Cafeteria plans cannot discriminate in favor of highly compensated or key employees.

Transcription

1 A. Overview of the Separate Nondiscrimination Sections in This Outline Cafeteria plans cannot discriminate in favor of highly compensated or key employees. Part 5 of the Outline contains the following Sections covering the Code's nondiscrimination rules that apply to cafeteria plans and their component benefit plans: Nondiscrimination Rules Core Concepts (Section XXVIII); Cafeteria Plan Nondiscrimination Rules (Section XXIX); Health FSA Nondiscrimination Rules (Section XXXI); and DCAP Nondiscrimination Rules (Section XXXII). In Section XXXIII, we discuss the Code's provisions regarding simple cafeteria plans, which can be established by eligible small employers effective for years beginning after December 31, 2010 and are treated as meeting the nondiscrimination rules for cafeteria plans and certain component benefits (e.g., health FSAs and DCAPs), so long as specified contribution, eligibility, and participation requirements are met. This Section XXVIII explains certain core concepts of nondiscrimination testing that apply to most plans. It lays the groundwork for the more detailed and plan specific discussion of the nondiscrimination rules in the plan specific nondiscrimination Sections that follow. Anyone reading the plan specific Sections should first review the core concepts in this Section. Similarly, anyone reading the core concepts in this Section should consult the other applicable Sections regarding the rules that apply to specific plans. For example, to learn about the nondiscrimination rules that apply to a salary reduction cafeteria plan with a health insurance premium payment feature, a health FSA, and a DCAP, you should read this Section and Sections XXIX through XXXII. Caution Regarding Nondiscrimination Rules for Other Plans. Nondiscrimination rules for other plans or arrangements (e.g., the Code 505(b) nondiscrimination requirements for plans offered through VEBAs) are not discussed in this manual. However, the nondiscrimination rules that apply to 401(k) plans are covered in 401(k) Plans (Thomson Reuters/EBIA, 1994 present, updated quarterly). And for a discussion of the comparability rules that apply to HSAs, see Consumer Driven Health Care (Thomson Reuters/EBIA, 2004 present, updated quarterly). Let's begin with the general principles that cafeteria plans and their component benefit plans have in common. Remember that each type of benefit plan has some unique twists, which will be fully explored in the plan specific Sections that follow. B. Plans Cannot Discriminate in Favor of Certain Highly Compensated and Key Employees Why have nondiscrimination rules for cafeteria plans at all? Because cafeteria plans, medical plans (including health FSAs), DCAPs, and other benefit programs enjoy favorable tax treatment under the

2 Code. The main reason for conferring those tax benefits was to encourage employers to provide benefits to their rank and file employees. Although Congress did not object to letting an employer's executives get some tax benefits as a byproduct, it wanted to make sure that providing benefits to these individuals was not the primary focus of the program. As a result, the Code's nondiscrimination rules are generally designed to prevent plans from discriminating in favor of individuals who are either highly compensated or otherwise key to the business. In other words, Congress wrote the rules so that the rank and file employees would get their fair share of the tax benefits. Nondiscrimination Under the Code vs. Other Types of Nondiscrimination. Our discussion in Part 5 of the Outline is confined to nondiscrimination rules under the Code, which address Congress's concerns about highly compensated or key employees receiving a disproportionate amount of tax free benefits. Part 5 does not address other types of discrimination prohibited under laws other than the Code (e.g., discrimination based on health status, age, disability, race, sex, etc.). (See Section XXII for a summary of these issues with respect to health FSAs.) However, the application of these laws may overlap. For example, a plan that improperly discriminates in favor of HCEs under Code 105(h) might also violate HIPAA (e.g., because it discriminates with respect to eligibility, premiums, or contributions based on specific health status related factors). The Code's discrimination rules are vastly different from these non Code laws. For details on how the non Code laws that prohibit discrimination apply to health plans in general, consult HIPAA Portability, Privacy & Security (Thomson Reuters/EBIA, 1997 present, updated quarterly) and Group Health Plans: Federal Mandates Other Than COBRA & HIPAA (Thomson Reuters/EBIA, 2002 present, updated quarterly). Just who are the highly compensated and key employees that Congress watches so closely (the prohibited group )? The Code defines the members of the prohibited group differently for each benefit plan, so the exact answer depends on the type of plan at issue. For general purposes in this manual, we sometimes use the term highly compensated employees (HCEs) to describe all of the individuals in the applicable prohibited group who are highly compensated, and the term Keys to describe individuals in the prohibited group who are key employees as defined in Code 416. However, these shorthand references should not be substituted for the statutory definition of the prohibited group, which varies from plan to plan and from test to test. Caution: Identifying HCEs and Keys for Testing. The individuals actually considered HCEs or Keys vary from one plan to the next getting their identity wrong can lead to incorrect testing results. For example, the DCAP nondiscrimination rules look to an individual's compensation during the preceding year to determine whether that individual is an HCE based on compensation. In contrast, the health FSA nondiscrimination rules look to an individual's compensation during the current year to determine status as an HCE based on compensation. An employer or advisor running any of the nondiscrimination tests should consult the subsection discussing which employees are HCEs or Keys, as applicable, in the Section for the specific plan. For example, if the plan being tested is a cafeteria plan with a self insured medical plan premium payment feature, a health FSA, and a DCAP, the employer should review Sections XXIX through XXXII to determine the members of the prohibited group for each plan.

