20080320 Creative Benefits Inc Letter re Nondiscrimination Testing Results Cafeteria Plans - Plan Year 2008 , r
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March 20,2008
Creative Benefits,Inc.
Christy L. Brummet
City of Rancho Palos Verdes
30940 Hawthorne Blvd
Rancho Palos Verdes, CA 90275
Re: Nondiscrimination Testing Results
Dear Christy:
We have completed the nondiscrimination tests for your Section 125 Plan for the 2008 plan year. Please find
attached a results booklet that explains in detail each test that was performed and our findings.
Nondiscrimination testing for cafeteria plans and the welfare benefits provided thereunder is an area of great
uncertainty. Numerous terms are not defined in the Internal Revenue Code and the Internal Revenue Service has
not provided guidance on many aspects of the tests. Thus, certain assumptions (which are described in the
attached endnotes) have been made that Creative Benefits,Inc. believes are reasonable. Please read these
assumptions carefully. Further,the outcomes of the nondiscrimination tests are highly dependent on the
information you provided. In providing this information, please ensure that you are using the same assumptions
as reflected in this document. You should consult legal counsel if you have any questions with regard to the
assumptions or comments in this document. Remember that Creative Benefits, Inc.is not licensed to practice law
and therefore,we encourage you to seek a legal opinion from counsel for definitive results.
We have summarized the results of each test for you below.
I. Code Section 125 Eligibility Test—all required tests passed
II. Code Section 125 Contributions and Benefits Test—passed
III. 25%Key Employee Concentration Test—passed
IV. Code Section 105 Health Care Flexible Spending Account Eligibility and Benefits Test—
Passed overall (However,some subtests may have failed. See results booklet for details)
V. Code Section 129 Dependent Care Flexible Spending Account Tests— all tests passed
Please review the enclosed booklet at your earliest convenience. Do not hesitate to contact me at 760.509.0120 or
dgrant@creativebenefits.com if you should have any questions.
Sincerely,
Daniel Grant, CFC
Assistant Controller
Enclosure
Creative Benefits,Inc. CBI Benefit Administrators License#0B36514 www.creativebenef ts.conm
Office—956 Vale Terrace Dr.,Vista,CA 92084 Mail—P.O.Box 1928,Vista,CA 92085-1928 p(760)758-4600 f(760)758-4610
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NONDISCRIMINATION TESTING
RESULTs
For City of Rancho Palos Verdes
Cafeteria Plans
Plan Year 2008
Creative Benefits, Inc.
956 Vale Terrace Drive
Vista, CA 92084
760.758.4600
Fax 760.631.3812
www.creativebenefits.com
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TABLE OF CONTENTS
INTRODUCTION 1
RELATIONSHIP TO OTHER NONDISCRIMINATION RULES 2
TAX TREATMENT 2
TEST RESULTS AND COMPUTATIONS3
GENERAL NONDISCRIMINATION TESTS FOR CAFETERIA PLANS 3
TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 125 4
General 4
Overview of the Results 4
Details of the Tests 4
I. Eligibility Test 4
Condition :1.: Employment Requirement 4
Condition 2: Entry into the Plan is Not Delayed 5
Condition 3: Nondiscriminatory Classification Test 5
Il:. Key Employee Concentration Test 7
III. Contributions and Benefits Test 8
IV. Consequences of failing the Code Section 125 Cafeteria Plan Tests 8
TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 105-HCSA 10
General 10
Overview of the Results 10
Details of the Tests 10
I. Eligibility Test 10
Subtest A. 70%Participation Test - 131 11
Subtest B. 70/80%Eligibility/Participation Test 146 11
Subtest C: Nondiscriminatory Classification Test 11
II. Benefits Test 14
III. Consequences of Failing the Code Section 105 Nondiscrimination Tests and Potential
Adjustments 15
TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 129-DCSA 17
General 17
Overview of the Results 17
Details of the Tests 17
I.
