QUESTION: Our company offers a cafeteria plan with a health FSA, and we are thinking about redesigning the health FSA for next year. What are some health FSA design and operational issues to watch out for to comply with the Benefits Test under Code § 105(h)?
ANSWER: The Benefits Test requires that health FSA benefits not discriminate in favor of participants who are highly compensated individuals (HCIs). An HCI is an individual who is (1) one of the five highest-paid officers; (2) a shareholder who owns (with the application of certain ownership attribution rules) more than 10% of the value of the employer’s stock; or (3) among the highest-paid 25% of all employees (with certain exclusions). The Benefits Test prohibits discriminatory benefits both on the face of the plan and in actual operation.
Here are some things to watch out for to avoid discriminatory benefits on the face of the plan:
The required employee contributions must be identical for each benefit level. For example, if, under your company’s health FSA, non-HCIs who contribute $2,400 per year receive $2,400 of coverage, but HCIs who contribute $2,400 per year receive $3,000 of coverage, the health FSA would fail the Benefits Test.
The maximum benefit level that can be elected cannot vary based on age or years of service. Thus, providing a higher level of benefits (e.g., more coverage for certain individuals, lower contributions for the same coverage, etc.) for individuals based on their age could violate the Benefits Test if any of them are HCIs. A similar problem is created by linking benefits to years of service. For example, if your company makes a contribution to each participant’s health FSA equal to $20 multiplied by each year of employment or $300, whichever is less, some HCIs with long tenure would receive more benefits than non-HCIs would, and your health FSA would fail the Benefits Test.
The type or amount of benefits subject to reimbursement cannot depend on employee compensation. For example, a health FSA that limits the annual amount of reimbursement available to employees to a percentage of their compensation would violate the Benefits Test if HCIs participate.
The same types of benefits (e.g., reimbursable medical expenses) available to HCIs must be available to non-HCIs on at least as favorable terms. For example, a health FSA cannot exclude orthodontia expenses for non-HCIs while covering them for HCIs.
Health FSAs cannot impose disparate waiting periods. Thus, your health FSA could not require non-HCIs to wait 30 days to enter the plan, while allowing HCIs to enter the plan immediately.
A health FSA also must not discriminate in favor of HCIs in actual operation, and this is a “facts and circumstances” determination. Such discrimination might arise, for example, if the administrator approves certain claims submitted by HCIs while denying similar claims for non-HCIs (e.g., by requiring less substantiation from HCIs than from non-HCIs without having justifiable reasons for treating their claims differently).
The plan features described above are only examples, and other features may cause a health FSA to fail the Benefits Test. If the plan does not pass the Benefits Test, then amounts considered to be “excess reimbursements” will not be excludable from HCIs’ income. (Non-HCIs will not lose their tax exclusion, however, and the health FSA will remain a valid Code § 105(h) plan.) Your company’s health FSA is also subject to an Eligibility Test under Code § 105(h) and is indirectly subject to the Code’s nondiscrimination rules for cafeteria plans. Because the Code’s nondiscrimination requirements are complex and need careful monitoring, many employers consult a third-party administrator or other advisor for assistance.
For more information, see EBIA’s Cafeteria Plans manual at Section XXXI (“Health FSA Nondiscrimination Rules”). See also EBIA’s Self-Insured Health Plans manual at Section XII (“Nondiscrimination Rules Under Code §105(h)”). You may also be interested in our upcoming webinars “Cafeteria Plan Nondiscrimination Rules: Design and Testing Fundamentals” (live on 5/23/18) and “Health FSA and DCAP Nondiscrimination Rules: Design and Testing Fundamentals” (live on 6/7/18).
Contributing Editors: EBIA Staff.