3 To make sure that cafeteria plans and their component plans do not discriminate in favor of HCEs and Keys, Congress came up with specific nondiscrimination tests. These tests are complicated but can be boiled down to three basic themes, all of which involve protecting employees who are not highly compensated or key to the business (i.e., non HCEs/non Keys): Eligibility. The first theme is that if enough non HCEs cannot get into a plan, then it will be discriminatory. One way to visualize this eligibility test is to think of the plan as a party where the guests get to save on taxes and to ask yourself, Have enough non HCEs been invited to the party? Benefits. The second theme is that a plan will not pass the nondiscrimination tests if the HCEs/Keys are able to get more benefits than the non HCEs. Think of the different benefits as being appetizers and ask, Who's being offered appetizers at the party? This is sometimes called a contributions and benefits test. Utilization. The third theme is that a plan will not pass the nondiscrimination tests if the HCEs/Keys actually take more benefits under the plan. In other words, ask yourself, Who's actually taking the appetizers? This is sometimes called a utilization test or concentration test. It is often the most difficult to pass, especially for smaller employers. Safe Harbor for Simple Cafeteria Plans. Health care reform law allows eligible small employers to establish a new type of cafeteria plan called a simple cafeteria plan effective for years beginning after December 31, These plans will be treated as meeting the nondiscrimination rules for cafeteria plans and certain component benefits (e.g., health FSAs and DCAPs), so long as specified contribution, eligibility, and participation requirements are met. For more information, see Section XXXIII. C. Where Did the Rules Come From and Where Can They Be Found? As Samuel Coleridge once said, If men could learn from history, what lessons it might teach us! 1 Below is a brief summary of the roller coaster history of our current nondiscrimination rules, which contains several nuggets that still affect contemporary cafeteria plan administration. We also explain how to find the various laws that have survived this stormy past. 1. Nondiscrimination Rules: A Brief History Code 125, as enacted in 1978, contained cafeteria plan nondiscrimination rules that were amended in 1984 to add the Key Employee Concentration test. Code 105(h), as enacted in 1978, contained nondiscrimination rules for self insured medical reimbursement plans, including health FSAs. Code 129, as enacted in 1981, contained nondiscrimination rules for DCAPs. And Code 79 was amended in 1982 to add nondiscrimination rules for group term life insurance. In 1986, Code 89 was enacted as part of the Tax Reform Act of 1986 (TRA '86) with a laudable goal: to bring uniformity to the vast array of disparate nondiscrimination provisions. 2 However, the attempt

4 failed miserably. Code 89 was so confusing and difficult to comply with that Congress repealed it just three years after its enactment. 3 In the words of Senator Lloyd Bentsen: Section 89 created an administrative nightmare that had exactly the opposite of its intended effect: Instead of extending health and life insurance coverage, some employers actually canceled their plans altogether. No one wants a cure that is worse than the disease! 4 When Code 89 was repealed, Congress reinstated the pre TRA '86 nondiscrimination rules for cafeteria plans, group term life insurance plans, and self insured medical reimbursement plans. It also restored the nondiscrimination rules for DCAPs, with some modifications. As part of this reinstatement, Congress noted that the wording of the nondiscrimination rules for welfare plans was similar in some respects to that of their retirement plan counterparts. Recognizing that health and group term life benefits nevertheless differ from retirement benefits in many ways, Congress admonished the Treasury Department to interpret the welfare plan rules in a different manner than the rules for qualified plans where appropriate. Presumably, this was intended to foster a more liberal approach for welfare plans. In discussing the reinstatement of the pre TRA '86 rules after the repeal of Code 89, Senator Bentsen stated the following: The provision generally reinstates the rules applicable before the enactment of section 89. Generally prior law contained nondiscrimination rules relating to employer provided self insured medical reimbursement plans (sec. 105(h)), cafeteria plans (sec. 125), and group term life insurance plans (sec. 79(d)). These prior law rules are generally reinstated under the provision. It is recognized that, in some instances, the nature of these benefits may differ from the nature of retirement benefits. Therefore, the Secretary should, where appropriate, interpret the prior law rules relating to benefits under the selfinsured medical reimbursement plans and group term life insurance plans in a different manner than those rules that apply in the area of qualified retirement plans, even where the statutory requirements with respect to such benefits are similar. 5 Employers and advisors still look to the Senator's remarks as providing a guidepost in areas where there may otherwise be little authority. Health care reform law 6 enacted in 2010 requires certain insured group health plans to satisfy the nondiscrimination requirements of Code 105(h)(2) (the Eligibility and Benefits Tests). 7 Although the statutory requirement applies for plan years beginning on or after September 23, 2010, 8 the IRS announced in IRS Notice that compliance will not be required until the government has issued regulations or other guidance on how the rules apply to insured plans. 9 See Health Care Reform for Employers and Advisors (Thomson Reuters/EBIA, 2010 present) at Section XIII for further discussion. Perhaps the first lesson to be learned from this nondiscrimination history is not to be discouraged when trying to sort out the various rules. Even some of the best legal brains in the country could not get things to work right on the first try. In addition, despite the repeal of Code 89, some principles stated in that section continue to be of some relevance Finding the Text of the Code's Nondiscrimination Rules

