Nondiscrimination Rules – An Overview for 2015

Nondiscrimination Rules – An Overview for 2015

The purpose of this paper is to clarify the various nondiscrimination rules for 2015. In practice I am seeing the rules frequently ignored or misapplied which is concerning. The nondiscrimination rules are long and detailed so only a brief overview of the rules is provided in this publication (otherwise the paper would exceed 20 pages). However, if you have a plan that is subject to nondiscrimination rules, a knowledgeable professional should review the details as the government has repeatedly stated it will be stepping up audits in 2015.

The consequences of failing the nondiscrimination tests vary, but they could have negative tax implications for an employer’s most important employees and/or lead to penalties being assessed against the employer. Additionally, misapplying one area of the law will only pique the auditor’s interest in what else you may be implementing incorrectly. This paper provides an overview of the nondiscrimination rules that exist for self-insured plans, insured plans, cafeteria plans, and the HIPAA nondiscrimination rules.

Self-Insured Plans

The purpose of the self-insured nondiscrimination rules is to make sure the plan is not discriminating in favor of highly compensated individuals (HCIs). A highly compensated individual for self-insured nondiscrimination testing is defined as (1) the five highest paid officers of the employer; (2) a 10 percent or more shareholder of the employer; or (3) an individual who is among the highest-paid 25 percent of all employees.

A self-insured plan must pass an eligibility test or a classification test. The purpose of these tests is to ensure enough employees, and not just employees with high salaries, are benefitting from the preferential tax treatment self-insured plans provide. The first eligibility test is a straight forward mathematical calculation which is either passed or failed based on the number of employees benefitting under the plan. An alternative eligibility test calculates the number of employees eligible to participate under the plan and then takes those employees who are eligible to participate and calculates the percentage of those employees who benefit from the plan.

An employer that does not pass either eligibility test must satisfy one of the classification tests. The first classification test, the fair cross-section test, is a facts and circumstances test. In the lone documented example provided by the IRS, the Service placed an emphasis on the fact the plan covered employees in all compensation ranges and employees in the middle and lower salary brackets were covered in more than nominal numbers. This test goes beyond simple number crunching.

The second classification test is referred to as the “nondiscriminatory classification test”. This test uses a table published in the Internal Revenue Code that is designed to measure the ratio of non-HCIs to HCIs benefitting under the plan. In addition, the plan must benefit a group of employees who qualify under a reasonable job classification. An employer’s job classification is reasonable if eligibility to the plan is based on specified job categories (i.e. job titles), nature of compensation (hourly verse salaried), geographic location, or other bona fide business criteria.

If the requirements of any of tests discussed above are satisfied, a self-insured plan will pass one part the nondiscrimination testing. Additionally, a self-insured plan must provide the same benefits it provides highly compensated individuals to all other participants and not discriminate in operation.

When applying the nondiscrimination rules for self-insured plans, certain employees can be excluded. The definitions of who can be excluded from the nondiscrimination tests are in direct conflict with certain provisions of the Affordable Care Act. Exactly who can be excluded for testing purposes is still unclear as the nondiscrimination rules have been lightly enforced since the regulations came out in the 1980s. Hopefully, the government provides more clarity on the issues surrounding these rules.

Insured Plans

For the first time ever, the ACA prohibits insured health plans from discriminating in favor of highly compensated individuals. These rules are supposed to be “similar to” the rules that are already in place for self-insured plans and are intended to prohibit discrimination in favor of highly compensated individuals. However, the government delayed the enforcement of this ACA provision in Notice 2011-1 until regulations are released. As of November 7, 2014 the regulations have still not been released. Employers will be given time to comply with the regulations, so the earliest the rules would need to be complied with is likely January 1, 2016.

With no rules in place for 2015, many employers have continued the practice of sponsoring insured plans that appear “discriminatory” for their upper management. This practice remains viable so long as proper procedures are followed. However, be aware the yet to be released regulations could invalidate such arrangements.

