by Susan Freed

Employers often provide an array of benefits to employees. One such benefit is a health flexible spending account (FSA), which allows employees to contribute pretax dollars to be used for unreimbursed medical expenses incurred during the year. FSAs are considered self-funded health plans and must not discriminate in favor of highly compensated employees.

Highly Compensated Employees and FSAs

Employers often think having a nondiscriminatory eligibility policy allowing all full-time employees to participate if they choose is sufficient to comply with nondiscrimination requirements, but it’s much more complicated. Even though any employee is eligible to participate, your FSA can violate nondiscrimination requirements if highly compensated employees participate in greater numbers than non-highly compensated employees.

Because highly compensated employees typically have more discretionary income and are more likely to be looking for ways to reduce their taxable income, they are more likely to participate in FSAs than employees in lower income brackets. When a higher proportion of highly compensated employees participate in an FSA than non-highly compensated employees, it can violate nondiscrimination rules even though you offered the benefit on a nondiscriminatory basis.

To ensure an FSA isn’t discriminating in favor of highly compensated employees, you should have your insurance vendor provide or arrange for nondiscrimination testing. The vendor will run eligibility and benefits tests prescribed by the IRS to determine whether the FSA has a discrimination issue.

Assumptions

The analysis of whether an FSA is discriminatory varies depending on whether it accepts pretax salary contributions from employees. FSAs funded with employee pretax salary contributions must also satisfy Internal Revenue Code Section 125’s nondiscrimination rules, which vary from those in Section 105(h).

This article will discuss the nondiscrimination requirements as applied to FSAs funded through participants’ pretax salary contributions, but we’ll assume they can pass the nondiscrimination requirements applicable under Internal Revenue Code Section 125. Thus, our analysis is limited to the applicability of Section 105(h) requirements to Section 125 FSAs that have successfully passed the Section 125 nondiscrimination requirements.

The following general information about FSAs is intended for educational purposes only and doesn’t constitute legal advice.

Who is considered a highly compensated individual? The first step in performing the Section 105(h) nondiscrimination test is determining which highly compensated individuals your plan cannot favor. A “highly compensated individual” is defined as:

• One of the five highest-paid officers;
• A shareholder owning more than 10% of the value of the employer’s stock; and
• Individuals who are among the highest paid 25% of all nonexcludable employees.

To determine who your “nonexcludable” employees are, you must first determine who is an “excludable employee.” Excludable employees are any of the following to the extent they are not eligible to participate in the FSA:

• Employees who haven’t completed three years of service;
• Employees who are younger than 25;
• Part-time or seasonal employees;
• Collectively bargained employees; and
• Nonresident aliens who receive no U.S. source-earned income.

If any employees in these categories are eligible to participate in the FSA, they would not be excludable employees.

How do I determine if my FSA is discriminatory? Once you have determined who your highly compensated individuals are, you must next determine whether your FSA discriminates in favor of them in either eligibility to participate or benefits offered. The FSA must pass two tests in order not to be discriminatory: (1) the benefits test and (2) the eligibility test.

Benefits Test

An FSA passes the benefits test if there’s no discrimination on its face or in operation. It will be discriminatory on its face if it varies benefits between highly compensated individuals and non-highly compensated individuals.

For example, allowing a certain highly compensated individual to elect up to $2,500 in salary reductions but allowing all others to elect only up to $1,500 in salary reductions would violate the nondiscrimination rules. Another example is a waiting period for participation but waiving that period for a highly compensated individual. Assuming all eligible employees are treated the same, there should be no discrimination on the face of the FSA.

An FSA is discriminatory in operation if it favors highly compensated individuals. For example, you can’t require expense substantiation from participants but waive that requirement for highly compensated individuals or allow only a highly compensated individual to be reimbursed for a certain type of expense. If the FSA terms are applied consistently to all eligible employees, the policy shouldn’t be discriminatory in operation.

Eligibility Tests

Most FSAs pass the benefits test but often have problems passing the eligibility test. The eligibility test determines whether the FSA is benefitting enough non-highly compensated individuals. To determine whether the policy passes the eligibility test, it must pass one of three alternative tests: (1) the 70% test, (2) the 70%/80% test, and (3) the nondiscriminatory classification test

70% test. The 70% test requires 70% or more of all nonexcludable employees to participate in the FSA. If at least 70% of your nonexcludable employees participate in the FSA, your plan passes the eligibility test. For example, if you have 100 nonexcludable employees and 70 of them participate in the FSA, you pass the 70% test.

70%/80% test. FSAs that can’t pass the 70% test will pass the 70%/80% test if at least 70% of all nonexcludable employees are eligible to participate and 80% of them actually do participate. For example, if an employer has 100 nonexcludable employees, at least 70 must be eligible to participate in the FSA, and at least 56 of them must actually participate.

Susan J. Freed is an attorney with Dentons Davis Brown in Des Moines, Iowa. Susan helps health care providers and health plans operate successfully in a challenging regulatory and reimbursement landscape. You can reach her at susan.freed@dentons.com.