5 Each of the plan specific nondiscrimination Sections in this manual identifies the applicable nondiscrimination laws (statutes, legislative history, regulations, etc.) in the context of issues discussed in those Sections. Each Section also includes a brief summary of those laws as a practical tool for our readers who prefer to form their own opinions about what Congress and the regulators have said. For an explanation of the different types of laws from a general standpoint, see Section IV. 11 Most of the key nondiscrimination rules that apply directly to cafeteria plans and their component welfare plans are found in statutes and in a few regulations. To fill in the gaps, employers and their advisors sometimes consult legislative history for the applicable statutes. In addition, many employers and advisors apply retirement plan statutes and related regulations to their welfare plan counterparts by analogy, even when there may not be direct support for such an approach. Warning Regarding Use of Retirement Plan Rules. Before using a retirement plan statute or regulation as guidance for nondiscrimination testing of cafeteria plans and related welfare plans, it is important to be aware of the risks involved. Our discussion of the specific statutory provisions applicable to cafeteria plans and their component benefits addresses the support for using such retirement plan provisions. Sometimes, the connection is clear; in other cases, it is less so (e.g., our reliance may be based on oral, nonbinding statements of IRS officials). Caution should be exercised before relying on such statements. D. Benefit by Benefit Listing of Relevant Nondiscrimination Tests Different nondiscrimination tests apply to each type of benefit plan. The various nondiscrimination requirements that may apply to a cafeteria plan and its component plans are listed below. Safe Harbor for Simple Cafeteria Plans. Health care reform law allows eligible small employers to establish a new type of cafeteria plan called a simple cafeteria plan effective for years beginning after December 31, These plans will be treated as meeting the nondiscrimination rules for cafeteria plans and certain component benefits (e.g., health FSAs and DCAPs), so long as specified contribution, eligibility, and participation requirements are met. For more information, see Section XXXIII. 1. Cafeteria Plans Eligibility Test Contributions and Benefits (C&B) Test Key Employee Concentration Test These tests, as well as a special safe harbor test for premium only plans in the 2007 proposed cafeteria plan regulations, are discussed in Section XXIX. 2. Health FSAs Eligibility Test

6 Benefits Test These tests are discussed in Section XXXI. 3. DCAPs Eligibility Test Contributions and Benefits Test More Than 5% Owners Concentration Test 55% Average Benefits Test These tests are discussed in Section XXXII. 4. Group Term Life Insurance Eligibility Test Benefits Test These tests are discussed in Fringe Benefits (Thomson Reuters/EBIA, 2006 present, updated quarterly). 5. Self Insured Major Medical, Dental, and Vision Plans Eligibility Test Benefits Test These tests are discussed in Section XII of Self Insured Health Plans (Thomson Reuters/EBIA, 2012 present, updated quarterly). Code 105(h) subjects any self insured medical reimbursement plan to nondiscrimination testing. For this purpose, a self insured medical reimbursement plan is a plan of an employer to reimburse employees for expenses for medical care for which reimbursement is not provided under a policy of accident and health insurance. 12 Consequently, a self insured major medical plan must comply with nondiscrimination rules. The same is true for a self insured dental or vision plan or a health FSA. 6. Fully Insured Major Medical and Dental Plans Prior to the health care reform law's enactment, fully insured accident and health plans were not subject to specific nondiscrimination requirements. 13 However, the health care reform law requires certain insured group health plans to satisfy the nondiscrimination requirements of Code 105(h)(2) (the Eligibility and Benefits Tests). 14 Although the statutory requirement applies for plan years beginning on or after September 23, 2010, 15 the IRS announced in IRS Notice that compliance will not be required until the government has issued regulations or other guidance on how the rules apply to

