Find the Right Answers for Non-Discrimination Testing
December 01, 2016
2016 is quickly coming to an end!
Have your clients completed their non-discrimination testing for this plan year? The IRS requires testing be done at the end of each plan year to ensure the Plan is compliant and can retain its tax-favored status. All employers are required to perform Non-Discrimination Tests. In order to qualify for tax-favored status, a benefit plan must not discriminate in favor of Highly Compensated Employees (HCEs) with respect to eligibility, contributions or benefits.
- An officer
- An owner of more than 5% of the company
- An employee who has earned over $120,000 in 2016
Experts highly recommend that employers have a Non-Discrimination Test run early in the plan year. This provides employers time for necessary adjustments if the Plan should fail.
There are multiple tests to be run for each Qualified Benefit and definitions of Highly Compensated or Key Employees may differ by test or benefit. A Qualified Benefit is any benefit (pre-tax withholding) which cannot be included in the gross income of the employee/participant.
Testing Components
1. Eligibility Test
The Eligibility Test includes three components: Eligibility, Participation and Benefits.
The Eligibility requirement looks at the Reasonable Classification Component to determine if Plan eligibility is the same for all employees without favoring the highly compensated. The Eligibility Test also includes a Ratio Test of HCEs to Non-Highly Compensated Employees (NHCEs) of those who are participating. The testing verifies that NHCEs are eligible to participate to the same degree and are offered the same benefits as the HCEs.
There are several classes of employees that can be excluded from testing, as long as it is done consistently. These include employees who are collective bargaining employees, non-resident aliens with no US income, or COBRA participants. Additional excludable classes may be employees with less than 3 years of service or under age 25.
The easiest way to remain compliant - Make all employees eligible to participate in the Plan!
2. Contributions & Benefits Test
The second Non-Discrimination Test verifies that the Plan does not discriminate in favor of HCEs regarding employer contributions or benefits offered by the Plan. The test looks at Plan Availability and Utilization. This test also takes "Similarly Situated" employees into consideration.
Availability - The same benefits or employer contributions are available to similarly situated HC and NHC employees on a nondiscriminatory basis.
Utilization - The actual election of qualified benefits through the Plan must not be disproportionate by HCEs. The two ratios must be calculated and compared: 1) the aggregate of qualified benefits elected (or employer contributions utilized) by the HCE's divided by the aggregate compensation of the HCE group; and 2) the aggregate of qualified benefits elected (or employer contributions utilized) by the NHCE's divided by the aggregate compensation of the NHCE group. The HCE ratio must be less than or equal to the NHCE ratio.
Similarly Situated - allows discrepancies that may apply to different employee groups. I.e., single versus family enrollment may allow for different levels of employer contributions to be available, or differences based on geographic locations.
3. Concentration Test
The Concentration Test applies to all pre-tax benefits and determines if non-taxable benefits provided to key employees exceed 25% of the non-taxable benefits provided for all employees through the Plan.
- Officers whose compensation exceeded the specified dollar threshold ($170,000 for 2016) during the previous plan year
- Owners with more than 5% ownership during the previous plan year (at any compensation level)
- Owners with more than 1% ownership and compensation over $150,000
Example
We're going to take a deeper look at one test, the Cafeteria 125 Test.
A couple of questions need to be answered for Eligibility & Reasonable Classification.
- Are all employees eligible to participate in the Plan?
- Does the Plan meet the Reasonable Classification Test Under Section 410 of the Code?
The Contributions & Benefits portion will require the following information: a unique employee ID; annual pre-tax payroll deductions by participant; total annual compensation by participant; percentage ownership in the company (if any) and whether the employee is an officer in the company. Then a calculation is performed to determine a percentage for the HCEs and a percentage for the NHCEs. If the percentage for HCEs is less than the percentage for NHCEs, the Plan has passed the test.
Lastly, the Concentration Test runs a calculation to determine if Key Employees' benefits are less than 25% of the total benefits provided.
In order to pass the Cafeteria 125 Test the Eligibility & Reasonable Classification questions need to have yes responses, the percentage for HCEs needs to be less than the percentage for NHCEs and the Key Employees benefits need to be less than 25% of the total benefits provided.
What happens if an employer's Plan doesn't pass the Eligibility or Contributions & Benefits Test? The HCEs will lose the favorable tax treatment of their benefits unless corrections are made. The NHCEs are not affected. If the tests are run early in the plan year, actions can be taken to ensure the Plan passes.
- Adjustments need to be made for the HCE's elections
- Employers can make an adjusted qualified contribution
- The guidance of a Tax Counselor can be sought
Need a little help?
It may seem simple to tackle non-discrimination testing without some help but utilizing a testing tool can provide a history and documentation of testing results for audit verification. The EnsuredComplianceŽ system provides an effective tool to manage the non-discrimination requirements and ensures your clients remain in compliance. Please contact us for additional information or to schedule a demonstration on how you can shorten the amount of time spent on non-discrimination testing for your clients.