Eligibility Test 17
II: 55%Average Benefits Test. 20
III:
5%-i- Shareholder Concentration Test 20
IV. Contributions and Benefits Test 21
V. Consequences of Failing the Code Section 129 Nondiscrimination Tests and Potential
Adjustments 21
EXHIBIT A—COMPARATIVE COVERAGE RATIOS 23
APPENDIX A—NONDISCRIMINATION TEST 24
ENDNOTES 32
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INTRODUCTIOAP
Nondiscrimination testing is at the very core of the legal requirements imposed by Section 125 of the Internal
Revenue Code (the"Code") that permits employers and employees to enjoy tax advantages through the use of a
cafeteria plan. A cafeteria plan gives employees an opportunity to choose among a menu of benefits consisting of
cash and certain nontaxable benefits (for example, health insurance benefits)while avoiding current taxation on
the nontaxable benefits offered. However, the tax advantages for highly compensated participants' and key
employees' of the employer are conditioned upon the cafeteria plan meeting certain nondiscrimination
requirements. Therefore, each employer with a cafeteria plan must ensure that its plan satisfies all applicable
nondiscrimination requirements imposed by the Internal Revenue Code. At a minimum, each employer should
undertake discrimination testing near the beginning and end of the plan year,and whenever there is a substantial
change in the participation and/or elections under the plan.
The nondiscrimination rules to which employers with cafeteria plans must satisfy can be broken down into two
broad categories: (1) the three separate nondiscrimination tests applicable to the cafeteria plan itself — the
Eligibility Test,the Contributions and Benefits Test,and the Concentration of Benefits Test;and(2)the specific
nondiscrimination tests applicable to each of the separate fringe benefits offered under the cafeteria plan. Failure
to satisfy these requirements will cause adverse tax consequences to highly compensated employees.
The Eligibility Test, the Contributions and Benefits Test, and the Concentration of Benefits Test are further
discussed herein. The specific nondiscrimination rules for benefits provided under a cafeteria plan (for example,
for self-insured medical plans, group term life insurance and dependent care benefits) are also discussed herein
under the section titled "Specific Nondiscrimination Tests for Benefits Provided Under a Cafeteria Plan".
1 General Disclaimer: Nondiscrimination testing for cafeteria plans and welfare benefits provided thereunder is an area of great
uncertainty. Numerous terms are not defined in the Internal Revenue Code and the Internal Revenue Service has not provided guidance
on many aspects of the tests. Thus,certain assumptions(which are described in the attached endnotes)have been made that Creative
Benefits,Inc.believes are reasonable. Please read these assumptions carefully. Further,the outcomes of the nondiscrimination tests are
highly dependent on the information you provided. In providing this information,please ensure that you are using the same assumptions
as reflected in this document. You should consult legal counsel if you have any questions with regard to the assumptions or comments in
this document.
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RELATIONSHIP TO OTHER NONDISCRIMINATION RULES
Code Section 125 does not override the separate nondiscrimination tests that apply to each of the qualified
benefits offered under a cafeteria plan. Thus, any benefits offered under a cafeteria plan must satisfy the
nondiscrimination requirements of Code Section 125,as well as any nondiscrimination requirements that apply to
that benefit ander Code Section 79 (group-term life insurance), Code Section 105(h) (self-insured medical
reimbursement plans),Code Section 129 (dependent care reimbursement plans),and(if applicable) 401(k) (cash-
or-deferred plans). In addition, employers should be aware that for plan years beginning after December 31,
1997,an employee's salary reduction contributions to a cafeteria plan will not reduce the amount of the employee's
compensation taken into account for purposes of the compensation limits in Code Section 415.3
TAX TREATMENT
If the benefits offered under a cafeteria plan satisfy the nondiscrimination requirements of Code Section 125,as
well as any nondiscrimination requirement that applies to that benefit, employees do not have to pay federal
income tax,or most state and local income taxes,Social Security taxes,or unemployment taxes on salary reduction
amounts contributed to a cafeteria plan. And, if a cafeteria plan with employer contributions offers a cash-out
option, employees who take health insurance or other benefits instead of cash will not be taxed on the cash they
could have received (but chose not to receive).
However,if a cafeteria plan discriminates with regard to eligibility to participate,or contributions and benefits,a
highly compensated participant who makes salary reductions will be taxed on the amount of those salary
reductions, or the maximum cash amount he or she could have elected for the cafeteria plan year, even if the
participant elected all qualified benefits and no cash. A cafeteria plan's failure to meet the concentration of
benefits test will result in the taxation of cash that is available to key employees under the cafeteria plan,even if
qualified benefits were instead elected. Violation of any of the nondiscrimination rules will also require the
employer to pay Social Security and unemployment taxes on the additional taxable income for highly compensated
participants and key employees.