7 insured plans. 16 See Section XIII of Health Care Reform for Employers and Advisors (Thomson Reuters/EBIA, 2010 present) for further discussion. In addition, fully insured accident and health plans provided through a cafeteria plan are indirectly subject to nondiscrimination rules because the benefits and contributions provided under a cafeteria plan cannot discriminate in favor of HCEs. See Section XXIX. 7. Long Term Disability (LTD) Plans There are no specific nondiscrimination tests required for long term disability (LTD) plans, whether insured or self insured. However, LTD plans provided through a cafeteria plan are indirectly subject to nondiscrimination rules because the benefits and contributions provided under a cafeteria plan cannot discriminate in favor of HCEs. 8. Accidental Death & Dismemberment (AD&D) Plans There are no specific nondiscrimination tests required for accidental death and dismemberment (AD&D) plans, whether insured or self insured. However, AD&D plans provided through a cafeteria plan are indirectly subject to nondiscrimination rules because the benefits and contributions provided under a cafeteria plan cannot discriminate in favor of HCEs. 9. Plans Provided Through a VEBA Some welfare benefits (e.g., medical, dental, LTD, and AD&D) are provided through a voluntary employees' beneficiary association (VEBA). A VEBA is an association providing for the payment of life, sick, accident, or other benefits to the members of the association, their dependents, or beneficiaries; it enjoys tax exempt status, provided that certain conditions are met. 17 Code 505(b) prescribes nondiscrimination requirements for plans offered through VEBAs. These requirements are outside the scope of this manual (k) Plans A cafeteria plan can offer participants the opportunity to make elective salary deferral contributions under a Code 401(k) cash or deferred arrangement. (See Section X.) There are myriad nondiscrimination rules that apply to 401(k) plans, which are outside the scope of this manual. See 401(k) Plans (Thomson Reuters/EBIA, 1994 present, updated quarterly). 11. Adoption Assistance Plans Adoption assistance plans must comply with an eligibility test and a 5% shareholder or owner test These tests are discussed in Fringe Benefits (Thomson Reuters/EBIA, 2004 present, updated quarterly). 12. Health Savings Accounts (HSAs) IRS guidance has confirmed that the Code 105(h) nondiscrimination rules do not apply to HSAs. 18 However, employer contributions to an HSA that are made outside a cafeteria plan are subject to certain

8 comparability requirements. 19 The comparability requirements do not apply to employer contributions to an HSA that are made through a cafeteria plan. 20 But employer contributions to an HSA that are made through a cafeteria plan are taken into account when testing the cafeteria plan for compliance with the Code 125 nondiscrimination requirements. For more information about which employer HSA contributions will be treated as made through a cafeteria plan, see Section XVI. For a general discussion of HSAs, including HSA comparability and the exception for employer HSA contributions made through a cafeteria plan, see Consumer Driven Health Care (Thomson Reuters/EBIA, 2004 present, updated quarterly). E. Flowchart of Nondiscrimination Tests Generally, the tests listed in subsection D can be separated into two categories: those that apply to the cafeteria plan and those that apply to the component benefit plans. The following Nondiscrimination Testing Flowchart provides a big picture view of the testing process.

9 F. Tests to Run for Common Plan Configurations Determining what nondiscrimination tests need to be run depends upon the exact configuration of the cafeteria plan and its component benefit plans. Below are the tests that would need to be run for three common plan configurations (all assume that no VEBA is involved): a salary reduction premium payment plan; a salary reduction plan with a premium payment feature, a health FSA, and a DCAP; and a flexible benefit plan. Additional tests may apply for other plan configurations (e.g., for a flexible benefit plan that includes a 401(k) option, adoption assistance benefits, or funding of any benefits through a VEBA). For information about how eligible small employers can qualify for a safe harbor from certain nondiscrimination testing requirements by establishing and maintaining a simple cafeteria plan, see Section XXXIII. Note that the addition of a grace period to a cafeteria plan as permitted under IRS Notice may further complicate nondiscrimination testing. See Section XVI for further discussion. 1. Salary Reduction Premium Payment Plan Figure 1 illustrates the basic features of a salary reduction premium payment plan. 21 Figure 1 Salary Reduction Premium Payment Plan The following nondiscrimination tests would need to be run for this plan: Cafeteria Plan Tests. Unless the plan passes the special safe harbor test for premium only plans, the three cafeteria plan tests must be run: Eligibility; Contributions and Benefits; and Key Employee Concentration. 22

10 Major Medical Plan Tests. If the medical plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured major medical plan once the government issues regulations or other guidance on how the rules apply to insured plans, unless the plan is grandfathered under the health care reform law. 23 Dental Plan Tests. If the dental plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured dental plan that is neither excepted from compliance with the HIPAA portability rules nor grandfathered under the health care reform law once the government issues regulations or other guidance on how the rules apply to insured plans Salary Reduction Plan With Premium Payment Feature, Health FSA, and DCAP Figure 2 illustrates the basic features of a salary reduction plan with a premium payment feature, a health FSA, and a DCAP. 25 Note that the addition of the health FSA and DCAP makes this plan subject to more nondiscrimination tests. Figure 2 Salary Reduction Plan With Premium Payment Feature, Health FSA, and DCAP The following nondiscrimination tests would need to be run for this plan: Cafeteria Plan Tests. The three cafeteria plan tests must be run: Eligibility; Contributions and Benefits; and Key Employee Concentration. 26 Major Medical Plan Tests. If the medical plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured major medical

11 plan once the government issues regulations or other guidance on how the rules apply to insured plans, unless the plan is grandfathered under the health care reform law. 27 Dental Plan Tests. If the dental plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured dental plan that is neither excepted from compliance with the HIPAA portability rules nor grandfathered under the health care reform law once the government issues regulations or other guidance on how the rules apply to insured plans. 28 Health FSA Tests. The two Code 105(h) tests must be run: Eligibility and Benefits. 29 DCAP Tests. The four DCAP tests must be run: Eligibility; Contributions and Benefits; More Than 5% Owners Concentration; and 55% Average Benefits Flexible Benefit Plan With Employer and Employee Contributions and a Cash Out Option Figure 3 illustrates the basic features of a typical flexible benefit plan with employer and employee contributions and a cash out option. 31 Note that the addition of three more component plans (group term life insurance, group LTD insurance, and AD&D insurance) makes this plan subject to more nondiscrimination tests (for group term life insurance). Figure 3 Flexible Benefit Plan With Employer and Employee Contributions and a Cash Out Option The following nondiscrimination tests would need to be run for this plan:

