Many employers are familiar with the term “nondiscrimination testing,” but fewer understand what actually happens when a cafeteria plan fails one of the required tests. Because cafeteria plans allow employees to pay for certain benefits on a pre-tax basis, IRC §125(b) requires employers to ensure those tax advantages do not disproportionately favor highly compensated employees (HCEs) or key employees.
The good news is that a failed test does not usually invalidate the entire plan for everyone. In most cases, the tax consequences fall only on the employees in the group the rules are designed to police, such as highly compensated employees.
The purpose of nondiscrimination testing is to confirm that a cafeteria plan operates fairly across employee groups. The IRS does not want plans structured so that owners, executives, or other highly compensated employees receive most of the tax advantages while rank-and-file employees are excluded or do not receive comparable access to benefits.
Under IRC §125(b), there are three main cafeteria plan nondiscrimination tests:
- Eligibility Test: The plan cannot discriminate in favor of highly compensated individuals regarding who is allowed to participate.
- Contributions and Benefits Test: The plan cannot discriminate in favor of highly compensated participants in how contributions or benefits are provided. In addition, HCE utilization of benefits cannot be disproportionately greater than non-HCE utilization.
- Key Employee Concentration Test: Key employees cannot receive more than 25% of the total qualified benefits provided under the plan.
Each test evaluates the plan from a different angle, but all are designed to support the same goal: broad, nondiscriminatory access to tax-favored benefits.
When a cafeteria plan fails nondiscrimination testing, the most significant impact is typically on the highly compensated employees or key employees who benefited from the discriminatory arrangement. In most cases, the plan itself does not lose its tax-favored status for all employees. Instead, the affected highly compensated or key employees may lose the ability to receive certain benefits on a pre-tax basis.
As a result, amounts previously excluded from taxable income may need to be added back into the affected employee’s taxable wages. Depending on the situation, those amounts could become subject to federal income tax, Social Security tax, Medicare tax, and potentially additional payroll reporting corrections.
For employers, a failed test can also create administrative challenges. Payroll corrections may be required, W-2 adjustments may need to be issued, and additional communication with affected employees may become necessary. In some situations, employers may also need to review plan design elements contributing to repeated failures, such as eligibility structures, contribution strategies, or owner participation levels.
One of the more common issues occurs with owner-heavy groups or smaller employers where highly compensated employees participate at significantly higher rates than non-highly compensated employees. Plans may also encounter problems when eligibility provisions unintentionally exclude large groups of employees or when employer contribution structures disproportionately favor leadership employees.
It is also important to remember that nondiscrimination testing is not simply a year-end formality. Testing results often reflect broader operational or plan design issues occurring throughout the year. Waiting until the end of the plan year to review participation trends can limit opportunities for correction and lead to more difficult adjustments later.
Employers can often reduce the risk of failed testing through proactive planning and regular review of eligibility, payroll data, employee classifications, and contribution structures. Accurate census information and properly maintained plan documents also play an important role in supporting compliant plan administration.
Failing cafeteria plan nondiscrimination testing can sound alarming, but it is often manageable when identified early. In most cases, the impact is not that the entire plan collapses; rather, the tax consequences are focused on the highly compensated participants or key employees who benefited from the discriminatory result.
For employers, the key is to understand that nondiscrimination testing under IRC §125(b) is both a compliance exercise and a plan design checkpoint. With regular reviews and timely corrections, many issues can be identified before they become larger payroll or employee-relations problems.
