Employers often provide an array of benefits to employees. One such benefit is a Health Flexible Spending Account (Health FSA). These accounts allow employees to contribute pre-tax dollars to be used for unreimbursed medical expenses incurred during the year. Health FSAs are considered self-funded health plans and must not discriminate in favor of highly compensated employees. 

Employers often think having a non-discriminatory eligibility policy allowing all full-time employees to participate if they choose is sufficient to comply with non-discrimination requirements; however, it is much more complicated. An employer’s health FSA can violate the non-discrimination requirements, even though any employee is eligible to participate, if highly compensated employees participate in greater numbers than non-highly compensated employees. 

Because highly compensated employees typically have more discretionary income and are more likely to be looking for ways to reduce their taxable income, these employees are more likely to participate in health FSAs than employees in lower income brackets. When a higher proportion of highly compensated employees participate in the Health FSA than non-highly compensated employees the employer’s health FSA can violate the non-discrimination rules even though the employer offered the benefit on a nondiscriminatory basis. The result of a discriminatory health FSA is a loss of tax benefits to the highly compensated employees and penalties for employers who fail to tax these highly compensated employees on the discriminatory benefit.

To ensure a health FSA is not discriminating in favor of highly compensated employees, employers should have their health FSA vendor provide or arrange for non-discrimination testing. The testing vendor will run eligibility and benefits tests prescribed by the Internal Revenue Service to determine whether the health FSA has a discrimination issue. 

This article summarizes the non-discrimination tests applied to health FSAs.

Assumptions

The analysis of whether a Health FSA is discriminatory varies depending on whether the Health FSA accepts pre-tax salary contributions from employees. Health FSAs funded with employee pre-tax salary contributions must also satisfy the Section 125 plan nondiscrimination rules which vary from those in 105(h). 

For purposes of this article, we will discuss the nondiscrimination requirements as applied to Health FSAs funded through participants’ pre-tax salary contributions BUT we’ll assume these Section 125 Health FSAs can pass the non-discrimination requirements applicable under Section 125 of the Internal Revenue Code.  Thus, our analysis is limited to the applicability of Section 105(h) requirements to Section 125 Health FSAs that have successfully passed the Section 125 nondiscrimination requirements.

The following is general information about Health FSAs and is intended for educational purposes only and does not constitute legal advice.

Who are the highly compensated individuals the plan cannot discriminate favor of?

The first step in performing the Section 105(h) nondiscrimination test is determining who are the highly compensated individuals your plan cannot favor. A “highly compensated individual” is defined as:

1. One of the five highest-paid officers;
2. A shareholder owning more than 10% of the value of the employer’s stock; and
3. Among the highest paid 25% of all nonexcludable employees.

To determine who your “nonexcludable” employees are, it is first necessary to determine who is an “excludable employee.” “Excludable employees” are any of the following employees to the extent they are not eligible to participate in the Health FSA:

1. Employees who haven’t completed three years of service,
2. Employees who have not attained age 25,
3. part-time or seasonal employees,
4. Collectively bargained employees, and
5. Nonresident aliens who receive no U.S. source earned income.

If any employees in these categories are eligible to participate in the Health FSA, they would not be excludable employees. Your nonexcludable employees for purposes of determining the top 25% paid employees as well as for applying the eligibility tests below are any employees other than the excludable employees.

How do I determine if my Health FSA is discriminatory?

Once you have determined who your highly compensated individuals are, you must next determine whether your Health FSA discriminates in favor of them in either eligibility to participate or benefits offered.  The Health FSA must pass two tests in order not to be discriminatory: (a) the Benefits Test and (b) the Eligibility Test.

Benefits Test

A Health FSA passes the Benefits Test if there is no discrimination on the face of the Health FSA or in operation. A Health FSA will be discriminatory on its face if it varies benefits between highly compensated individuals and non-highly compensated individuals. 

For example, allowing a certain highly compensated individual to elect up to $2,500 in salary reductions but allowing all others to only elect up to $1,500 in salary reductions. Another example is a waiting period for participation but waiving the waiting period for a highly compensated individual. Assuming all eligible employees are treated the same, there should be no discrimination on the face of the Health FSA.

A Health FSA is discriminatory in operation if in practice the Health FSA favors highly compensated individuals. For example, if the Health FSA requires expense substantiation from participants but waives this requirement for highly compensated individuals or only allows a highly compensated individual to be reimbursed for a certain type of expense. If the Health FSA terms are applied consistently to all eligible employees, the Health FSA should not be discriminatory in operation.

Eligibility Tests

Most Health FSAs pass the Benefits Test but often have problems passing the Eligibility Test. The Eligibility Test determines whether the Health FSA is benefitting enough non-highly compensated individuals. To determine whether the Health FSA passes the Eligibility Test, the Health FSA must pass one of three alternative tests the:

1. 70% test;
2. 70%/80% test; and
3. Nondiscriminatory Classification Test 

70% Test

The 70% test requires 70% or more of all nonexcludable employees (any employees other than your excludable employees) to participate in the Health FSA. If at least 70% of your nonexcludable employees participate in the Health FSA, your plan passes the eligibility test.  For example, if an employer has 100 nonexcludable employees and 70 of them participate in the Health FSA, the 70% test is passed.

70%/80% Test

For Health FSAs who cannot pass the 70% test, they will pass if at least 70% of all nonexcludable employees are eligible to participate and 80% of the eligible nonexcludable employees actually do participate.  For example, if an employer has 100 nonexcludable employees, at least 70 of them must be eligible to participate in the Health FSA and at least 56 of the 70 who are eligible to participate must actually participate in the Health FSA.

Nondiscriminatory Classification Test

If an employer cannot pass the 70%/80% test, the last test is the Nondiscriminatory Classification test.  There are two versions of the Nondiscriminatory Classification test - a Post- TRA Fair Cross Section Test and a Pre-TRA Fair Cross Section Test.  Because the Pre-TRA Fair Cross Section Test is subjective, most testing services run only the Post-TRA Fair Cross Section Test and advise employers with Health FSAs that cannot pass the test to discuss it with legal counsel. 

The Post-TRA Fair Cross Section Test is satisfied if the employer’s eligibility policy for Health FSA participation is based on a reasonable classification using objective business criteria and the group of employees and the ratio of non-highly compensated individuals participating in the Health FSA to highly compensated individuals is 50% or more OR if less than 50% it exceeds a Safe Harbor Percentage. 

The Safe Harbor Percentage is based on the employer’s concentration percentage of non-highly compensated individuals and must be determined by consulting the table published by the IRS in Treasury Regulation §1.410(b). If the employer can’t satisfy the Safe Harbor Percentage, the nondiscrimination testing service typically advises the employer to seek outside legal counsel regarding whether it can pass the Post-TRA Fair Cross Section Test or Pre-TRA Fair Cross Section Test.

Next in the second part of this series, we’ll cover what to do if the Health FSA is discriminatory.

Notice: This article series is intended to provide general information about significant legal issues and should not be construed as legal advice regarding any specific facts or circumstances. You are encouraged to consult with appropriate legal counsel to address your specific legal questions. This article series is provided for informational purposes only.