12 Cafeteria Plan Tests. The three cafeteria plan tests must be run: Eligibility; Contributions and Benefits; and Key Employee Concentration. 32 Major Medical Plan Tests. If the medical plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured major medical plan once the government issues regulations or other guidance on how the rules apply to insured plans, unless the plan is grandfathered under the health care reform law. 33 Dental Plan Tests. If the dental plan is self insured, then the two Code 105(h) tests Eligibility and Benefits must be run. These tests must also be run for an insured dental plan that is neither excepted from compliance with the HIPAA portability rules nor grandfathered under the health care reform law once the government issues regulations or other guidance on how the rules apply to insured plans. 34 Health FSA Tests. The two Code 105(h) tests must be run: Eligibility and Benefits. 35 DCAP Tests. The four DCAP tests must be run: Eligibility; Contributions and Benefits; More Than 5% Owners Concentration; and 55% Average Benefits. 36 Group Term Life Insurance Plan Tests. Two group term life insurance plan tests must be run: Eligibility and Benefits. Group LTD Insurance Plan Tests. No tests need to be run on the LTD plan (other than indirectly under the cafeteria plan tests). This is the case whether the LTD plan is insured or self insured. Group AD&D Insurance Plan Tests. No tests need to be run on the AD&D plan (other than indirectly under the cafeteria plan tests). This is the case whether the AD&D plan is insured or self insured. G. When Must Discrimination Testing Be Performed? None of the statutes that directly apply to cafeteria plans and their component welfare benefit plans discuss when discrimination testing must be performed. Only the 2007 proposed cafeteria plan regulations provide guidance on this issue, indicating that the cafeteria plan tests must be performed as of the last day of the plan year, taking into account all nonexcludable employees (or former employees) who were employees on any day during the plan year. 37 Because the group of employees included in the testing can change during the year, the final results cannot be known until the end of the year. As a general rule, however, testing should be performed at each of the following times: Prior to the Beginning of the Plan Year. This is when the employer can first predict, based on estimates of participation levels, whether the plan will be in danger of failing any of the nondiscrimination tests. Such early testing is especially valuable because anticipated problems

13 may be resolved with election or plan design changes, although it is important to keep in mind that changes during the plan year can affect test results. Several Months Before the End of the Plan Year. At this point, the employer can take into account actual data for the year, including new hires, midyear election changes for change in status, terminations of employment, etc. If any testing problems appear at this point, the employer will still have time to make corrections before the end of the plan year. Note that employees whose employment terminates during the plan year may have to be included in testing. After the Close of the Plan Year. The employer will have its final year end data to use for testing purposes. Final plan testing with year end numbers should be documented and retained so that the employer can show, upon audit, that the plan passes the appropriate tests. If a discrimination testing problem is discovered during the plan year, can the prohibited group members' elections be reduced to ensure compliance? As discussed in Sections XIV and XXXII, we think that such election changes mandated by the administrator, and made during the year, should be possible. The IRS has informally stated that reductions in prohibited employee elections should be permissible to ensure compliance with the applicable tests. 38 But if a discrimination testing problem is discovered with respect to one of the utilization tests after the end of the plan year, prohibited group members' elections cannot be adjusted. In contrast to the Average Deferral Percentage (ADP) and Average Contributions Percentage (ACP) nondiscrimination tests that apply to 401(k) plans, the utilization tests applicable to cafeteria plans (the Key Employee Concentration Test and the Contributions and Benefits Test) and DCAPs (the 55% Average Benefits Test and the More Than 5% Owners Concentration Test) cannot be met through corrections made after the end of the plan year. Therefore, employers should monitor nondiscrimination issues throughout the plan year, so that adjustments may be made before year end if needed to bring the plan into compliance. H. Using Plan Design and Monitoring to Avoid Discrimination The cafeteria plan should give the plan administrator the authority to cut off any employee's salary reductions with respect to the plan and its component benefits if the administrator deems it necessary in order to comply with the nondiscrimination rules. At the beginning of the plan year, the plan administrator typically will have a good idea as to which employees will be HCEs or Keys for that year, based on prior year compensation and current or prioryear ownership percentages and officer status. (Note that employees hired during the plan year could also be HCEs for purposes of some tests.) By monitoring the benefits provided to the prohibited group as compared to other employees, the plan administrator can judge during the year whether the plan risks violating the rules. If the risk seems great enough and the plan so provides, the plan administrator can revoke the HCEs' or Keys' salary reduction contributions under some or all components of the plan, thereby preserving the tax exclusion for all the HCEs and Keys. As discussed above, the IRS has