In addition,employers should be aware that in the event their cafeteria plan fails to satisfy the legal requirements
for a cafeteria plan (for example -- existence of a written plan document adopted by the employer,signed salary
reduction agreements, limiting eligibility to employees, and only offering qualified benefits4),and,as a result of
such failures the cafeteria plan is disqualified by the Internal Revenue Service,then all plan participants could be
taxed on the cafeteria plan benefits.
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TEST RESULTS AND COMPUTATIONS
The following calculations and results are performed as of March 18, 2008. These calculations were prepared
based upon the information you provided to us.
GENERAL NONDISCRIMINATION TESTS FOR CAFETERIA PLANS
Testing Conducted on a Disaggregated Basis - In certain circumstances, benefit offerings (e.g., coverages or
credits) may vary by business unit or geographic location. If this is the case, the most conservative course of
action is to create a separate cafeteria plan. Alternatively,based upon analogous qualified plan authority,you may
choose to test each group separately under the eligibility test (and thereby avoid the uncertainty of cross-testing
for contributions and benefits). Consult your legal counsel for further guidance on this issue. If you have
authorized testing on a disaggregated basis,you will receive a report for each disaggregated plan.
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TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 125
General
There are three (3) nondiscrimination tests required by Code Section 125:
1. Eligibility Tests (an objective test),
2. Contributions and Benefits Tests (a subjective test), and
3. Key Employee Concentration Test' (an objective test).
Overview of the Results
The following is a general overview of the test results for each objective test identified above. The details of how
we conducted each test and the results are described below. We also explain below the mechanics of the
subjective Contributions and Benefits Test established by the IRS;however,we do not indicate whether the Code
Section 125 Cafeteria Plan passes or fail this test due to the subjective nature of the test. We will be glad to
discuss the Contributions and Benefits test with you to assist you in determining whether any potential
discrimination issues exist.
Objective Test Results
1.Eligibility Test Pass
2.Key Employee Concentration Test Pass
Details of the Tests
I. Eligibility Test
Code Section 125(b)(1)(A) provides that Highly Compensated Employees (HCEs)8 must include
cafeteria plan contributions in income if the cafeteria plan discriminates in favor of HCEs as to eligibility
to participate. A plan does not discriminate in favor of HCEs as to eligibility to participate if the plan
satisfies the following three conditions:
1. No employee is required to complete more than 3 years of employment to participate and the
same employment requirement applies to all employees ("Employment Requirement")9;
2. Entry into the cafeteria plan occurs no later than the first day of the plan year beginning after
they satisfy the Employment Requirement ("Entry Requirement")10; and
3. The Plan meets a nondiscriminatory classification test ("Nondiscriminatory Classification
Test")11
Condition 1: Employment Requirement
No employee is required to complete more than 3 years of employment prior to becoming eligible for the
plan and the employment requirement is the same for all eligible employees.
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{X} PASS-Under the Plan,no employee is required to complete more than 3 years of employment to be
eligible for the Plan and all eligible employees are subject to the same employment requirement.
{ } FAIL-Under the Plan,no employee is required to complete more than 3 years of employment to be
eligible for the Plan BUT one or more groups of employees are subject to different employment
requirements.
{ } FAIL-Under the Plan,one or more groups of employees are required to complete more than 3 years
of employment prior to becoming eligible for the Plan.
IF"FAIL"IS MARKED ABOVE,THE ENTIRE ELIGIBILITY TEST IS FAILED. See "IV.
Consequences of Failing the Eligibility Test" below for information concerning potential tax
consequences to HCEs and possible adjustments to avoid failing the test.
Condition 2: Entry into the Plan is Not Delayed
Upon satisfying the Employment Requirement,an employee must be able to enter the plan(i.e.become a
participant) no later than the first day of the next plan year after satisfying the Employment Requirement.
{X} PASS-Under the Plan,eligible employees become participants no later than the first day of the plan
year following the date the employee satisfies the Employment Requirement.
{ } FAIL - Under the plan, one or more groups of employees DO NOT become participants on or
before the first day of the plan year following the date the employee satisfies the Employment
Requirement.
IF"FAIL"IS MARKED ABOVE, THE ENTIRE ELIGIBILITY TEST IS FAILED. See "IV.
