Payroll Brass Tax: Benefit Nondiscrimination Testing and What It Means for Your Forms W-2

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Mike Mahoney: Welcome back to Payroll Brass Tax. Today we’re unpacking how employee benefit plan non-discrimination rules intersect with payroll and tax reporting. What hits the Form W-2, what’s subject to FICA, and how timing-like run-out periods can change the year of taxation. I’m Mike Mahoney, a shareholder in Ogletree’s Morristown, New Jersey and New York City offices, and I’m joined by Stephen Kenney and Steven Riga, both Ogletree attorneys, Stephen Kenney out of our Dallas, Texas office, and Steven Riga out of our Minneapolis office. I’m just going to quickly set the stage. There are three parts of the tax code that are central here: (1) section 125 for cafeteria plans, (2) section 105(h) for self-insured health plans, and (3) section 129 for dependent care assistance programs.

Stephen Kenney: Thanks for setting the stage, Mike. Let me dive in a little bit on each one of those. So, each has rules designed to make sure benefits don’t favor highly paid folks too much. So, if testing is failed and testing is done to make sure that there isn’t that favoritism towards the highly compensated folks, then favorable tax treatment for the highly compensated is lost, and the benefits provided by a plan become taxable.

So first, let’s consider who counts as highly compensated, or another way to say that is a key employee for these rules. In cafeteria plans under section 125, highly compensated individuals includes officers, 5% owners, and employees who exceed the prior year compensation threshold under internal revenue code section 414(q). So, for 2026, that’s $160,000. There’s also a separate category for key employees, and that includes certain officers and owners, and there’s a 25% concentration limit for them. For self-insured health plans under section 105(h), as Mike referenced, the definition of highly compensated is different. It looks to the five highest paid officers, 10% shareholders, or the highest paid 25% of employees. That difference matters because the same person may or may not be considered highly compensated depending on the rule you’re applying.

Steven Riga: Now let’s take a look at the test. So, section 125 cafeteria plans have three core tests: (1) eligibility, (2) contribution and benefits, and (3) a key employee concentration. In plain terms, a plan needs to offer participation in employer contributions and benefits in a way that doesn’t tilt towards highly compensated people, and benefits for key employees can’t exceed 25% of the total provided by the plan. In self-insured plans under section 105(h), there are two tests. The eligibility test requires that enough non-excludable employees benefit. There are bright line thresholds or a more complex demographic formula to pass, and if one approach is passed, then the test is met. Then the benefits test requires that the plan provide the same types and amounts of benefits, highly compensated and non-highly compensated employees. No richer coverage or lower employee contributions for the highly compensated. Section 129 for dependent care has four tests: (1) an eligibility test, (2) contribution and a benefits test, (3) a 25% concentration cap or more than 5% owners, and (4) the 55% average benefits test, which says the average benefit for non-highly compensated employees must be at least 55% of the average benefit for highly compensated employees.

Mike Mahoney: So, where do plans get into trouble? Well, some of the classic issues we see include executive carve-outs like richer employer-paid health options for executives or lower required contributions for them. Multiple locations with uneven subsidies inside a single cafeteria plan is also another classic red flag that we’ve seen. These designs can look fine, and they make sense from a business perspective perhaps, but they fail the test when you run the numbers.

Steven Riga: Okay, suppose there’s a failure. What then happens from a payroll perspective? Failures don’t blow up the plan’s existence. They don’t invalidate the plan in their entirety, but they do change tax treatment for the affected highly compensated individual. For cafeteria plans, the participating highly compensated employees lose the pre-tax treatment. Their wage reductions get included in taxable income essentially as if they had taken cash instead of benefit. Non-highly compensated employees keep their tax advantage. For section 105(h), the remedy is a bit different. The highly compensated employees must include excess reimbursements in gross income, the portion of reimbursements that go beyond what non-highly compensated individuals could receive. In some cases, an entire discriminatory benefit ends up being taxable to the highly compensated employee. For example, a discriminatory high-cost transplant benefit paid just for a highly compensated employee’s transplant would be fully taxable to that person presumably. Dependent care assistance program failures result in dependent care benefits becoming taxable to highly compensated participants.

Mike Mahoney: And here’s the payroll nuance that surprises many team members. Not all taxable amounts due to these failures are subject to FICA. Income resulting from a section 105(h) failure is not reportable for FICA purposes even though it is taxable and must be included in the highly compensated employee’s gross income. So, you may need to adjust income tax withholding and the W-2 boxes, but not necessarily FICA taxes or wages for those section 105(h) excess reimbursements.

Stephen Kenney: And in contrast, when a cafeteria plan pre-tax treatment is lost under internal revenue code section 125, the affected wage reductions are taxable wages. That generally means that they show up on the Form W-2 and are going to be subject to income tax withholding and FICA just like regular wages because the employee didn’t qualify for the constructive receipt exception.

Steven Riga: Timing matters here, especially with runout periods. Some plans like dependent care assistance programs allow claims that were paid in the plan year to be paid as a benefit at the start of the subsequent year during a plan’s “runout period”. If discriminatory benefits are actually paid in the next calendar year, they are properly taxed in the year of payment by the plan. That means payroll needs to track payment dates from the plan and report in the correct tax year, not just report income for the failure for the plan year in that year.

Mike Mahoney: So, let’s make that concrete. If a dependent care plan is discriminatory in 2025 and has a runout period through March of 2026, and a highly compensated employee gets paid in February 2026 for a reimbursement of expenses made by the employee in 2025, that taxable amount belongs on the 2026 W-2, not the 2025 W-2. So, this really requires payroll to coordinate with the benefits administration team to pull claim-level payment dates and make sure things are reported properly for the year the reimbursement by the plan is paid.

Stephen Kenney: So, that begs the question then: what if you find a failure after W-2s go out? If that failure changes taxable amounts, you’ll need to issue a corrected W-2. In other words, a Form W-2C. The rules also emphasize understanding which amounts are income, which are subject to FICA and how each plan type treats the failure before you decide which boxes to correct.

Mike Mahoney: Can employers fix these failures to avoid the change in tax treatment?

Steven Riga: So, there’s no formal IRS correction mechanism for these non-discrimination tests once the year is closed. During the plan year, employers can head off failures by increasing employer contributions for non-highly compensated employees or by adjusting elections for highly compensated employees or key employees if the plan terms will allow for changes to pass testing. Employers who have known testing issues, it is advisable to run mid-year test and dry runs or even evaluate elections after open enrollment, but before the start of the plan year. Don’t wait until December to discover your plan has a lot of managers and executives and not enough rank and file to pass testing. Second, map each type of potential failure to the right payroll codes so you know whether income tax, FICA or both apply. Third, track payment dates so reporting lands in the correct year.

Stephen Kenney: And it’s important to not forget that data hygiene is important. So, if the data hygiene is incorrect, if the numbers are incorrect that you’re relying upon, then you may not know who is highly compensated or is a key employee, and misclassifying someone can cause you to miss a failure or to over-report tax.

Steven Riga: Let’s walk through an example. Say your cafeteria plan offers two medical plan options, and executives get a richer employer subsidy than everyone else. This favors the highly compensated and fails testing on its face, meaning highly compensated employees pre-tax salary reductions under the cafeteria plan become taxable wages. Payroll would include these amounts, inform W-2 wages, and withhold FICA and income tax accordingly. Another scenario, a self-insured health plan reimburses a high-cost procedure with plan provision that practically only a highly compensated employee can access because it’s an executive-only feature. That presumably causes a section 105(h) benefits testing failure, and the highly compensated employee must include the discriminatory reimbursement in gross income. Arguably, the full amount. Payroll includes this as taxable income but does not treat the discriminatory benefit as FICA wages because section 105(h) income is not subject to FICA reporting. And let’s also try out a dependent care example. If your dependent care is passing testing under the 55% average benefits test most of the year, but you end up with late-year usage by a couple of highly compensated employees that pushes concentration below 55%, meaning you’ve got a test and plan failure, that results in dependent care benefits becoming taxable to highly compensated employees for the plan year of the failure. But if some of those reimbursements are paid to the employee next year during the plan’s runout, you report them in the year paid, not the plan.

Stephen Kenney: Thanks for walking through all that. That sure sounds like a lot and like it requires careful consideration and coordination. I will say that there is a silver lining here that if there’s early monitoring and you catch these issues early on, then you have options. You can increase employer contributions for non-highly compensated employees or reduce contributions for highly compensated employees consistent with the plan terms so that you can avoid the failure rather than reporting income on Forms W-2 later.

Mike Mahoney: Let’s do a quick lightning round of questions and answers. Is every non-discrimination failure a payroll event? Yes, unless it can be remedied before the end of the plan year, highly compensated employees will have additional income, but how it gets reported depends on the test failed and the timing of the plan payment.

Stephen Kenney: Another common question is, do failures invalidate the entire plan for everyone? No, failing doesn’t disqualify the plan wholesale. Instead, it changes tax treatment for the highly compensated or key employees depending on the tests, while non-highly compensated employees generally keep their tax advantages,

Steven Riga: Can we fix past year failure? There’s no formal correction program after year-end, so prevention during the year is the best approach. After year-end, you’re looking at accurate income inclusion and corrected W-2s if needed.

Mike Mahoney: So, just some final takeaways from this conversation. The first is you need to know your populations. Who are your highly compensated employees and who are your key employees? And recognize that the definitions differ under sections 125 and 105(h). Second, understand the tests and spot risky designs like executive only benefits or tiered premium designs that favor the highly compensated early. Third, map failures to the right payroll reporting. Finally, always watch run out period payments to ensure that you get the tax year of reporting right.

Stephen Kenney: Thanks, Mike, and thanks, Steven Riga, for your insight and knowledge. We’ll be back next time with more payroll tax insights. We look forward to speaking with you then.

Mike Mahoney: Until then, stay compliant and keep those Forms W-2 clean.

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