Your organization probably has a flexible spending arrangement that provides some very nice income tax benefits to your employees. These arrangements, also known as cafeteria plans, can allow employees to avoid income tax on salary they use to pay for their portion of the company health insurance premium, certain other health care expenses, and dependent care expenses. But did you know that there are limits on how much tax-free benefit can be derived by those of your employees who are officers or who are considered “highly compensated”? Highly compensated employees (HCEs) are generally those whose salary exceeds $90,000. Your plan should be tested at least once a year to make sure it does not violate the limits. The limits are embodied in a jumble of rules referred to as “nondiscrimination rules.”

Eligibility
One limitation addresses discrimination in favor of HCEs as to eligibility to participate in the plan. If you have any employees who do not participate in the plan, or if your plan requires more than 3 years of employment before an employee may join the plan, then you may have a problem.

Overall Plan Benefits
A second limitation deals with making sure that the plan benefits do not accrue disproportionately to officers and HCEs. Testing for compliance involves comparing the amount of the benefits that go to the officers and HCEs with the amount of the benefits that go to all other employees.

Key Employee Test
A third limitation is known as the key employee concentration test. A “key employee” is an employee who, at any time during the plan year, is an officer receiving more than $130,000 in compensation. The plan’s income tax benefits will be denied to your key employees if the nontaxable benefits provided to all key employees exceed 25% of the nontaxable benefits provided to all employees under the plan.

Dependent Care Tests
A fourth limitation affects only one of the types of nontaxable benefits that your plan may offer — dependent care assistance benefits. This limitation prescribes four tests that must be passed to ensure that the nontaxable dependent care benefits going to HCEs will hold up (note that this limitation does not trap officers who are not HCEs, unlike the second limitation discussed above dealing with overall plan benefits). Two of the four dependent care benefits tests usually do not apply to nonprofits. One of the other two tests mandates that the set of employees who sign up for this benefit must not disproportionately consist of HCEs. Finally, the dependent care benefits received may not accrue disproportionately to HCEs. If the average dependent care benefits received by each non-HCE who could theoretically elect this benefit (even if they opt not to, because, for instance, they obtain these benefits through their spouse’s employer’s cafeteria plan) do not exceed 55% of the average dependent care benefits received by each HCE who could theoretically elect this benefit, then your plan has a problem.

Violation
If your plan were to be in violation of any of the limitations, the consequence would normally be that affected officers or HCEs would not be able to exclude the plan’s benefits from their taxable income. If the problem was not discovered until after the end of a plan year, the affected individuals may also be subject to income tax penalties and interest. Unaffected plan participants would likely continue to enjoy the tax benefits of the plan.

Test Your Plan
The best time to test your plan is as soon as possible after employees have submitted their plan elections for the upcoming year. That way, if there is a problem, you can adjust the elections of the officers and HCEs to bring the plan into compliance before you get too far into the year. Although it is unclear in the law, the IRS would probably contend that the plan must be nondiscriminatory on each day of the plan year. Therefore, it would be advisable to redo the testing any time there is a significant change in the facts and circumstances that may influence the testing (e.g., the hiring or termination of an officer or HCE). One final reminder — nontaxable reimbursement may be made under a flexible benefits plan in connection with the purchase of nonprescription medicine and drugs. Examples of items which are considered to be medicines and drugs for this purpose are antacids, allergy medicines, pain relievers, and cold medicines. Examples of items which are not considered to be medicines and drugs are dietary supplements (e.g., vitamins), toiletries (e.g., toothpaste), cosmetics (e.g., face creams), and similar items. Any item that is merely beneficial to general health will not be reimbursable under a flexible benefits plan. If you have not yet upgraded your plan to allow these benefits, you might consider doing so. You may need to amend your plan document and your participant election forms.