Consequences of Failing the Cafeteria Plan Nondiscrimination Test"below for information concerning
tax consequences to HCEs and possible adjustments to avoid failing the test.
Condition 3: Nondiscriminatory Classification Test
There are two parts to the Nondiscriminatory Classification Test. First, the classification(s) of
employees eligible for the plan must be "reasonable." Second, the classification(s) must be
nondiscriminatory under a"safe harbor test". We have discussed these two parts in more detail below.
(a)Reasonable Classification
A reasonable classification is established by the employer if and only if the classification is reasonable,
based on all the facts and circumstances,and is established under"objective business criteria"that identify
the category of employees who benefit under the plan. Examples of"objective business criteria"are as
follows:
• Salaried
• Hourly
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• Full-time
• Part time
• Type of job (e.g. mechanics, management, etc)
• Geographic location
Although this portion of the test requires"objective"business criteria,it is still a subjective test. Because
this is a subjective test,we cannot conclusively indicate whether you have passed or failed this portion of
the Nondiscriminatory Classification Test. However,if the eligibility classifications under the Plan do
not fall under one of the above mentioned"objective business criteria"you should consult with your legal
or tax advisor.
(b)Safe Harbor Test
The reasonable classification is nondiscriminatory if it passes the Safe Harbor Test. The Safe Harbor
Test compares the percentage of non-excludable non-highly compensated employees who are eligible
under the Plan to the percentage of non-excludable highly compensated employees who are eligible
under the Plan. We assume that the data that you provided to us on the Request Form excluded all
employees that satisfied one of the"Excludable Employees"categories for this Test that were identified
in the Request Form.12
1. Determine the eligibility percentages for each group of employees.
The eligibility percentage for each group is determined by dividing the number of non-
excludable employees in the group that are eligible to participate in the Plan by the total number
of non-excludable employees in that group.
EMPLOYEE GROUP BENEFITING PERCENTAGE
HCEs Eligible = HCE%
Highly Compensated Employees Total HCEs
NHCEs Eligible =NHCE%
Non-highly Compensated Employees Total NHCEs
2. Determine the Plan's"ratio percentage". A Plan's ratio percentage is:
NHCE Eligibility% =Ratio percentage for the Plan
HCE Eligibility%
3. Determine the Plan's"non-highly compensated employee concentration percentage",which is
the percentage of the employer's non-excludable employees that are non-highly compensated.
(Again, employees who are excludable for purposes of testing are not taken into account.)
# (Eligible NHCEs) =NHCE concentration%
# (All Eligible Employees)
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4. Once the Plan's non-highly compensated employee concentration percentage has been
determined, the Safe Harbor and Unsafe Harbor Percentage is identified using the Non-
Discriminatory Classification Chart(see Exhibit A). The Safe and Unsafe Harbor percentages
correspond to the Plan's NHCE Concentration Percentage. If the Plan's ratio percentage is
equal to or greater than the safe harbor percentage, then the plan's employee classification is
deemed nondiscriminatory. If the ratio percentage is less than the safe harbor percentage but
more than the unsafe harbor percentage, then the Plan may still pass if it passes the"facts and
circumstances"test (described in more detail below).
The following is a summary of the applicable percentages generated by the information that you provided
on the Request Form and the results of the Test that are based on these percentages.
Item Percentage
Highly Compensated Employee Eligibility% 100.00%
Non-highly Compensated Employee Eligibility% 100.00%
Ratio Percentage 100.00%
Non-Highly Compensated Employee Concentration% 88%
Safe Harbor% 29.00%
Unsafe Harbor% 20.00%
{X} PASS—Based upon the percentages identified above,the Plan passes the safe harbor test because the
ratio percentage is greater than or equal to the safe harbor%.
{ } CAUTION—Based upon the percentages identified above,the Plan's ratio percentage is less than
the safe harbor%but greater than or equal to the unsafe harbor%. You should review the"facts
and circumstances"test with your tax or legal advisor to determine if you pass. Some factors to be
considered are:
• The underlying business reasons for the classification. The greater the business reason,the
more likely the eligibility classification is nondiscriminatory;
• The percentage of the employer's employees eligible for the plan. The higher the
percentage the more likely the classification is nondiscriminatory;
• Whether the number of employees benefiting under the Plan in each salary range is
representative of the number of employees in each salary range of the employer's workforce;
• The difference between the Plan's ratio percentage and the safe harbor percentage. The
smaller the difference, the more likely the classification is nondiscriminatory.
