A Section 125 plan, or a cafeteria plan, allows employers to provide their employees with a choice between cash and certain qualified benefits without adverse tax consequences. To receive this tax advantage, the cafeteria plan must generally pass the following three nondiscrimination tests:
- Eligibility to participate test;
- Benefits and contributions test; and
- Key employee concentration test.
These tests are designed to ensure that the plan does not discriminate in favor of highly compensated employees. If a cafeteria plan fails to pass nondiscrimination testing, highly compensated employees lose the tax benefits of participating in the plan (that is, they must include the benefits or compensation in their income). However, even if a cafeteria plan is discriminatory, non-highly compensated employees will not lose the tax benefits of participating in the plan.
Certain exceptions and safe harbors apply to the cafeteria plan nondiscrimination tests. Also, additional nondiscrimination tests apply to specific benefits that may be offered under a cafeteria plan, such as health flexible spending accounts (FSAs) and dependent care FSAs.
This Nondiscrimination Tests for Cafeteria Plans Legislative Brief provides a general overview of the three nondiscrimination tests for cafeteria plans. It does not cover all of the detailed testing rules. Because these tests are so complex, employers should work with their benefit advisors or legal counsel when performing cafeteria plan nondiscrimination testing.
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