Can Your Cafeteria Plan Pass the Test?

Over the past year, we have noticed the trickle-down impact of the increased cost of living due to inflation on the benefits elected through a cafeteria plan. More specifically, the benefits elected by highly compensated participants (HCPs) have remained steady or increased, while those chosen by non-highly compensated participants (NHCPs) have decreased. This trend can cause the cafeteria plan to fail the contribution and benefits test, meaning all benefits provided through the plan for HCPs are taxed as additional income.  

As we enter the fourth quarter of the calendar year, now is the time to test your cafeteria plan and make the necessary adjustments through payroll by year-end if the plan fails this nondiscrimination test. After year-end, it is too late to make any plan corrections, and corrected W-2s may need to be issued to the HCPs, depending on the timing of the testing. 

The Cafeteria Plan Section 125 

Under Section 125, a cafeteria plan must pass eligibility, contributions, and concentration tests for HCPs to receive tax-free benefits. However, failing to meet the nondiscrimination requirements does not affect NHCPs. While several tests exist to promote compensation and workplace equality, the contribution and benefits test makes sure HCPs and NHCPs receive fair and equal treatment.  

HCPs 

HCPs include the following individuals: 

• An officer; 
• A shareholder owning more than 5 percent of the voting power or value of all classes of
• stock of the employer; 
• Highly compensated; or 
• A spouse or dependent of a person described above. 

Employees are "highly compensated" if their compensation exceeds a specific threshold for the previous year. This threshold is $150,000 for 2023 and $155,000 for 2024.  

The End and Outs of the Contribution and Benefits Test  

The contribution and benefits test is part of a series of nondiscriminatory tests required for specific employee benefit programs. This test makes sure that HCPs are not given taxable advantages or increased opportunities compared to NHCPs. 

The test requires that the cafeteria plan satisfies the contribution and benefits test by meeting the three requirements: availability, utilization, and nondiscriminatory operation.  

The Availability Requirement  

For a cafeteria plan to meet the availability requirement, the employer must prove that employer contributions and benefits are equally accessible to everyone. Typically, a cafeteria plan must offer all eligible participants the same qualified benefits at the same cost. 

The Utilization Requirement  

The utilization requirement analyzes whether HCPs elect benefits to a greater extent than NHCPs in proportion to their compensation. A plan would likely fail this test if benefits were so expensive that only highly compensated participants could afford to elect the benefits.  

For example, as health insurance premiums continue to increase faster than inflation, a significant portion of NHCPs waive coverage, resulting in a disproportionate percentage of benefits going to the HCPs and causing the test to fail. While the test aggregates all benefits elected (health, dental, vision, health FSA, and dependent care), mounting health insurance premiums significantly impact the test. 

Nondiscrimination in Operation 

The plan may not operate favorably toward HCPs. For example, a cafeteria plan may be discriminatory if the duration of a benefit offered through the plan is for a period during which only HCPs utilize the benefit. 

The Safe Harbor Rule  

Suppose the test fails and the plan provides major medical benefits (as most plans do). In that case, the employer can perform an alternative test to determine whether reducing HCPs' benefits is necessary. 

The Code contains a special safe harbor rule for cafeteria plans that provide health benefits. The rule provides that a cafeteria plan offering health benefits is not discriminatory if: 

• Contributions under the plan on behalf of each participant include an amount which –  
  
  • Equals 100 percent of the cost of the health benefits coverage under the plan of the majority of the highly compensated participants similarly situated, or 
  • Equals or exceeds 75 percent of the cost of the health benefit coverage of the participant (similarly situated) having the highest cost health benefit coverage under the plan. 
• Contributions or benefits under the plan are more than those that bear a uniform relationship to compensation. 

Understanding the Contribution and Benefits Test 

Let’s assume that the employer’s cafeteria plan covers 5 HCPs and 160 NHCPs. Furthermore, the plan provides primary medical insurance and a health FSA as benefits. The HCPs elect $120,000 in aggregated benefits and earn $1 million in compensation. This gives a benefit to compensation ratio of 12%. Meanwhile, the NHCPs elect $1 million in aggregated benefits, earning $10 million in compensation. This gives an advantage to the compensation ratio of 10%. The test failed since the compensation ratio of the HCPs exceeds the compensation ratio of the NHCPs. 

However, suppose the employer reduces the HCP's benefits by $4000 each or $20,000. In that case, the HCP’s benefit-to-compensation ratio is reduced to 10%, and the contribution and benefits test is passed. Other benefit reduction methods, such as the pro rata method, are permissible.  

Testing for Future Success  

Employers must realize the importance of the cafeteria plan nondiscrimination tests when creating compensation and benefit guides. With the new year approaching quickly, avoid getting lulled into believing that your cafeteria plan does not need any testing. Now is the time to perform your tests, ask questions, and make impactful changes to keep your organization compliant with the IRS. Contact us below for more information on cafeteria plans, contribution and benefits testing, or other nondiscriminatory tests.