{ } FAIL Based upon the percentages identified above, the plan fails the safe harbor test because the
ratio percentage is less than both the safe harbor%and the unsafe harbor%.
IF"FAIL"IS MARKED ABOVE, THE ENTIRE ELIGIBILITY TEST IS FAILED. See "IV.
Consequences of Failing the Cafeteria Plan Nondiscrimination Tests"below for information concerning
tax consequences to HCEs and possible adjustments to avoid failing the test.
IL Key Employee Concentration Test
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No more than twenty-five percent (25%) of the statutory nontaxable benefits under the Plan may be
provided to "key" employees.14 The statutory nontaxable benefits are the total value of the pre-tax
coverage elected, which includes both employer and employee pre-tax contributions to the extent the
employer and employee contribute to such coverage. Employer contributions for benefit levels of
coverage to which the employee is not required to contribute are presumably not required to be
included.15
The following is a summary of the data that you provided to us on the Request Form and the results of
the Test based on this data.
Item Amounts
Total non-taxable benefits selected by key employees 0
Total non-taxable benefits selected by all employees 310319
(including Key Employees)
Key Employee Percentage 0%
Maximum Key Employee Benefit Amount 103440
{X} PASS—Under the Plan, the key benefit percentage does not exceed 25%.
{ } FAIL—Under the Plan, the key benefit percentage exceeds 25%.
IF "FAIL" IS MARKED ABOVE, THE KEY EMPLOYEE CONCENTRATION TEST IS
FAILED. See "IV. Consequences of Failing the Cafeteria Plan Nondiscriminati0n Tests" below for
information concerning tax consequences to Key Employees and possible adjustments to avoid failing the
test.
III. Contributions and Benefits Test
Under the plan, an equal opportunity to select benefits appears to exist for eligible highly compensated
employees and non-highly compensated employees.
In certain circumstances, benefit offerings (e.g., coverages or credits) may vary by business unit or
geographic location. If this is the case, the most conservative course of action is to create a separate
cafeteria plan. Alternatively,based upon analogous qualified plan authority,you may choose to test each
group separately under the eligibility test (and thereby avoid the uncertainty of cross-testing for
contributions and benefits). Consult your legal counsel for further guidance on this issue. If you have
authorized testing on a disaggregated basis, the results for each sub-plan are shown on the attached
appendices A, B, etc.
IV. Consequences of failing the Code Section 125 Cafeteria Plan Tests
Under Code Section 125, if a plan is discriminatory, HCEs and/or key employees (whichever is
applicable)must include their pre-tax contributions in income. If the plan is discriminatory,non-HCEs
and non-Key Employees are not affected.
If a cafeteria plan discovers that it fails the nondiscrimination tests after the Plan year has ended the tests
8
cannot be satisfied through corrective election adjustments." In that instance, all HCE and/or key
employees will be taxed on the amount of their salary reductions,plus any cash or taxable benefits they
could have received under the plan. For example,if an HCE could have applied an employer-provided
flexible credit towards the cost of health insurance or received it in cash,the HCE is taxed on the"cash
out" amount even if the HCE applied it towards the cost of the benefit. These amounts are subject to
income tax withholding,FICA and FUTA. You should contact your tax advisor to determine the proper
method for including such amounts in income and properly reporting income and employment taxes to
the IRS.
If the discriminatory nature of the Plan is discovered before the end of the plan year,the employer may
be able to satisfy the nondiscrimination tests for that plan year by making adjustments to the elections of
HCEs and/or key employees. Here are some examples of potential adjustments for the various tests:
Test Potential Adjustments
1.Eligibility Test Terminate the pre-tax participation of HCEs,
beginning with the highest paid participant,until
the Eligibility Test is passed.
2.Key Employee Concentration Test Determine the amount of non-taxable benefits for
Key Employees that exceeds the 25%
NOTE: We have provided above the total amount of requirement. Divide that amount by the number
nontaxable benefits that may be provided to Key of Key Employees and reduce or stop the on-
Employees for the year to pass. going pre-tax contributions of each Key Employee
by that amount. Alternatively,you may be able to
base the allocation of reductions on the amount
elected by each Key Employee..
