'Tis the season for nondiscrimination testing (NDT). But what is that exactly? Is it required for your business? See below for answers to some common FAQs regarding NDT.
What is nondiscrimination testing?
Cafeteria plans, health flexible spending accounts (FSAs), dependent care assistance programs (DCAPs), and health reimbursement arrangements (HRAs) allow employers and participants to enjoy tax advantages by using them. However, the tax advantages for certain highly compensated participants are contingent on these plans meeting certain nondiscrimination requirements. Specifically, the IRS created a series of tests designed to make sure that certain highly compensated participants don’t use or select more nontaxable (pre-tax) benefits than rank-and-file, or ‘non-highly compensated’, employees and that eligibility, contributions, and benefits are available to all employees on a uniform and nondiscriminatory basis.
Is this required?
Yes. In order to document a plan is in compliance, an annual test must be performed, and the results documented for each plan. Because corrections cannot be made after the end of the plan year, the impact and cost of learning a plan failed nondiscrimination testing in previous plan years can be significant.
What happens if my plan fails the tests?
The nondiscrimination tests for cafeteria plans, health FSAs, DCAPs, and HRAs cannot be passed by making corrections after the end of the plan year. Benefits that fail the nondiscrimination test are included in gross income for highly compensated participants when they would have been nontaxable if the plan benefits had passed the nondiscrimination tests. In other words, the tax-free treatment of benefits provided under the plan is lost, and highly compensated participants will have imputed income equal to the salary reductions that they elected for the plan year, even if they elected all qualified benefits.
The employer must treat the amount of highly compensated employees’ salary reductions as taxable income for W-2 reporting and for income tax, FICA, and FUTA withholding. That means that if the IRS discovers that your plan was discriminatory over a period of several years then there will have to be amended W-2s (and amended tax filings) for every highly compensated participant in every year the plan was out of compliance.
Is there any way to fix my plan during the current year?
Yes. The good news, if a discrimination testing problem is discovered during the plan year, the highly compensated participants' elections can be reduced to make sure the plan passes the tests.
When should plans be tested?
The plan tests must be passed as of the last day of the plan year. As a general rule, however, we recommend that testing should also be performed several months before the end of the plan year. At the mid-plan year, the employer can consider actual data for part of the year, including new hires, permissible midyear election changes, terminations, etc. As mentioned above, if there are any testing problems discovered when the plan is tested mid-plan year, the employer still has time to make corrections before the end of the plan year.
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Disclaimer: Please note that this is not all inclusive. Our guidance is designed only to give general information on the issues actually covered. It is not intended to be a comprehensive summary of all laws which may be applicable to your situation, treat exhaustively the subjects covered, provide legal advice, or render a legal opinion. Consult your own legal advisor regarding specific application of the information to your own plan.
Editor’s Note: This post was originally published in November 2017 and has been updated for freshness, accuracy, and comprehensiveness.