibility test
  • Benefits test

Health FSA (Flexible Spending Account) Tests:

  • Eligibility test
  • Benefits test

These tests also apply to self-insured medical, dental, and vision plans, as well as health reimbursement arrangements.

HSA Test:

  • Comparability test (generally)

Dependent Care Assistance Program Tests:

  • Eligibility test
  • Contribution and benefits test
  • More than 5% owner’s concentration test
  • 55% average benefits test

Adoption Assistance Program Tests:

  • Eligibility test
  • Concentration test

Even though some of the benefits have similar tests, the tests must be performed separately for each benefit. Each plan is governed by a separate Code section and each Code section uses different definitions and thresholds so the test for each component plan must be performed separately. Ideally, the tests would be performed at the beginning, during, and end of the plan year. Since most employers do not operate in this fashion, the fourth quarter is the best time to perform nondiscrimination testing for your cafeteria plan.

P&N can help you understand how nondiscrimination testing applies to your business, and how to perform the necessary tests to ensure that your cafeteria plan meets IRS requirements. Contact your P&N tax advisor for guidance.

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