Nondiscrimination Rules for Employee Benefit Plans

Employee benefit plans in the U.S. often provide tax advantaged benefits by excluding some or all of those costs from the employees’ gross income. To retain these advantages, employers must ensure their benefit plans comply with nondiscrimination rules, which are designed to prevent preferential treatment for highly compensated employees (“HCEs”) or key employees.

Overview of Nondiscrimination Rules

The application of nondiscrimination rules varies by benefit type, but some key principles are consistent:

1. Defining the Prohibited Group: The Prohibited Group typically includes HCEs and key employees, although the exact criteria depend on the benefit plan.
2. Eligibility Standards: Plans must meet specific benchmarks regarding the percentage of employees who are eligible to participate or receive benefits.
3. Exclusion Criteria: Certain groups, such as employees who have not met minimum age or service requirements, part-time or seasonal workers, or those covered by collective bargaining agreements, may be excluded from testing calculations.
4. Impact of Noncompliance: If a plan is found to discriminate, affected employees may lose tax benefits, with key employees or HCEs often bearing the brunt of the penalties. In rare cases, all employees could face tax repercussions.

Specific Nondiscrimination Rules by Benefit Type

Fully-Insured Group Health Plans

The Affordable Care Act (“ACA”) extends nondiscrimination requirements to fully-insured group health plans, aligning them with rules for self-funded plans under Internal Revenue Code (“IRC”) § 105(h). However, these requirements for insured plans are currently on hold, pending further regulatory guidance. Employers should monitor developments and prepare for eventual implementation.

Exclusions: Plans such as standalone vision or dental coverage are generally not subject to these rules.

Tests for Compliance:

• Eligibility Test: Requires coverage of at least 70% of non-excludable employees, 80% of eligible employees if 70% are eligible, or adherence to a nondiscriminatory classification.
• Benefits Test: Mandates that benefits for HCEs are also offered to all eligible employees without operational or design-based discrimination.

Self-Funded Group Health Plans

These plans must comply with IRC §105(h) by ensuring nondiscrimination in both eligibility and benefits. If a plan favors HCEs, the excess reimbursements they receive must be included in their taxable income.

Cafeteria Plans

Under IRC § 125, cafeteria plans must not favor HCEs or key employees in terms of eligibility or benefits offered. Violations result in tax penalties for the prohibited group.

Voluntary Employees’ Beneficiary Associations (“VEBAs”)

To retain tax-exempt status, a VEBA must provide nondiscriminatory eligibility and benefits. Uniform benefit structures tied to a percentage of compensation are allowed, provided they apply equally to all eligible employees.

Group-Term Life Insurance

Employer-provided group-term life insurance is excluded from taxable income for coverage up to $50,000. For the plan to remain compliant:

• Eligibility and benefits must not disproportionately favor key employees.

If a plan fails this test, key employees lose the $50,000 tax exclusion.

Educational Assistance Programs

Programs offering up to $5,250 in annual educational benefits are tax-free if they comply with nondiscrimination rules. If these rules are violated, all participants lose the tax advantage.

Dependent Care Assistance Programs

Employees can exclude up to $5,000 ($2,500 for separate filers) of dependent care benefits from taxable income, provided the plan’s eligibility and benefits do not favor HCEs. Non-compliant plans require HCEs to include these benefits as taxable income.

Key Takeaways for Employers

Navigating nondiscrimination requirements is complex but essential for maintaining the tax advantages of employee benefits. Employers should:

• Conduct regular nondiscrimination testing.
• Evaluate plan design and eligibility criteria for compliance.
• Seek legal counsel to address uncertainties or potential issues.

By understanding these rules and implementing appropriate measures, employers can ensure their benefit plans remain compliant while delivering valuable incentives to their workforce.