By Stacey Stewart
If you have a 401(k) plan, then chances are you know all about the nondiscrimination testing required by the tax code for your plan. At least once per year, you review the nondiscrimination testing results to determine what, if anything, needs to be done to ensure your plan passes all requisite tests. Perhaps you even designed your 401(k) plan to reduce this testing obligation by adopting a “safe harbor plan” design. But what about your health and welfare plans? Are you aware that the need to test for nondiscrimination extends to those as well? Do your plans comply? Do you understand the risks of noncompliance?
It may surprise you to learn that there are a host of nondiscrimination testing requirements that may apply to your health and welfare plans! Applicable testing varies depending on the type of benefits provided, whether the benefits are self-funded or insured and the ability of participants to pay premiums pre-tax. You can lighten the testing burden by plan design, but it is unlikely an employer with a robust benefit offering could eliminate the need for testing completely.
First, let’s examine your knowledge of health and welfare plan nondiscrimination testing. Each of the following benefit arrangements may be subject to testing: self-funded major medical (including a separate obligation for any stand-alone self-funded dental and vision program), cafeteria plans, health flexible spending arrangements, dependent care assistance programs, health reimbursement arrangements, group term life insurance, employer contributions to health savings accounts, educational assistance plans and adoption assistance plans.
Nondiscrimination testing is relatively straightforward for some benefits. You can assess, based upon your plan design, whether a potential problem exists. For example, a group term life insurance program that covers all employees at a fixed percentage of compensation would, by design, pass testing. An employer with an adoption assistance or educational assistance program open to all employees generally need not worry about nondiscrimination issues apart from confirming no more than 5% of benefits are paid to more than 5% shareholders each year.
However, nondiscrimination testing for other benefits is complex and the potential outcome unclear without actually running the test. For example, cafeteria plan testing requires satisfying three different component tests (some with multiple prongs), including an eligibility test, a contribution and benefits test, and a key employee concentration test. The latter two tests are based on benefit utilization, which can make the testing outcome difficult to determine in advance. A failed test results in the highly compensated being taxed on salary reductions they made under the plan. This is typically not a high-dollar ‘penalty’ but it often affects the C-Suite, which can make communicating the result particularly uncomfortable.
The testing for self-funded health plans is another complex animal. It includes testing both eligibility and benefits. While the same testing applies for all self-funded health plans – such as HRAs, health FSAs and self-funded major medical – it can be more difficult and the stakes are a lot higher for major medical. Some failures require the highly compensated to report the value of medical benefits provided (e.g., the value of a surgical procedure) in income. Imagine having to explain to your CEO that he or she must include the value of a new baby’s in-hospital neonatal care in income. Ouch!
Perhaps you are thinking “we never worried about testing before, why should we pay attention to it now?” Several reasons come to mind. First, to quote Ben Franklin, “An ounce of prevention is worth a pound of cure.” There are often easy ways to avoid potential problems. Understanding your testing obligations can help you ensure your plan design does not automatically run afoul of the rules. It is usually easier (and cheaper) to prevent a problem rather than to fix it.
Second, testing failures can be expensive, both in terms of the employer’s cost of correction and the applicable ‘penalties.’ The purpose of nondiscrimination testing for retirement, as well as health and welfare plans, is to ensure they do not unduly favor highly compensated workers over the rank and file. Both types of plans provide tax benefits, such as the ability to fund and grow 401(k) accounts on a tax-advantaged basis and the ability to pay certain health and welfare plan premiums pre-tax through a cafeteria plan. Hence the penalties for a plan testing failure often involve the loss of some or all of the tax benefits.
When it comes to health and welfare plan testing failures, penalties fall mainly on the highly compensated. The personal tax impact may be light as with most cafeteria plan testing failures, but the burden can be severe, especially in the case of self-funded major medical. And when things get expensive, employees often look for deep pockets to blame which can result in additional employer expenses beyond the cost of correction, such as legal fees, litigation costs, and potentially employer reputational harm.
Although testing failures primarily impact the highly compensated, that will change if and when the new insured health plan nondiscrimination testing rules take effect. These rules, once effective, would impose penalties on the plan sponsor for maintaining a discriminatory insured group health plan.
Finally, we continue to hear that the government intends to increase audits in the context of health and welfare area. Perhaps now is a good time to examine whether your plans are in compliance by conducting an internal audit? Keep in mind that nondiscrimination testing is just one piece of the compliance puzzle. You want to be confident that your plans comply with ERISA, HIPAA, COBRA and ACA. It’s always better to be prepared rather than wait until the IRS (or DOL or HHS) comes knocking.