There are many variations of the question posed in the title of this article, but the question basically is whether an employer can provide different/better health benefits to certain employees (usually managers or executives) than to others, or can provide the same benefits to all employees but charge managers or executives less for the same benefits.
The answer is that “it depends” – on several factors:
- Whether benefits are self-funded or insured,
- Whether employees can pay pre-tax via a cafeteria plan, and
- The amount of the difference between costs for “highly-compensated” versus other employees or participants, and
- What percentage of total benefits under the plan are paid for “Key employees” or “highly-compensated” individuals.
The Short Answer
Below are some brief answers to the four bullet points above. However, the nondiscrimination rules are complicated, as evidenced by the summary in the next section. For example, there are various categories of “prohibited employees,” the definition of “highly-compensated” is different for cafeteria plans than for self-funded plans, plans generally must be nondiscriminatory both as to eligibility and as to contributions or benefits, and the non-discrimination tests themselves are different for cafeteria plans than for self-funded plans. Most “real life” situations will require nondiscrimination testing, so the short answers below are usually just the beginning of the answer.
1- Self-insured plans. An employer generally canNOT offer better benefits (or lower cost) to highly compensated employees.
- Reason: Self-insured health plans are subject to the nondiscrimination rules under Code §105(h). These have been in effect since before the Affordable Care Act (ACA) & continue to apply. These prohibit discrimination as to Eligibility and as to Contributions & Benefits.
2- Insured plans. An employer CAN offer better benefits (or lower cost) to highly compensated employees, if there is no cafeteria plan.
- Reason: Although the ACA added nondiscrimination rules for insured plans that are virtually the same as those that apply to self-insured plans, the IRS indefinitely delayed the enforcement of these nondiscrimination rules (IRS Notice 2011-1), and it is quite possible they will never become effective.
3- Cafeteria plans. Allowing employees to pay for insured benefits pre-tax through a cafeteria plan (Code §125 plan) will often mean that an employer canNOT offer better benefits (or lower cost) to highly compensated employees. If self-insured benefits are offered through a cafeteria plan, both Code §105(h) and Code §125 nondiscrimination rules will apply.
- Reason: There are nondiscrimination rules under Code §125 (Cafeteria plans), so if the employer allows employees to pay for benefits on a pre-tax basis through a §125 cafeteria plan, then the cafeteria plan nondiscrimination rules will apply. These applied before the ACA and continue to apply. These rules are similar to, but not exactly the same as, the Code §105(h) nondiscrimination rules noted above for self-insured group health plans.
4- Difference in Cost to Employees. If employees can pay pre-tax through a cafeteria plan, it generally is NOT OK to charge less for Highly Compensated Employees, but there are some “safe harbors” under cafeteria plan nondiscrimination rules.
- The special rule that addresses cost is at Code §I25(g): Insured health benefits will not be discriminatory if the ER contribution amount for non-highly compensated participants (non-HCPs) is at least 75% of the ER contribution amount for the similarly-situated HCP with the highest-cost coverage. “Similarly situated” means the same tier (e.g., self-only, family coverage). For a self-insured plan, however, this discrepancy would violate Code §105(h).
5- Some nondiscrimination tests limit the percentage of benefits that can be paid for certain “prohibited groups.”
- Cafeteria plan “Key Employee Concentration Test” – Key Employees cannot receive more than 25% of the total benefits under the cafeteria plan.
- Dependent Care Assistance Plan (DCAP) – 5% owner test and 55% average benefits test.
6-Premium-Only Plans (POP) – Safe Harbor. This safe harbor does not address cost, but it’s worth noting here: If all employees can participate in the same major medical plan and can elect the same salary reduction amounts for the same benefits, the POP and major medical plan are not discriminatory, even if they do not meet the Contributions & Benefits Test or Key Employee Concentration Test. However, if not all employees can participate in the same plan, additional testing is required.
- One caveat for employers who offer high-deductible health plans (HDHPs): the POP safe harbor applies if it allows employees to pay pre-tax for their share of the premium for the HDHP; however, some experts claim the safe harbor would not be available if the POP plan also allows employees to make HSA contributions on a pre-tax basis.
Overview of the Nondiscrimination Rules
Nondiscrimination rules under both Code §105(h) (self-insured plans) and Code §125 (cafeteria plans) prohibit discrimination in favor of the “prohibited group” as to Eligibility and as to Contributions or Benefits. The “prohibited group” includes:
- “Highly compensated” employees, participants, or individuals (HCEs, HCPs or HCIs), and
- Key employees, and
- Family members of the above two groups
See below for definitions of these terms. Note that the Eligibility tests compare HCIs (or HCEs) to non-HCIs (or non-HCEs), and Contributions and Benefits tests compare HCPs to non-HCPs.
The cafeteria plan nondiscrimination rules also include a “Key Employee Concentration Test,” which provides that Key Employees cannot receive more than 25% of the total benefits under the plan. This is often a problem for small employers, if they have a lot of Key Employees, or if they offer the same benefits to all employees but many non-Key Employees decline the coverage. The POP safe harbor described above will help many small employer plans meet the nondiscrimination rules.
The nondiscrimination rules prohibit discrimination in favor of the prohibited group, but they do not prohibit discrimination among or between different categories of non-highly-compensated individuals or participants, nor do they prohibit discrimination in favor of non-highly-compensated individuals or participants. If the cafeteria plan provides that HCEs are not eligible to enroll in the cafeteria plan (for example, because the employer pays for 100% of their benefits anyway), then there will not a problem passing the cafeteria plan nondiscrimination tests.