14 informally indicated that cutbacks to prevent discrimination violations are permissible. However, the plan document must specifically allow such changes. And once the plan year has closed, it's too late to take any corrective action other than to impute income to the HCEs and Keys. For information about how eligible small employers can qualify for a safe harbor from certain nondiscrimination testing requirements by establishing and maintaining a simple cafeteria plan, see Section XXXIII. I. Identifying the Employer: Controlled Groups and Affiliated Service Groups Particularly for the various eligibility tests, employers must take into account all employees of the employer. For example, if the employer has 100 non HCEs during a plan year and 60 of them are eligible for the cafeteria plan, then for eligibility testing purposes, the plan takes into account all 100 non HCEs by including them in the denominator of a fraction used to determine whether the plan covers a sufficient number of the employer's non HCEs for that plan year. The numerator of that fraction is 60 (the non HCEs who are eligible). To pass the various eligibility tests, a specified minimum percentage of non HCEs must be eligible. Identifying the employees that must be included in this calculation also requires knowing who the employer is and what employees can be disregarded (excluded) for testing purposes. Congress has indicated that some businesses are so closely connected that they should be considered a single employer for purposes of the various nondiscrimination tests, and so all employees of those employers must be included in the denominator (less certain employees that the rules specifically permit the employer to exclude for testing purposes). This subsection describes the principles that apply when determining which employees and which employers must be included and may be excluded when running the nondiscrimination tests. Caution: Complex and Detailed Rules. Confirming who the employer is and whose employees must be counted is very complex and requires careful application of detailed rules. This subsection I is intended only to provide a broad overview of these rules, not to provide a comprehensive description or analysis. Anyone seeking to interpret these rules for a specific fact situation should consult with experienced benefits counsel. 1. Mandatory Inclusions and Permissive Exclusions of Employees In performing nondiscrimination tests, certain individuals must be included in the testing group (mandatory inclusions) because of their relationship with the plan sponsor. Many nondiscrimination tests require that each plan sponsor consider not only its own employees, but also certain other individuals employed by related entities and (if applicable) employee leasing entities. Therefore, if a company is related to another company (whether through stock ownership, a partnership, or otherwise) or utilizes leased employees, the plan sponsor must determine which employees to include in its nondiscrimination testing. While in many circumstances, plan participation may not need to be extended to all individuals, failure to consider them could lead to inaccurate test results. Likewise, certain employees may be excluded on a uniform basis (permissive exclusions) from the testing group

15 because of their age, limited service, etc. The mandatory inclusions are discussed in this subsection I. The permissive exclusions from the testing group are discussed for the applicable benefits plans in Sections XXIX through XXXII. 2. Treating Multiple Employers as a Single Employer For plan testing purposes (among others), the Code treats two or more employers as a single employer if there is sufficient common ownership or a combination of joint ownership and common activity. These rules are described in Code 414(b), (c), and (m), which are directly incorporated into the cafeteria plan rules. 47 The concept of aggregating multiple employers because of common ownership applies to corporations, partnerships, sole proprietorships, and all other forms of business entities. When these rules are applied to a group of commonly owned corporations, the group is referred to as a controlled group of corporations. 48 When the rules are applied to a mixed group of corporations, partnerships, proprietorships, and other business entities, the group is referred to as trades or businesses under common control. 49 In addition, the affiliated service group rules link certain types of groups based on joint activity or a combination of joint activity and common ownership. 50 The following two examples illustrate how the controlled group rules apply to related corporations and related unincorporated business entities. Following the examples is a discussion of the different types of business relationships that must be analyzed to answer the question: Who is the employer? Those relationships are as follows: controlled group of corporations; trades or businesses under common control; and affiliated service groups. 3. Controlled Group of Corporations A controlled group of corporations may be composed of a parent subsidiary controlled group, a brothersister controlled group, or a combined group. 51 Caution: Definitions of Controlled Group May Differ for Different Tax Purposes. The definition of a controlled group of corporations for various employee benefit plan purposes is set forth in Code 414(b), which refers to the rules in Code 1563(a) with certain limitations. Employers that determine the members of their corporate controlled group for certain tax purposes under Code 1563(a) need to be aware that not all of the controlled group rules under that Code section apply in the context of the

16 controlled group rules for benefit plans under Code 414(b). * * See, e.g., Code 414(b) (referencing Code 1563(a), but without regard to Code 1563(a)(4) (relating to special rules for certain insurance companies) and 1563(e)(3)(C) (relating to stock owned by qualified plans)). See also Code 1563(f)(5) (applying different rule for brother sister corporations for certain purposes). a. Parent Subsidiary Controlled Group of Corporations A parent subsidiary controlled group is one or more chains of corporations connected through stock ownership with a common parent if 80% or more of the total combined voting power of all classes of stock entitled to vote (or 80% or more of the total value of all shares of all classes of stock) of each of the corporations, except the common parent corporation, is owned, directly or indirectly, by one or more of the other corporations; and the common parent corporation owns, directly or indirectly, 80% or more of the total combined voting power of all classes of stock entitled to vote (or 80% or more of the total value of shares of all classes of stock) of at least one of the other corporations. 52 In determining whether a common parent owns the requisite stock in at least one subsidiary, stock held by other subsidiaries is disregarded. 53 This exclusion reduces the total number of shares considered to be outstanding and increases the percentage of total shares owned by the common parent. The following examples illustrate some typical combinations of parent subsidiary relationships that are treated as a single employer for nondiscrimination testing. As the examples illustrate, the ownership analysis frequently is complicated. b. Brother Sister Controlled Group of Corporations A brother sister controlled group of corporations is a group where five or fewer persons who are individuals, estates, or trusts own, directly or indirectly, stock possessing 80% or more of the total combined voting power of all classes of stock entitled to vote (or 80% or more of the total value of all shares of all classes of stock) of each corporation; and more than 50% of the total combined voting power of all classes of stock entitled to vote (or more than 50% of the total value of all shares of all classes of stock) of each corporation, taking into account the stock ownership of each owner only to the extent that the level of ownership interest is identical with respect to each corporation. 54

