Question: What are the main Section 125 nondiscrimination rules that apply for imposing different health plan contribution structures for certain employee groups?
Compliance Team Response:
In general, employers will run into Section 125 nondiscrimination issues where they charge the highly compensated participants less for the same plan option than those who are not highly compensated. This is because employee pre-tax contributions for coverage are governed by Section 125 of the Internal Revenue Code.
Highly Compensated Participants
The Section 125 nondiscrimination rules are designed to (among other things) make sure that contributions and benefits are available on a nondiscriminatory basis, and that highly compensated participants (HCPs) do not select more nontaxable benefits than non-HCPs do. An HCP is generally defined as an officer, 5% shareholder, or employee earning more than $120,000 in the prior year.
The regulations implementing the Section 125 nondiscrimination rules have been in proposed form since 2007, however the IRS has advised to rely on them as is until they are finalized.
Uniform Election Requirement
The Section 125 rules require that employers provide a “uniform election with respect to employer contributions.”
A contribution structure that charges more to certain non-HCPs for the same benefit (whether for employee or dependent coverage) does not provide a “uniform election with respect to employer contributions.” This means that all full-time non-HCP employees eligible for the same plan option as an HCP must be offered at least the same employer contribution amount that is available to the HCPs for that plan.
However, there are limited exceptions to this requirement for different geographical regions of employee groups and different divisions described below.
Exception: Employees in Different Geographical Locations
The general rule described above applies to “similarly situated participants.” In other words, the employer generally cannot provide a greater contribution for any HCP than any non-HCPs who are “similarly situated participants” eligible for the same plan option.
This means that the employer is permitted to provide a greater contribution to certain employees (even if some of them are HCPs) as long as any non-HCPs participating in the same plan option and receiving the lower employer contribution rate are not “similarly situated.”
The definition of “similarly situated” permits the employer to categorize employee groups based on reasonable differences in plan benefits. The primary example they use is employees in different geographical locations. This means the employer may have different contribution structures for different employee groups by region.
Exception: Different Cafeteria Plans for Separate Divisions
Although it is not entirely clear from the rules, it appears that employers with multiple EINs for subsidiaries, divisions, or other related entities within the same controlled group may devise separate contribution structures under separate Section 125 cafeteria plans for different divisions participating in the same underlying health benefits.
This approach isn’t needed if the different divisions are different regions (see above). However, there may be cases where there are differences in contributions structures for divisions that are in the same region. In that case, the rules appear to permit employers to create a separate cafeteria plans for each entity with separate contribution structures.
There is an argument that separate cafeteria plans are not needed for this purpose. In other words, some argue that the contributions and benefits provided for each division within a cafeteria plan can be disaggregated and tested separately. There is some support in the regulations for that approach in very narrow circumstances. However, because it is rather easy to create a separate cafeteria plan for each group, the better approach would be to do so.
Effect of Discriminatory Plan
If the IRS were to audit the company’s Section 125 cafeteria plan and find the contribution structure to be discriminatory, HCPs would be taxed on all contributions for coverage. For example, an HCP who paid $1,500/month for family coverage would retroactively have those contributions re-characterized as taxable—within the three-year statute of limitations period.
Application of Section 125 Nondiscrimination Rules
These Section 125 nondiscrimination rules apply to all employers regardless of size, and they are not related to the ACA.
The ACA did add new nondiscrimination rules for fully insured plans that have not yet taken effect. However, those pending new ACA rules (which are not likely to take effect soon, and may never take effect) are not the issue here because this is an employee contribution issue. Those ACA fully insured plan nondiscrimination rules would prevent, for example, offering a superior fully insured benefit that’s available only to executives.
There is never any issue with providing a greater taxable salary/wage to employees. If these employees were paid a greater amount intended to cover the full cost of coverage, the employee could then make an election to apply that extra amount on a pre-tax basis to the employee-share of the premium.
The relevant Section 125 regulations are below for reference.
Prop. Treas. Reg. §1.125-7(c):
(c) Nondiscrimination as to contributions and benefits.
(1) In general. A cafeteria plan must not discriminate in favor of highly compensated participants as to contributions and benefits for a plan year.
(2) Benefit availability and benefit election. A cafeteria plan does not discriminate with respect to contributions and benefits if either qualified benefits and total benefits, or employer contributions allocable to statutory nontaxable benefits and employer contributions allocable to total benefits, do not discriminate in favor of highly compensated participants. A cafeteria plan must satisfy this paragraph (c) with respect to both benefit availability and benefit utilization. Thus, a plan must give each similarly situated participant a uniform opportunity to elect qualified benefits, and the actual election of qualified benefits through the plan must not be disproportionate by highly compensated participants (while other participants elect permitted taxable benefits). Qualified benefits are disproportionately elected by highly compensated participants if the aggregate qualified benefits elected by highly compensated participants, measured as a percentage of the aggregate compensation of highly compensated participants, exceed the aggregate qualified benefits elected by nonhighly compensated participants measured as a percentage of the aggregate compensation of nonhighly compensated participants. A plan must also give each similarly situated participant a uniform election with respect to employer contributions, and the actual election with respect to employer contributions for qualified benefits through the plan must not be disproportionate by highly compensated participants (while other participants elect to receive employer contributions as permitted taxable benefits). Employer contributions are disproportionately utilized by highly compensated participants if the aggregate contributions utilized by highly compensated participants, measured as a percentage of the aggregate compensation of highly compensated participants, exceed the aggregate contributions utilized by nonhighly compensated participants measured as a percentage of the aggregate compensation of nonhighly compensated participants.
Prop. Treas. Reg. §1.125-7(e)(2):
(2) Similarly situated. In determining which participants are similarly situated, reasonable differences in plan benefits may be taken into account (for example, variations in plan benefits offered to employees working in different geographical locations or to employees with family coverage versus employee-only coverage).
Prop. Treas. Reg. §1.125-7(g):
(g) Permissive disaggregation for nondiscrimination testing.
(1) General rule. If a cafeteria plan benefits employees who have not completed three years of employment, the cafeteria plan is permitted to test for nondiscrimination under this section as if the plan were two separate plans—
(i) One plan benefiting the employees who completed one day of employment but less than three years of employment; and
(ii) Another plan benefiting the employees who have completed three years of employment.
(2) Disaggregated plans tested separately for eligibility test and contributions and benefits test. If a cafeteria plan is disaggregated into two separate plans for purposes of nondiscrimination testing, the two separate plans must be tested separately for both the nondiscrimination as to eligibility test in paragraph (b) of this section and the nondiscrimination as to contributions and benefits test in paragraph (c) of this section.
Prop Treas. Reg. §1.125-7(m)(2):
(m) Tax treatment of benefits in a cafeteria plan.
(1) Nondiscriminatory cafeteria plan. A participant in a nondiscriminatory cafeteria plan (including a highly compensated participant or key employee) who elects qualified benefits is not treated as having received taxable benefits offered through the plan, and thus the qualified benefits elected by the employee are not includible in the employee’s gross income merely because of the availability of taxable benefits. But see paragraph (j) in §1.125-1 on nondiscrimination rules for sections 79(d), 105(h), 129(d), and 137(c)(2), and limitations on exclusion.
(2) Discriminatory cafeteria plan. A highly compensated participant or key employee participating in a discriminatory cafeteria plan must include in gross income (in the participant’s taxable year within which ends the plan year with respect to which an election was or could have been made) the value of the taxable benefit with the greatest value that the employee could have elected to receive, even if the employee elects to receive only the nontaxable.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).