Definitions Vary Under Code §125 and Code §105(h)
The definitions of HCIs and HCPs are slightly different under Code §125 and Code §105(h)!
Under Code §125, “highly compensated” means:
- More than 5% owners
- Family attribution rules apply (Code §318)
- “Highly compensated” individuals and family members of same
- $120,000 annual compensation from the employer (same in 2018 and 2017); and employer can elect to include only those employees who are also in top-paid 20% by pay
- If compensation in preceding plan year was greater than Code §414(q)(1) amount, individual is “highly compensated” (2007 proposed regs)
- If just hired in current plan year, use current plan year compensation amount
Under Code §105(h), “highly compensated” means:
- Five highest-paid officers of the company
- More than 10% shareholders
- Among the highest-paid 25% of all employees (other than excludable employees who aren’t participants)
Note that the five highest-paid officers and the more-than-10% shareholders often will be included in the group of highest-paid 25% of all employees, but this should never be assumed.
“Key employees” are defined under Code §416 as:
- Officers with annual compensation greater than $175,000 (same threshold for 2017 and 2018)
- Was $170,000 in 2016
- More than 5% owners
Penalties and Testing Dates
Penalties vary under different nondiscrimination tests, but generally they provide that benefits (that would otherwise be non-taxable) will be taxable to Highly Compensated Employees and/or Key Employees if benefits or eligibility are discriminatory. There is no penalty on non-HCEs, and the plan itself remains valid or qualified. Cafeteria plan proposed regulations (2007) require that plans be in compliance with nondiscrimination rules on the last day of the plan year. However, employers cannot re-characterize employee salary reduction contributions after the end of the plan year to fix prior-year noncompliance issues. Thus, it is recommended that employers test within a month or two after enrollment each year and again within a month or two before the end of the plan year so that any needed corrections can be made. Employers are not required to submit proof of testing to the IRS or Department of Labor (DOL) but could be required to show proof of compliance if requested during a subsequent IRS or DOL audit (which could be several years later).
Action Items for Employers
Talk with your broker/advisor, cafeteria plan administrator or health plan administrator (for self-insured plans). As noted previously, most “real life” situations will require nondiscrimination testing, so the short answers above are usually just the beginning of the answer. If you have eligibility or cost provisions that clearly don’t comply with nondiscrimination rules, you might want to change them during the plan year to bring the plan into compliance this tax year. If you are considering implementing changes next year, it is advisable to consider now whether these provisions will run afoul of nondiscrimination rules.
If you offer a health flexible spending account (HFSA) or a self-insured plan, your third-party administrator (TPA) probably performs (or will perform) nondiscrimination testing at least once annually. To run the nondiscrimination tests, the TPA must have compensation information from the employer, because the tests compare eligibility and contributions/benefits amounts for certain categories of highly-compensated employees versus other employees. If the employer doesn’t provide this data, the TPA cannot run the tests. If your TPA only runs the tests at the end of the year, you may want to request that they also test shortly after enrollment, to make sure the plan seems to be compliant.
Sometimes TPAs run the tests and send the results, but the employer does not read the report to see if all the tests have been met. Be sure to read emails and reports from your TPA, and ask your TPA to explain the results if you need clarification. You can also ask your broker/advisor to review the results with you as well. If you don’t pass one or more of the nondiscrimination tests, the report usually provides information on what adjustment(s) could or should be made to meet the tests. If not, ask your TPA or broker for their advice. Don’t wait for an IRS audit a year or two from now to finally read through your Nondiscrimination Test report, because by then it will be too late to “fix” prior years’ problems.
Nondiscrimination Testing Procedures:
Nondiscrimination testing is a crucial process to ensure that an employer’s benefit plans don’t unfairly favor higher-paid employees over lower-paid ones. The procedures for this testing typically involve the following steps:
- Data Collection: The first step is gathering all necessary data. This includes employee salary details, the status of each employee (e.g., full-time, part-time), and specifics about the benefits each employee receives. This data should be up-to-date and comprehensive.
- Identification of Highly Compensated and Key Employees: Using IRS guidelines, identify which employees fall into the “highly compensated” and “key employee” categories. The criteria for these classifications can vary based on the specific nondiscrimination test being conducted.
- Comparative Analysis: With the data in hand, compare the benefits provided to highly compensated and key employees against those given to other employees. This will help determine if there’s a disproportionate benefit to the higher-paid employees.
- Conduct Specific Tests: Depending on the benefit plan in question, different tests may need to be performed:
- Eligibility Test: Checks whether a sufficient proportion of non-highly compensated employees are eligible for the benefits compared to highly compensated ones.
- Benefits Test: Examines if all participants, regardless of their pay or position, receive the same level of benefits.
- Utilization Test: Assesses if highly compensated employees are disproportionately utilizing the benefits more than others.
- Corrective Actions: If any tests indicate potential discrimination, corrective actions must be taken. This could involve adjusting the benefits, changing the eligibility criteria, or refunding excess contributions.
- Documentation and Record Keeping: Maintain thorough records of all tests performed, the data used, and any actions taken. This is crucial not only for internal review but also to be compliant if subjected to an external audit by bodies like the IRS or DOL.
- Regular Review: Nondiscrimination testing shouldn’t be a one-time event. Regular reviews, ideally annually, ensure ongoing compliance, especially as employee demographics and company benefits evolve.