17 The five or fewer individuals, estates, or trusts with respect to whom stock ownership is considered for purposes of determining whether the 80% requirement is satisfied must be the same individuals, estates, or trusts whose stock ownership is considered for purposes of the greater than 50% requirement. Thus, the brother sister controlled group should be of concern where five or fewer shareholders (who are individuals, estates, or trusts) (1) own at least 80% of each corporation; and (2) own more than 50% of all corporations, taking into account identical ownership interests with respect to each corporation. Ownership in Brother Sister Analysis Does Not Include Corporations. A brother sister controlled group of corporations can only result if the shareholders are individuals, estates, or trusts. Sometimes, in the analysis, there can be confusion over whether a corporation s partial ownership is included in the ownership analysis. It is not. The following two examples explain how to identify brother sister controlled groups that are treated as a single employer for nondiscrimination testing. Example 1: Identifying a Brother Sister Controlled Group of Corporations. Individual Corp. A Corp. B Identical Ownership 1 20% 20% 20% 2 15% 15% 15% 3 10% 10% 10% 4 30% 25% 25% 5 25% 30% 25% Total 100% 100% 95% Analysis: Do five or fewer individuals, estates, or trusts own at least 80% of each corporation in the group? Yes. Between them, Individuals 1, 2, 3, 4, and 5 own 100% of Corp. A and 100% of Corp. B, which is more than 80% of each corporation. Do five or fewer individuals, estates, or trusts own more than 50% of the group of corporations to the extent that their ownership is identical with respect to each corporation? Yes. Together, Individuals 1, 2, 3, 4, and 5 have 95% identical ownership of Corps. A and B, which is more than 50%. Answer: A and B are a brother sister controlled group of corporations. This is because (1) five or fewer

18 individuals own 80% of each corporation; and (2) the same five or fewer individuals own more than 50% of both corporations, taking into account identical ownership interests with respect to each corporation. Example 2: Identifying a Brother Sister Controlled Group of Corporations. Individual Corp. A Corp. B Identical Ownership 1 12% 12% 12% 2 12% 12% 12% 3 12% 12% 12% 4 12% 12% 12% 5 13% 13% 13% 6 13% 13% 13% 7 13% 13% 13% 8 13% 13% 13% Total 100% 100% 100% Analysis: Do five or fewer individuals, estates, or trusts own at least 80% of each corporation in the group? No. The most that any five individuals own in each corporation is 64% (13% + 13% + 13% + 13% + 12% = 64%), which is less than the requisite 80%. Do five or fewer individuals, estates, or trusts own more than 50% of the group of corporations to the extent that such ownership is identical with respect to each corporation? Yes. There are several configurations that meet this test. For example, Individuals 1, 2, 3, 4, and 5 hold 61% (12% + 12% + 12% + 12% + 13% = 61%), which is more than 50%. Answer: A and B are not a brother sister controlled group of corporations. Although at least one group of five individuals controls more than 50% of a group of corporations on an identical ownership basis, no group of five or more individuals controls 80% of the stock of each corporation. Both the 80% and 50% tests must be satisfied. c. Combined Group of Corporations

