For HR practitioners, it’s not always possible (or practical) to follow a strict interpretation of the rules and regulations. In reality, in some cases, it’s appropriate to weigh the potential risks of making an exception or of not fully complying against the effort, cost, and potential impact of doing exactly what the rules require.
Today, we are exploring whether employers can differentiate health and welfare benefit offerings for different employees.
If you are short on time, read this:
Technical answer: Assuming the benefits are being offered on a tax-favored basis, employers may offer differing benefits to different classes of employees (reasonable designed) so long as the offering complies with applicable benefit nondiscrimination rules, which generally restrict the ability to favor the highly compensated individuals. The safest approach is not to differentiate benefit offerings between employees unless the employer is intentionally being more generous to the lower-paid employees.
Practical answer: It is possible to offer richer benefits to higher paid employees without violating nondiscrimination rules so long as there are enough non-highly compensated individuals also eligible for and participating in the same benefits. Even when that can’t be accomplished, some employers may be comfortable taking the risk of potential tax penalties depending upon the individuals and benefits involved.
If you are looking for further detail:
Many employers differentiate benefit eligibility, coverage and employer contributions between classes of employees. The reasons for doing so vary greatly and can be impacted by the employer’s location and industry. For example, some employers may offer higher employer contributions to lower paid employees in an attempt to meet the affordability requirements under the employer mandate, while many others are offering something more generous to attract better talent into certain positions, especially management level and above.
While employers are not prohibited from differentiating benefit offerings so long as the employer is not discriminating based on a federally-protected class (e.g. race, gender, age), it could potentially cause an issue under benefit nondiscrimination rules, which restrict the extent to which employers can favor highly compensated individuals when offering benefits on a tax-favored basis. Different nondiscrimination rules apply depending upon the type of benefit involved:
§105(h) nondiscrimination rules apply to self-funded group health plans (including HRAs and health FSAs).
§125 nondiscrimination rules apply to any benefits run through the employer’s cafeteria plan.
§129 nondiscrimination rules apply to dependent care account plans (DCAPs).
§79 nondiscrimination rules apply to life insurance plans.
Each of the rules have their own tests, and the definition of a highly compensated individual varies between the tests.
If employers are choosing to differentiate benefit offerings, but favoring the lower paid employees (sometimes referred to as “reverse discrimination”), there shouldn’t be any discrimination issues. It will also generally be okay for employers to offer more generous benefits to a class of employees with a decent mix of highly and non-highly compensated employees.
However, it is more common that employers are offering something richer to a class consisting primarily of higher paid employees. The conservative approach is to provide additional taxable compensation to highly compensated individuals versus providing them with richer tax-favored benefits, but offering the benefits on a tax-favored basis (for the employer and the employee) is certainly more attractive. For such structures, it is recommended to run applicable discrimination testing. If the plan is considered discriminatory, the IRS may tax (retroactively) the highly compensated individuals on some or all of the benefit received under the discriminatory plan; in other words, the employer may end up penalizing the same employees the employer is trying to reward. The employer can avoid this result by testing and making adjustments (i.e. adjusting the tax-favored contributions for some or all highly compensated individuals) before the end of the plan year. For employers who want to avoid any taxation risk to highly compensated individuals while still favoring the highly compensated individuals on a tax-favored basis as much as possible, the employer should run discrimination testing before the end of the plan year and make necessary adjustments if the plan is discriminatory.
Many TPAs will run annual discrimination testing if they handle the administration for some or all of the employer’s benefits. Make sure when they run such testing, all applicable benefits are included. For example, if the TPA handles only the health FSA and DCAP administration, make sure information is provided so that §125 discrimination testing includes all plans offered through the employer’s cafeteria plan. If the TPA does not offer discrimination testing, or will not test those benefits for which it does not provide the administration, there are many vendors or attorneys who will perform discrimination testing as needed.
NOTE: Performing the testing annually without any further action may serve only as a record of discrimination and knowledge of such discrimination. Vendors who automatically run discrimination testing for employers who do not understand the rules or who choose not to address failed testing may actually be doing a disservice to the employer. Employers may need help understanding the testing and the types of changes needed, if any, as a result of the testing.
There may be situations in which the employer chooses to be more generous to the highly compensated individuals even when there is a risk of violating the applicable nondiscrimination rules. There is certainly more risk in discriminating under medical plans because the benefits received may be significant (and therefore the potential tax on such benefits would be more). On the other hand, while still a hassle, the potential impact of retroactive taxation would be less under a health FSA which allows only limited annual contributions. In addition, the reality is that there has not been a significant level of enforcement of the nondiscrimination rules over the past decade, which may cause more employers to ignore these rules. However, benefit nondiscrimination rules are considered during agency (e.g. the IRS or DOL) audits and could certainly become subject to more aggressive enforcement in the future.