PC with only Highly Compensated employees

We don't handle cafeteria plans, and I'm going to refer this client to a local outfit who does, but I'm curious. A PC with NO NHCE's wants to establish a 125 plan for the purpose of having HSA's. Since there are no NHCE's, and they are paid salaries as W-2 employees,  I don't see any problem with this. I don't see how any coverage/nondiscrimination could apply. Am I missing anything?

If everyone is $160k+ you would want to use the top-paid group (top 20%) election for the cafeteria plan, which I'm assuming they are already doing for the 401(k) (unless it is safe harbor).  Then you would have NHCEs and therefore likely no issues.

Prop. Treas. Reg. §1.125-7(a)(9):

(9) Highly compensated. The term highly compensated means any individual or participant who for the preceding plan year (or the current plan year in the case of the first year of employment) had compensation from the employer in excess of the compensation amount specified in section 414(q)(1)(B), and, if elected by the employer, was also in the top-paid group of employees (determined by reference to section 414(q)(3)) for such preceding plan year (or for the current plan year in the case of the first year of employment).

Treas. Reg. §1.414(q)-1, Q/A-9(b)(2)(iii):

(iii) Method of election. The elections in this paragraph (b)(2) must be provided for in all plans of the employer and must be uniform and consistent with respect to all situations in which the section 414(q) definition is applicable to the employer. Thus, with respect to all plan years beginning in the same calendar year, the employer must apply the test uniformly for purposes of determining its top-paid group with respect to all its qualified plans and employee benefit plans. If either election is changed during the determination year, no recalculation of the look-back year based on the new election is required, provided the change in election does not result in discrimination in operation.

But if an employer has not made a top-paid group election for any employee-benefit plan and all employees are classified as “highly compensated” within the meaning of Internal Revenue Code § 125(e)(1)(C), does this mean a § 125 plan does not discriminate “in favor of” highly-compensated participants or individuals because there are none other?

You wouldn't pass the reasonable classification portion of the eligibility test (i.e., the safe harbor percentage or unsafe harbor w/ facts/circumstances) without any NHCEs.  That would cause the HCEs (everyone in this case) to lose the Section 125 safe harbor from constructive receipt (i.e., be taxed on their contributions).

Prop. Treas. Reg. §1.125-7(b):

(b) Nondiscrimination as to eligibility.

(1) In general. 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, as defined in §1.410(b)-4(b), and the group of employees included in the classification satisfies the safe harbor percentage test or the unsafe harbor percentage component of the facts and circumstances test in §1.410(b)-4(c). (In applying the §1.410(b)-4 test, substitute highly compensated individual for highly compensated employee and substitute nonhighly compensated individual for nonhighly compensated employee).

Prop. Treas. Reg. §1.125-7(m):

(2) Discriminatory cafeteria plan. A highly compensated participant or key employee participating in a discriminatory cafeteria plan must include in gross income (in the participant's taxable year within which ends the plan year with respect to which an election was or could have been made) the value of the taxable benefit with the greatest value that the employee could have elected to receive, even if the employee elects to receive only the nontaxable benefits offered.

Thanks Gentlemen. Very interesting.

Brian Gilmore, thank you for your continuing generosity in teaching health plans and cafeteria plans to the many of us who don’t work in those fields.

Now that Internal Revenue Code § 125 is a 47-year-old, some might wish the Treasury department would do more than proposed interpretations. (You’re right to remind us that some IRS people might act following proposed rules as if they were rules.)

Like Belgarath, I don’t work with cafeteria plans. And it’s inconvenient to look up something that, because it’s only proposed, does not appear in the Code of Federal Regulations.

The -7(b)(1) text you quote describes a situation in which a cafeteria plan does not discriminate in favor of highly-compensated individuals. But the sentence does not say meeting its conditions is the only way to not discriminate.

Is there more text in the proposed rule that describes when a plan does discriminate in favor of highly-compensated individuals?

I seek to learn not to become a cafeteria-plans expert but rather so I or a practitioner I advise doesn’t miss a step in designing or administering a retirement plan.

For retirement plans, there are situations for which no one states in a plan’s governing documents or otherwise elects a top-paid-group election because that election is unneeded for the plan one designs or administers.

If one interprets § 125 to look to § 414(q) to find who’s a highly-compensated individual, the § 414(q) rule suggests that an employer might prefer that its retirement plan state an otherwise unneeded top-paid-group election to remove a doubt about whether “[t]he elections . . . [are] provided for in all plans of the employer and [are] uniform and consistent with respect to all situations in which the section 414(q) definition is applicable to the employer.” 26 C.F.R. § 1.414(q)-1(b)(2)(iii).

If a plan intended as a cafeteria plan might fail to meet a condition for § 125 tax treatment because of a lack of nonhighly-compensated individuals, that’s a point a retirement-plans practitioner might want to be aware of.

This is a little more than an abstract curiosity. There are some employers for which every employee has compensation no less than $160,000.

Brian Gilmore, we’d welcome more of your generous teaching.

Yeah the regs have been proposed forever, but that's all we have to work with given that the statute is generic.  They're still easily accessible in the Federal Register: https://www.govinfo.gov/content/pkg/FR-2007-08-06/pdf/E7-14827.pdf

The rules here piggyback on the coverage testing rules by imposing the nondiscriminatory classification test.  Basically there's the safe harbor ratio percentage, and the unsafe harbor ratio percentage that requires the facts and circumstances test.  See the table on page 3 here: https://www.govinfo.gov/content/pkg/CFR-2012-title26-vol5/pdf/CFR-2012-title26-vol5-sec1-410b-4.pdf

I don't see how you could pass either with exclusively highs given that the applicable ratio percentage is is determined by dividing the percentage of non-HCPs benefitting from the plan by the percentage of HCPs who benefit.  Seems to me zero divided by anything non-zero will always be zero.

That's why I was saying the top-paid group (top 20%) approach would be needed and the easy workaround.

Thanks for the info. (In this particular case, since they are all >5% owners, the top 20% election wouldn't help.)

Oh interesting.  And I guess because it's a PC none are considered self-employed.  That's an unusual one. 

But the silver lining is that they can just make the HSA contributions outside of payroll and take the above-the-line deduction in Schedule 1.  True they miss out on the FICA exemption by not using the cafeteria plan, but that probably isn't very meaningful here since I assume they're all over the Social Security wage base for the 6.2%.  So they're just missing the 1.45% Medicare tax exemption (and potentially the 0.9% additional Medicare tax).