19 A controlled group also may be composed of an overlapping parent subsidiary controlled group of corporations and a brother sister controlled group of corporations. This occurs if each corporation is a member of either a parent subsidiary controlled group or a brother sister controlled group; and at least one of the corporations is the common parent of the parent subsidiary controlled group and is a member of a brother sister controlled group. 55 d. Constructive Ownership Rules In determining ownership for purposes of the controlled group rules, constructive ownership is taken into account. 56 Constructive ownership is an ownership interest attributed to a party other than the actual owner. The most common of these rules attributes stock ownership to a related party, but the rules also take into account interests other than stock. In application, constructive ownership can be complex. The following is only a general description of the constructive ownership rules. For corporations, an interest owned, directly or indirectly, by a corporation is considered as owned by any person who owns 5% or more in value of the corporation's stock in that proportion which the value of the stock that such person owns bears to the total value of all the stock in the corporation. 57 Ownership of an option to acquire an outstanding interest in an organization is treated as actual ownership. 58 For partnerships, an organization owned, directly or indirectly, by a partnership is treated as being owned by its partners that have an interest of 5% or more in the partnership, in proportion to the partner's interest in the profits or capital, whichever is greater. 59 For estates and trusts, an interest in an organization owned, directly or indirectly, by an estate or trust is considered to be owned proportionately by beneficiaries who have actuarial interests of 5% or more in the estate or trust. For estates, property of a decedent is considered to be owned by the decedent's estate if the property is subject to an executor's administration for the purpose of paying claims against the estate and expenses of administration. 60 With certain limited exceptions, an individual is considered to own any interest owned by the individual's spouse as well as any interest owned by the individual's children under age 21. If the individual is in effective control of an organization, then the individual also is considered to own an interest in the organization owned, directly or indirectly, by the individual's parents, grandparents, grandchildren, and children who have attained the age of Attribution of Spouse's Interest. For this purpose, a spouse's interest would include the interest of a legally married same sex or opposite sex spouse, regardless of state of residence. Individuals in registered domestic partnerships, civil unions, or similar relationships are not considered spouses for this purpose. The rules for determining who is a spouse are discussed in Section XI. And although the general rule is that a spouse is considered to own the other spouse s interest, there is an exception to

20 this rule if certain requirements are met. * * See Treas. Reg (b) 1, (b)(5), and 1.414(c) 4(b). e. Exclusion and Attribution of Interests If a controlling interest in another entity is found, the next question is whether any of the interests in or stock of that entity should be excluded that is, whether the interest is held by a related party and should be disregarded. 62 For example, in a parent subsidiary group, certain interests can be excluded if a parent organization owns directly, or indirectly under the constructive ownership rules, an interest of at least 50% in the subsidiary. 63 In particular, the following should be excluded: interests in a subsidiary held by certain employees; 64 an interest in a subsidiary owned by a 5% owner, an officer, a partner, or a fiduciary of the parent organization; 65 an interest in the subsidiary held by a deferred compensation plan for the benefit of the subsidiary or parent organization's employees; 66 and an interest held by an organization (other than the parent organization) organized under Code 501 (generally, qualified plans and tax exempt organizations) if the organization is controlled, directly or indirectly, by (1) the parent; (2) a subsidiary; (3) an individual or an estate or trust that is a principal owner of the parent; (4) an officer, partner, or fiduciary of the parent; or (5) any combination of the above. 67 Even if an interest would normally be excluded, there is an exception to this rule. An interest otherwise excludable will not be excluded if, by applying that rule, two entities (which would otherwise have been part of the same controlled group) are treated as separate employers that are not in the same controlled group. In other words, the exclusion rules generally will only apply to increase (not decrease) the percentage of ownership by an individual, estate, trust, or parent corporation in another entity. 68 Similar rules to those for parent subsidiary controlled groups apply, with some modifications, to brother sister controlled groups. 69 Example: Constructive Ownership. Alice is a 50% shareholder of Shore Corporation. Shore owns 50% of Beach Corporation. Under the constructive ownership rules, Alice is deemed to own 25% of Beach because 50% of the Beach stock that is owned by Shore is attributed to Alice. Caution: Different Constructive Ownership Rules. The constructive ownership rules discussed in this subsection I are only applicable for determining who is the employer. Different rules may apply in determining who is an HCE or Key, and the rules differ from one plan to the next. See the plan specific nondiscrimination Sections of this manual.

21 4. Trades or Businesses Under Common Control The Code's aggregation rules also apply to business entities other than corporations, including partnerships, sole proprietorships, and other non corporation business entities. When referring to a combination of corporate and non corporate entities, the Code uses the term trades or businesses. 70 The tests for determining common control of multiple trades or businesses are substantially the same as the tests for determining controlled groups of corporations. Trades or businesses under common control may be made up of: a parent subsidiary group of trades or businesses under common control; a brother sister group of trades or businesses under common control; or a combined group of trades or businesses under common control. The common control tests parallel the tests discussed in connection with corporations. The principal difference is that, instead of stock ownership, the tests look at the control that an entity or individual has over another entity. This is necessary because the analysis considers trades or businesses that are not exclusively corporations; therefore, the concept of stock ownership is not always applicable. For example, control of a partnership generally is determined by the capital or profits interest in the partnership. 71 Determining the Partnership Interest. A partnership might distribute its profits based on criteria other than each partner s capital interest so it can be important to understand a partnership s capital and profits interests when determining control. a. Parent Subsidiary Group of Trades or Businesses Under Common Control Similar to a parent subsidiary controlled group of corporations, a parent subsidiary group of trades or businesses under common control is found to exist if: 80% or more of the ownership interest of each of the organizations (except the common parent organization) is owned, directly or indirectly, by one or more of the other organizations; and the common parent organization owns, directly or indirectly, an 80% or more interest in at least one of the other organizations. 72 b. Brother Sister Group of Trades or Businesses Under Common Control Similarly, the rules for determining whether a brother sister group of trades or businesses are under common control mirror the rules for determining a brother sister controlled group of corporations. Essentially, five or fewer individuals, estates, or trusts must own directly or indirectly in the aggregate: 80% or more of the ownership interest in each business entity; and