Non-discrimination test for Medical FSA: What Happens If I Don’t Pass?

The non-discrimination test, also called a compliance test, is required for all Medical FSA, Dependent Care Accounts, and Pre-tax of Premiums under section 125 of the IRS code.

You can read part one of the article on non-discrimination testing here.

A non-discrimination test has three parts:

1. Eligibility test: There must be at least as many non-highly compensated workers participating as HCEs.
2. Benefits test: The same type of benefits (i.e., medical expenses) provided to highly-compensated employees must be provided to all other participants. The minimum employee contribution must be the same at each benefit level. The maximum benefit level cannot vary based on the percent of compensation, age, or years of service.
3. Key-Employee Concentration test: The value of non-taxable benefits selected by HCEs cannot exceed 25% of the total non-taxable benefits selected by all participants under the plan.

What happens if a company doesn’t pass?

• Not passing the nondiscrimination testing means the company will have to correct.
• Those highly compensated employees will have imputed income equal to the salary reductions that they elected for the plan year. This is true no matter the amount of elected benefits.
• The amount of reductions from highly compensated employee's salary will then be taxable income for the company’s W-2 reporting and income tax (FICA and FUTA withholding).
• You cannot go back into previous years and correct if you have not completed your testing. Therefore you should make all efforts to be testing your cafeteria plan each year along with the guidelines we suggested.
• If a company doesn't make any corrections, failing to pass means that the company has lost the tax-free stamp on benefits.
• Non-discrimination testing results are subject to audit from the IRS.

Non-discrimination tests are essential and not passing can have serious consequences. However, by planning ahead and testing early, a company can ensure they are on track to pass by the end of the calendar year.

Get Benefits can help you through the correction process to ensure that your company passes the test with the administrator of your cafeteria plan.