Flexible Spending Accounts (FSAs) and Dependent Care Accounts are valuable employee benefits offered by many employers to assist workers with managing healthcare and dependent care expenses. However, to ensure these accounts comply with regulations and aren’t unfairly advantageous to higher-paid employees, discrimination testing is mandated by the Internal Revenue Service (IRS).
Purpose of Discrimination Testing
The primary aim of discrimination testing is to prevent discrimination in favor of highly compensated employees (HCEs) in employer-sponsored benefit plans. It ensures that FSAs and Dependent Care Accounts don’t disproportionately benefit higher-income employees compared to lower-income individuals.
Types of Discrimination Testing
Section 125 Nondiscrimination Testing
For FSAs offered under Section 125 of the Internal Revenue Code, employers must conduct two main tests:
The Eligibility Test: This evaluates if the plan benefits a broad cross-section of employees. It checks if enough non-highly compensated employees (NHCEs) participate compared to HCEs.
The Benefits Test: It ensures that contributions and benefits provided to HCEs aren’t disproportionately higher than those provided to NHCEs.
Dependent Care Assistance Program (DCAP) Testing
For Dependent Care Accounts, testing involves assessing contributions and benefits to confirm they’re not biased towards HCEs. This ensures the plan doesn’t favor executives or top earners over other employees.
Discrimination Testing Methods
Actual Contribution Percentage (ACP) Test: Compares the percentage of FSA contributions made by HCEs to those made by NHCEs. If the ratio exceeds a certain limit, the plan might fail the test.
Actual Deferral Percentage (ADP) Test: Examines the deferral rates into FSAs by HCEs and NHCEs. Similarly, if HCEs contribute significantly more compared to NHCEs, it could indicate discrimination.
Dependent Care Testing: Evaluates the usage and benefits provided through the Dependent Care Account to ensure it doesn’t disproportionately benefit HCEs. The average DCAP benefits provided to the non-HCEs under all plans of the employer must be at least 55 percent of the average benefits provided to HCEs under all plans of the employer. This test ensures that HCEs do not participate disproportionately and focuses on the average (per capita) benefit received by HCEs as compared to that received by non-HCEs. If the non-HCE average is not at least 55 percent of the HCE average, the plan fails this test.
Consequences of Failure
If discrimination testing indicates a plan favors HCEs excessively, the employer might need to take corrective actions. Failure to correct the discrimination could result in penalties or the disqualification of the plan, impacting both the employer and employees.
Mitigation Strategies
Employers can adopt various strategies to avoid discrimination issues, such as adjusting contribution limits, offering matching contributions, educating employees about benefits, or restructuring plan designs.
Conclusion
Discrimination testing for FSAs and Dependent Care Accounts is essential to ensure these benefits are fairly distributed among employees. Compliance with IRS regulations through proper testing methods helps employers maintain the tax advantages of these plans while providing equitable benefits to their workforce. Employers should regularly conduct these tests and implement corrective actions if necessary to avoid penalties and maintain the integrity of their benefit plans.
Are your FSAs and DCAs compliant with IRS regulations? Ensure fairness and avoid penalties with discrimination testing from Kona HR. Contact us today to safeguard your benefits and maintain tax advantages!