Cafeteria Plans

In general a cafeteria plan must satisfy three separate nondiscrimination tests to provide beneficial tax treatment to all of the plans participants. The first nondiscrimination test, the “eligibility test”, examines whether enough non-highly compensated individuals (non-HCIs) are eligible to participate in the plan. The definition of highly compensated individuals (HCIs) is different for the cafeteria plan rules than the definition used for self-insured plans. An HCI for cafeteria plans is an officer of the employer, a five percent shareholder of the employer, or an individual who for the preceding plan year had compensation from the employer in excess of $120,000. Additionally, a spouse or dependent of an individual described in one (or more) of the three categories above is counted as an HCI. A non-HCI is an individual who is not an HCI.

The first part of the eligibility test requires a cafeteria plan to benefit a group of employees who qualify under a reasonable job classification. Additionally, the eligibility test requires that either a “safe harbor test” or an unsafe harbor facts and circumstances test (“unsafe harbor test”) be satisfied using a table published in the Internal Revenue Code. The “unsafe harbor test” also requires an IRS finding that the classification is nondiscriminatory based on relevant facts and circumstances.

The second test, the contributions and benefits test, is designed to measure the contributions and benefits available to highly compensated participants to ensure they do not select more nontaxable benefits than non-highly compensated participants. A highly compensated participant is an HCI who is eligible to participate in the cafeteria plan. A non-highly compensated participant is a participant who is not a highly compensated participant. A cafeteria plan must give each similarly situated participant a uniform opportunity to elect qualified benefits (the “availability test”) and the actual election of qualified benefits through the plan must not be disproportionately made by highly compensated participants (the “benefit utilization test”).

Finally, the key employee concentration test prohibits the benefits provided to key employees under the plan from exceeding 25 percent of the aggregate of such benefits provided to all employees under the plan. A key employee is different from an HCI. For 2015 a key employee is (1) an employee who is a five percent owner of the employer; (2) an employee who is a one percent owner of the employer and whose annual compensation from the employer exceeds $150,000; or (3) an officer having annual pay of more than $170,000.

After an employer labels its key employees, the employer accumulates the benefits provided to the key employees under the plan and divides that number by the total number of benefits provided to all employees under the plan. If that number exceeds 25 percent, the cafeteria plan will fail the key employee concentration test.

The nondiscrimination rules for cafeteria plans are incredibly complex and detailed. Typically only passing one part of the nondiscrimination rules does not mean the cafeteria plan satisfies the other cafeteria plan nondiscrimination rules. To complicate matters further, a separate set of rules applies to premium only plans and simple cafeteria plans. If you have a cafeteria plan, I would highly recommend reviewing these tests in detail to confirm proper compliance.

HIPAA

Finally, ERISA, through its largely forgotten HIPAA provisions, prohibits a group health plan from conditioning eligibility or charging a higher premium compared to similarly situated individuals enrolled under the plan based on any health status-related factor. The term health status-related factor includes health status, medical conditions (including both physical and mental illnesses), claims experience, receipt of health care, medical history, genetic information, evidence of insurability (including conditions arising out of acts of domestic violence and participation in activities such as motorcycling, snowmobiling, all-terrain vehicle riding, horseback riding, skiing, and other similar activities), and disability.

An employer needs to be extremely careful if it is singling out employees under its health care plan even if the employer believes it has a legitimate reason. If an employee being singled out could be categorized under one of the factors in the paragraph above, it could lead to significant penalties. Additionally, employers charging different premium amounts need to be cognizant of the HIPAA rules. The HIPAA rules only prohibit discrimination based on a health status-related factor which still allows for strategic planning. However, this planning must be done with caution and properly apply related laws.

Conclusion

The various nondiscrimination rules apply differently depending on the course of action an employer selects. The rules often overlap and need to be applied concurrently. In the past, these rules have frequently been neglected or misapplied. In light of the government’s increased audit efforts, every employer should review its testing practices.


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