What Is Section 125 Non-Discrimination Testing for Cafeteria Plans?

Section 125 non-discrimination testing is a compliance requirement for cafeteria plans under the Internal Revenue Code. The purpose of these tests is to ensure that tax-advantaged benefits offered through the plan do not disproportionately favor highly compensated employees (HCEs) or key employees at the expense of non-highly compensated employees (NHCEs). Without proper testing, employers risk losing the favorable tax status of their cafeteria plans, leading to significant tax implications for certain participants.

Cafeteria plans allow employees to choose between cash compensation (taxable) and qualified benefits (tax-free), such as health insurance premiums, flexible spending accounts (FSAs), or dependent care benefits. To comply with Section 125, plans must pass three key tests:

1. Eligibility Test: This test ensures that a sufficient number of NHCEs are eligible to participate in the plan. It examines whether the plan discriminates against NHCEs in terms of eligibility criteria.
2. Contributions and Benefits Test: This test checks whether the contributions and benefits offered under the plan are uniformly available to all participants, without favoring HCEs or key employees.
3. Key Employee Concentration Test: This test ensures that key employees (such as company officers, employees earning above a certain threshold, or significant shareholders) do not receive more than 25% of the plan’s total benefits.

If a cafeteria plan fails any of these tests, the tax-advantaged benefits enjoyed by HCEs or key employees may become taxable, reducing the value of the plan for these individuals. For employers, compliance failures can attract IRS scrutiny and damage employee trust in their benefits program.

Employers should conduct Section 125 non-discrimination testing annually, ideally before the end of the plan year. Changes to employee populations, benefit structures, or contributions throughout the year can impact compliance, making it critical to monitor regularly. Many employers use third-party administrators or specialized compliance software to manage the complexities of testing and ensure their plans meet regulatory requirements.

By adhering to Section 125 non-discrimination rules, employers can protect the tax benefits of their cafeteria plans, maintain compliance, and promote equitable access to valuable employee benefits.

References

1. Internal Revenue Code § 125. Retrieved from https://www.law.cornell.edu/uscode/text/26/125
2. Internal Revenue Service. (n.d.). Cafeteria Plan Nondiscrimination Rules. Retrieved from https://www.irs.gov/pub/irs-pdf/p15b.pdf
3. Society for Human Resource Management. (2023). Section 125 Plans: Compliance Tips for Employers. Retrieved from https://www.shrm.org
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