Let’s begin by saying that this is a complicated section of our module.  This is the Reader’s Digest version, but there’s still a tangle of rules here.  But this module is about medical savings accounts, and health FSAs are medical savings accounts offered through cafeteria plans.  You need to understand cafeteria plans to understand health FSAs, so here we are. 

When an employee is given the choice between taxable income (cash) and nontaxable benefits, they are generally in “constructive receipt” of taxable income.  There are a few exceptions to this rule, authorized by Congress, including when employees are allowed to choose between taxable wages and nontaxable “qualified benefits” under cafeteria plans.  Cafeteria plans are described in Section 125 of the Code.  They are sometimes called “Section 125” plans.

Nontaxable qualified benefits that may be offered in a cafeteria plan include the following:

• Group-term life insurance (up to $50,000);^[1]
• An accident and health plan, including vision and dental plans;^[2]
• Contributions to health flexible spending arrangements (health FSAs);^[3]
• Premiums for COBRA continuation coverage under an accident or health plan (for example, under an accident and health plan sponsored by a prior employer);^[4]
• An accidental death and dismemberment insurance policy (favored by pirate crews);^[5]
• Long-term or short-term disability coverage;[6]
• Dependent care assistance program (dependent care FSAs);^[7]
• Adoption assistance;^[8]
• Contributions to Health Savings Accounts (HSAs);^[9]
• 401(k) plans (not relevant to public employees);
• Paid time off (PTO) days.

Certain other programs, such as 403(b) plans and qualified transportation plans have their own, separate exemptions from the constructive receipt rules.

[1] Code § 79(a).

[2] Code §§ 105 or 106

[3] Code § 105 (limited to $2,500 in 2013 and beyond)

[4] Code §§ 105 or 106.

[5] Code § 106.

[6] Code Sec.§ 106.

[7] Code § 129.

[8] Code § 137.

[9] Code §§ 223 and 125(d)(2)(D).

A highly compensated participant is a highly compensated individual who is eligible to participate in the cafeteria plan.  A member of a school board may be officer, for example, but they are not a highly compensated participant if they are not eligible to participate in the plan.

A cafeteria plan must not discriminate in favor of highly compensated individuals as to eligibility to participate for that plan year. A cafeteria plan does not discriminate in favor of highly compensated individuals if the plan benefits a group of employees who qualify under a reasonable classification established by the employer.  Most cafeteria plans cover all nonexcludable eligible employees and meet the reasonable classification requirements by default.  If you offer different benefits to different classifications of employees, however, you must do some extra work to make sure they are kosher.  Reasonable classifications generally include specified job categories, employees grouped by nature of their compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria.  A classification based on listing individuals by name or something similar doesn’t cut it.^[1]

Each classification must satisfy the numbers-based Nondiscriminatory Classification Test we described in nondiscrimination rules for group health plans (including VEBAs and HRAs as we described in Section V(4)(b) of this module available here). The “Fair Cross Section Test” we described earlier, however, is not available for a cafeteria plan.^[2] You may exclude the same employees for cafeteria plan testing as under the group health plan rules described in Section V(4)(B), and you may also exclude any employees who have elected COBRA under the cafeteria plan.  Although the test is complicated, we think most cafeteria plans treat everyone the same, and the odds of failure are low.

[1] Prop. Treas. Reg. 1.125-7; 1.410(b)-4(b).

[2] Unlike the nondiscrimination rules for health plans at 1.105-11, which were published in 1979 and cite to an outdated provision of the tax code that used to permit the Fair Cross Section Test, the 2007 proposed cafeteria plan rules include the correct reference to the updated version of Section 410(b).

Not more that 25% of qualified benefits under a cafeteria plan may be provided to “key” employees.^[1]  A key employee covered by a collective bargaining agreement is still treated as a key employee.  Employees in the public sector covered by a collective bargaining agreement will not usually be officers, so this would be an unusual case.

The key employee concentration test applies across all benefits made available through a cafeteria plan.  You don’t test health FSAs or dependent care FSAs separately under the key employee concentration test:  you lump all qualified benefits together.  Because key employees are “officers” who earn at least $220,000 (in 2024), they are a relatively small percentage of total employees, and they do not usually contribute more than 25% towards these benefits relative to non-key employees. 

Very small employers are most at risk of failing the key employee test. If you have two key employees who each select $2,000 in nontaxable benefits through salary reduction, for example, and four non-highly compensated participants who each select $2,000 in nontaxable benefits, the arrangement seems fair on its face – everyone gets the same benefit.  But the key employees, combined, receive $4,000 in nontaxable benefits, and the non-highly compensated participants, combined, receive  $8,000 in nontaxable benefits.  Key employees in this case receive 33 percent of statutory nontaxable benefits (4,000/12,000). Because the cafeteria plan provides more than 25 percent of nontaxable benefits to key employees, the plan fails the test.[2]  The “keys” have to include their salary reduction elections for all benefits under the cafeteria plan in taxable wages for the year.

[1] Code Section 125(b)(2).

[2] We took this straight out of an example in the proposed cafeteria plan regulations at 1.125-7.

Under the Contributions and Benefits Test, all eligible participants must be given the same opportunity to elect the same amount of qualified benefits, and any employer contributions (flex credits) must be made available equally.  In addition, actual utilization of qualified benefits may not discriminate in favor of highly compensated participants. The dollar amount of benefits selected by all highly compensated participants in the plan divided by the total compensation of those employees (expressed as a percentage) cannot exceed the dollar amount of benefits elected by all non-highly compensated participants divided by the total compensation of those employees (also expressed as a percentage).[1] 

That’s tough to follow so let’s break it down.

Step 1:  Facts and Circumstances Test.  All benefits made available to highly compensated individuals must be made available to non-highly compensated benefits.  For example, an employer could not allow HCPs to elect more nontaxable than non-HCPs, and it could not contribute higher amounts of flex credits to HCPs than to Non-HCPs.  No one does this anyway, so it’s a gimme. 

Step 2:  Benefit Utilization Test. 

Compare:

Step 1:   Salary reduction contributions of highly compensated participants divided by the total compensation of all highly compensated participants (expressed as a percentage)

With

Step 2:   Salary reduction contributions of non-highly compensated participants divided by the total compensation of non-highly compensated participants (expressed as a percentage).

If the percentage determined in (1) above is higher than the percentage determined in (2) above, the cafeteria plan fails the benefit utilization test.

Because there are usually a lot more non-highly compensated participants than highly compensated participants, and available benefits to elect are somewhat limited, most cafeteria plans pass this test easily.

[1] Prop. Treas. Reg. 1.125-7(c).  Similarly, if certain “key employees” elect more than 25% of the aggregate benefits elected by all employees under a cafeteria plan, key employees must include amounts that could have been elected in income.  Code Sec. 125(b)(2).