Employers offering health benefit plans must ensure those plans comply with non-discrimination rules under the IRS code. These rules are designed to ensure that highly compensated employees (HCEs), key employees, and owners don’t receive disproportionate benefits compared to rank-and-file employees. To prove compliance, businesses must perform Non-Discrimination Testing (NDT) annually.
Failing these tests can lead to serious consequences, including tax penalties and plan disqualification. In this article, we’ll break down what non-discrimination testing is, why it’s important, and share examples and common scenarios of penalties companies have faced when they failed to comply.
What Is Non-Discrimination Testing?
Non-Discrimination Testing is a series of tests required by the IRS for various health benefit plans, including Health FSAs, HSAs, HRAs, self-insured health plans, and cafeteria plans. The goal is to prevent employers from favoring certain groups of employees over others, ensuring fair access to benefits.
Plans Subject to NDT Include:
Health Flexible Spending Accounts (FSAs)
Dependent Care Assistance Programs (DCAPs)
Health Reimbursement Arrangements (HRAs)
Self-Insured Medical Plans
Who Are Highly Compensated Employees (HCEs)?
An employee is considered an HCE if they meet one of the following criteria:
An Employee earning above the IRS-defined threshold ($150,000 for 2024)
An Employee owning more than 5% of the company
Family attribution rules apply when an employee is also related to an HCE. This can include a spouse, children, parents, and grandparents.
Why Is Non-Discrimination Testing Important?
Avoid Tax Penalties
If your plan fails NDT, benefits provided to HCEs may become taxable income. This can result in unexpected tax liabilities for both the company and affected employees. There could also be additional penalties for ERISA or ACA Violations.
Prevent Plan Disqualification
In severe cases, failing NDT can lead to the entire plan being disqualified by the IRS, which may invalidate the tax-advantaged status of all benefits provided.
Promote Fairness and Transparency
Non-discrimination rules are designed to ensure all employees have equal access to benefits, fostering a more equitable workplace.
Maintain Regulatory Compliance
Regular testing ensures your organization remains compliant with IRS regulations, avoiding audits and legal complications.
Potential Real-Life Examples and Common Penalties for Non-Compliance
While specific companies penalized for failing non-discrimination testing are rarely made public, the IRS has clear guidelines on the consequences of non-compliance. Here are some hypothetical examples based on common industry scenarios:
Tech Company with 150 Employees Faces $250,000 in Unexpected Taxes
A mid-sized tech company offered generous Health FSAs but failed to monitor contributions from HCEs. After an IRS audit, they discovered that their plan disproportionately favored executives. The company had to pay $250,000 in taxes and penalties, and several executives faced additional personal tax liabilities.
Penalty Breakdown:
$150,000 in back taxes for misclassified benefits provided to HCEs over two plan years.
$50,000 in IRS penalties for late reporting and non-compliance, calculated at $100 per day per affected employee (approximately 10 executives over 50 days).
$50,000 in interest accrued over two years of non-compliance, based on IRS interest rates.
Remedial Actions:
The company had to adjust future FSA contribution limits to ensure compliance.
They conducted mandatory non-discrimination training for HR and benefits teams.
Implemented quarterly internal audits to proactively monitor compliance going forward.
Small Business with 30 Employees Has Cafeteria Plan Disqualified
A small business owner unknowingly structured their Section 125 Cafeteria Plan to favor key employees. Upon failing NDT, the IRS disqualified the plan, and all employees’ pre-tax contributions were reclassified as taxable income, resulting in disgruntled employees and financial strain on the business.
Penalty Breakdown:
$35,000 in additional payroll taxes due to reclassification of pre-tax contributions across all employees.
$10,000 in fines for failure to comply with Section 125 requirements, calculated at $50 per day per affected employee for non-compliance over two months.
Remedial Actions:
The business had to reimburse employees for unexpected tax liabilities.
They restructured the cafeteria plan to meet non-discrimination standards.
Implemented annual non-discrimination testing to prevent future issues.
Large Manufacturer with 250 Employees Hit with $500,000 in Penalties
A large manufacturing company failed to test its self-insured medical plan, which heavily favored upper management. After a random IRS audit, the company was slapped with $500,000 in penalties and had to restructure its benefits program immediately to avoid future issues.
Penalty Breakdown:
$300,000 in excise taxes for discriminatory practices, based on $100 per day per non-HCE affected by reduced benefits over a six-month period.
$100,000 in legal fees and compliance consulting to correct plan structure and defend against IRS claims.
$100,000 in interest and additional fines for delayed corrections, calculated according to IRS penalty rates for late compliance
Remedial Actions:
The company had to revise its benefits eligibility criteria to ensure equitable distribution.
Implemented a comprehensive compliance program with regular audits.
Provided training for HR staff on non-discrimination regulations and best practices.
Note: These examples are illustrative and based on common compliance issues seen in the industry. For specific guidance on IRS enforcement and penalties, refer to IRS Non-Discrimination Rules.
How to Stay Compliant with Non-Discrimination Testing
Conduct Annual Testing
Ensure that NDT is part of your annual compliance routine. It’s best to test early in the year to allow time for corrections if needed.
Monitor Plan Design
Work with benefits administrators to ensure that your plans are designed to pass NDT. Avoid offering benefits that disproportionately favor HCEs.
Adjust Contributions if Necessary
If testing reveals potential issues, adjust employer contributions or modify plan eligibility criteria to achieve compliance.
Partner with Compliance Experts
Working with a third-party administrator like MoneyWise can simplify the process, ensuring that your health benefit plans are tested properly and remain compliant.
How MoneyWise Can Help
At MoneyWise, we specialize in helping businesses navigate the complexities of Non-Discrimination Testing. Our services include:
Comprehensive NDT Administration: We handle all aspects of testing to ensure compliance.
Plan Design Consulting: We help you structure your benefits to minimize the risk of failing.
Corrective Strategies: If your plan fails, we’ll guide you through the steps to correct it and avoid penalties.
Stay compliant and protect your business from costly penalties with MoneyWise. Contact us today to learn more about how we can support your compliance needs.
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