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Non-discrimination testing

Non-discrimination testing is a method you can use to make sure your benefits don’t favor highly compensated or key employees. For Flexible Spending Accounts (FSAs), a common test to use is the key employee concentration test. For Dependent Care Flexible Spending Accounts (DCFSA), both the key employee concentration test and the average benefits test are commonly used. You are encouraged to check with your tax expert and/or legal counsel to confirm which tests are necessary for your company.

We suggest that you run non-discrimination tests three times during your policy year to avoid any issues with the IRS:

  1. After open enrollment. Results at this time will confirm if you’re likely to pass before your benefit policy year begins.

  2. 2-3 months before your next renewal. Results at this time will confirm if you’re likely to pass at the end of the policy year.

  3. End of the policy year. Results at this time will confirm if you’ve passed for the past policy year.

If you have concerns about failing these tests throughout the policy year, you should check with your tax expert and/or legal counsel to determine which of the options below is best for you and then reach out to our team so we can help make changes to your benefits. Here’s what we may recommend:

  1. The highly compensated employee(s) and/or key employees can lower or remove their contribution amount.

  2. Other non-highly compensated employees can enroll, which could make the balance of participation more equally distributed across employees.

  3. If your company fails the test at the end of the policy year, you may need to change some or all contributions to be post-tax, meaning those employees would pay taxes on their benefit contributions and employers would owe payroll taxes in association with those contributions.

Key employee concentration testing

The key employee concentration test requires that, of your employees’ total annual benefit amount, 25% or less of this amount comes from your key employees’ benefit totals. The total annual benefit amount includes pre-tax premiums of all lines of coverage, such as medical, dental, and vision, for both employees and dependents. If none of your company’s key employees opt in to the Health FSA, your company passes this test automatically.

If key employees account for greater than 25% of the total annual benefit amount, you are likely to fail the key employee concentration test at the end of your policy year

A key employee, is defined by the IRS as:

  • An officer having an annual pay of more than $175,000, OR

  • An employee or officer who for the length of the policy year is either of the following:

    • A 5% or greater owner of the business, OR

    • A 1%-4.99% owner of the business whose annual pay is more than $150,000.

Average benefits testing

The average benefits test applies in a variety of situations, but for Gusto customers it’s especially important for DCFSAs. This test requires that the average election amount for the DCFSA of non-highly compensated employees be at least 55% of the average contribution amount for the DCFSA of highly compensated employees.

It can be difficult to predict whether your company may pass or fail this test until open enrollment is over, as it is based solely on your employees’ choice to opt into (or out of) the Dependent Care FSA.  It can also be difficult to predict throughout the duration of your policy year, as any new hires opting in (or terminated employees losing this benefit), can also affect your pass/fail result at the end of your policy year.

A highly compensated employee, as defined by the IRS, is identified as an employee:

  • Who owns more than 5% of the outstanding stock or total voting power of a corporation or 5% of capital profits interest if not a corporation at any time during the policy year, OR

  • For the preceding year, received >$120,000 in compensation OR

  • For the preceding year, was among the top 20% of employees in terms of compensation paid.

If everyone at your company owns more that 5% of the company and/or the majority of the team earns more than $120k, the DCFSA may not be the best benefit for your company.

Employees who satisfy the following criteria do not count toward the top-paid group:

  • Have not completed 6 months of service, OR

  • Normally work less than 17.5 hours per week, OR

  • Normally work not more than 6 months during any year, OR

  • Are under 21 years of age.

Note: This article is for general and educational reference only and is accurate as of April 1, 2019. Since IRS laws are complex and change frequently, we'd recommend working with a tax professional to perform non-discrimination testing.

Here is some additional information on the specific IRS regulations pertaining to non-discrimination testing: