Employer reduction of key employees' elections for current year--is it

[Guest Kathleen Meagher]

Our client has a medical reimbursement plan that became effective this year. The benefits elected by key employees would cause the available reimbursement amounts to exceed the 25% limit by a small amount. These employees have made no claims as yet.

The TPA has advised the client that they must unilaterally reduce the keys' available benefits in order to meet the test--so far, so good. But the TPA also insists that even though the benefits amounts are reduced before any benefits are paid, the keys' total reimbursements for the year must be treated as taxable income, or the plan will be subject to penalties and fines.

I'm sure the penalties and fines part is wrong, and I'm also very dubious about the need to take reimbursements into income if the employer reduces the key employees' available benefits prospectively. What would be the point of any corrective reduction if the benefits would be taxable anyway?

The TPA says that the IRS thinks that the TPA's position is correct.

Any thoughts?

[Joe Priselac]

It sounds like you are describing a Health FSA under a Section 125 plan. Since elections are made prior to the start of the plan year and the enrollment process should be completed prior to the start of the plan year for the payroll people to input participants' elections, the TPA should be able to perform the concentration test prior to the start of the plan year and communicate any necessary changes. I agree with you that if you correct the situation on timely basis there is no need to tax the key employees.

[Lisa Hand]

If the plan is a under Section 125, usually the SPD and enrollment packet should detail the possiblity of reducing the HCE participation to insure compliance. Joe is correct the testing shoudl be done prior to the start of the plan year, since the elections must be made then. Our confirmation letters also have a reminder statement on them to that effect, so HCE do not call and say the amounts are wrong when they were reduced to meet the testing. If major changes occur mid-year the testing may need to be done again and adjustments could be necessary at that point also. As long as the adjustments are properly made and documented, I am not sure how the TPA is coming to the conclusion that the entire HCE reimbursements are taxable. Did they give you any regulation or reference?

[This message has been edited by Lisa Hand (edited 03-22-2000).]

[EGB]

If the 25% concentration test is failed, how is it corrected? Let's assume that the ratio is 50,000/100,000 (ie, key employees' benefits are 50,000 and total benefits under the plan are 100,000), such that the test is failed. So, you reduce the 50,000 to 25,000, which yields 25%. Is that it? Or, do you then have to rerun the test, taking the 25,000 reduction out? For example, do you then run the test using a ratio of 25,000/75,000, etc. and continue this process until the test is passed?

[SLuskin]

When a 25% concentration test is failed, I work backwards t find out the amount the key ees can have in total. I divide the total election of the non-key employees by .75. That tells me the total for the company. I then subtract the nonkey election from that total and communicate that number to the employer/sponsor.