3. Contributions and Benefits Test Separate the different classifications of employees
into separate plans. For example, if full-time
employees are required to contribute less than
full-time employees,separate full-time employees
into their own plan. BEWARE: This approach
can result in the failure of the Eligibility Test.
Mid-year adjustments are not specifically provided for in the statute or regulations;however,the IRS has
informally indicated mid-year corrections are acceptable. Such an adjustment may prevent either adverse
tax consequences for all HCEs and/or Key Employees or limit the consequences to only a few. The plan
document must permit the plan administrator to adjust HCE and key employee elections in order for
adjustments to be made.
Please contact us for further information regarding election adjustments and the consequences of failing
the nondiscrimination tests.
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TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 105-HCSA
General
There are two (2)nondiscrimination tests required by Code Section 105 for self-insured medical reimbursement
plans (e.g. Health Care Spending Account-HCSA and/or Health Reimbursement Arrangement-HRA):
1. Eligibility Test (Objective)17 and
2. Benefits Test (Subjective)18.
Overview of the Results
The following is a general overview of the test results for the Eligibility Test. The details of how we conducted
this test and the results are described below. We also explain below the mechanics of the subjective Benefits
Test;however,we do not indicate whether you pass or fail this test due to its subjective nature. We will be glad
to discuss the Benefits Test with you separately to assist you in determining whether any potential discrimination
issues exist.
Objective Test* Results
1. Eligibility Test (Counting only those that actually Pass
participate in the Plan)
2.Eligibility Test(Counting only those that merely eligible to Pass
participate in the Plan)
*The Code Section 105 Eligibility Test compares the percentage of HCEs "benefiting"under the Plan to non-
HCEs"benefiting"under the Plan. There are two different interpretations as to the definition of"benefiting"for
purposes of the Code Section 105 Eligibility Test. We conducted the test using both interpretations. We have
provided more detail on this issue below.
Details of the Tests
L Eligibility Test
Code Section 105(h)states that self-insured medical reimbursement plans cannot discriminate in favor of
Highly Compensated Employees (HCEs) as to eligibility to participate.19 To meet the
nondiscriminatory eligibility requirement set forth in Code Section 105,a plan must satisfy at least one of
the three subtests set forth below.
Subtest A. The plan must "benefit" 70% of all non-excludable employees (i.e., 70% of all non-
excludable employees must participate);
Subtest B. 70%of all non-excludable employees are eligible and "benefit" at least 80% "benefit"; or
Subtest C. Each classification of employees eligible for the Plan is a nondiscriminatory classification.
10
The following is a summary of the subtest and results of each subtest. The results are based on the data
that you provided on the Request Form.20
Subtest A. 70%Participation Test
{ } PASS-The Plan passes Subtest A because 70%of all non-excludable employees are participating in
the Plan. Stop,you pass the Eligibility Test.
{X} FAIL-The Plan does not pass Subtest A because less than 70%of all employees are participating in
the Plan. Go to Subtest B.
Subtest B. 70/80%Eligibility/Participation Test
{ } PASS - The Plan passes Subtest B because 70% of all non-excludable employees are eligible to
participate in the Plan and 80%of those eligible actually participate.Stop,you pass the Eligibility
Test
{X} FAIL - The Plan does not pass Subtest B because either 70%of all employees are not eligible to
participate in the Plan or 80%of those eligible do not participate. Go to Subtest C.
Subtest C:Nondiscriminatory Classification Test
There are two parts to the Nondiscriminatory Classification Test. First, the classification(s) of
employees eligible for the plan must be "reasonable." Second, the classification(s) must be
nondiscriminatory under a"safe harbor test". We have discussed these two parts in more detail below.
(a)Reasonable Classification
A reasonable classification is established by the employer if and only if the classification is reasonable,
based on all the facts and circumstances,and is established under"objective business criteria"that identify
the category of employees who benefit under the plan. Examples of"objective business criteria"are as
follows:
• Salaried
• Hourly
• Full-time
• Part time
• Type of job (e.g. mechanics, management, etc)
• Geographic location
Although this portion of the test requires"objective"business criteria,it is still a subjective test. Because
this is a subjective test,we cannot conclusively indicate whether you have passed or failed this portion of
the nondiscriminatory classification test. However,if the eligibility classifications under the Plan do not
fall under one of the above mentioned"objective business criteria"you should consult with your legal or
tax advisor.
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(b)Safe Harbor Test
The reasonable classification is nondiscriminatory if it passes the Safe Harbor Test. The Safe Harbor
Test compares the percentage of non-excludable non-highly compensated employees who are
"benefiting"under the Plan with the percentage of non-excludable non-highly compensated employees
who are "benefiting"under the Plan.
There is much debate over the definition of "benefiting" for purposes of the Code Section 105
nondiscriminatory classification Test. One interpretation is that"benefiting"means"participating in the
Plan. This is based on the two subtests that precede this subtest, both of which define"benefiting"as
"participating". On the other hand,this test is based on a similar pension discrimination test established
in Code Section 410(b). Under Section 410,"benefiting"means"merely eligible". Consequently,this is
how the Code Section 125 and 129 Eligibility Tests are operated. Due to the uncertainty surrounding
the definition of"benefiting" for Code Section 105 purposes, we requested information necessary to
conduct the test using both interpretations.
The following is a summary of how to conduct the test:
1. Determine the benefiting percentages for each group of employees.
The eligibility percentage for each group is determined by dividing the number of employees in
the group that are"benefiting"by the total number of employees in that group.
EMPLOYEE GROUP BENEFITING PERCENTAGE
Highly Compensated Employees HCEs Eligible/Participating =HCE%
Total HCEs
Non-highly Compensated NHCEs Eligible/Participating =NHCE%
Employees Total NHCEs
2. Determine the Plan's "ratio percentage". A Plan's ratio percentage is:
NHCE Benefiting% = Ratio percentage for the Plan
HCE Benefiting%
3. Determine the plan's"non-highly compensated employee concentration percentage",which is
the percentage of the employer's non-excludable employees that are non-highly compensated.
(Again, employees who are excludable for purposes of testing are not taken into account.)
# (Eligible NHCEs) = NHCE concentration%
# (All Eligible Employees)
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4. Once the Plan's non-highly compensated employee concentration percentage has been
determined, the Safe Harbor and Unsafe Harbor Percentage is identified using the Non-
Discriminatory Classification Chart(see Exhibit A). The Safe and Unsafe Harbor percentages
correspond to the plan's NHCE Concentration Percentage. If the Plan's ratio percentage is
equal to or greater than the safe harbor percentage, then the plan's employee classification is
deemed nondiscriminatory. If the ratio percentage is less than the safe harbor percentage but
more than the unsafe harbor percentage,then the Plan may still pass if it passes the"facts and
circumstances" test (described in more detail below).
The following is a summary of the applicable percentages generated by the information that you provided
on the Request Form and the results of the Test that are based on that information.
Item Percentage Percentage
(Using (Using those that are
"Participants") merely"Eligible")
Highly Compensated Employee Benefiting% 15.38% 100.00%
Non-highly Compensated Employee Benefiting% 21.62% 100.00%
Ratio Percentage% 140.54% 100.00%
Non-Highly Compensated Employee 74% 74%
Concentration%
Safe Harbor% 39.50% 39.50%
Unsafe Harbor% 29.50% 29.50%
Results when measuring participant count only:
{X} PASS—Based upon the percentages identified above,the Plan passes the safe harbor test because the
ratio percentage is greater than or equal to the safe harbor%.
{ } CAUTION—Based upon the percentages identified above,the Plan's ratio percentage is less than
the safe harbor%but greater than or equal to the unsafe harbor%. You should review the"facts
and circumstances"test with your tax or legal advisor to determine if you pass. Some factors to be
considered are:
• The underlying business reasons for the classification. The greater the business reason,the
more likely the eligibility classification is nondiscriminatory;
• The percentage of the employer's employees eligible for the plan. The higher the
percentage the more likely the classification is nondiscriminatory;
• Whether the number of employees benefiting under the Plan in each salary range is
representative of the number of employees in each salary range of the employer's workforce;
• The difference between the Plan's ratio percentage and the safe harbor percentage. The
smaller the difference, the more likely the classification is nondiscriminatory.
{ } FAIL Based upon the percentages identified above, the Plan fails the safe harbor test because the
ratio percentage is less than both the safe harbor%and the unsafe harbor%.
13
4110
Results when measuring those that are merely eligible:
{X} PASS—Based upon the percentages identified above,the Plan passes the safe harbor test because the
ratio percentage is greater than or equal to the safe harbor%.
{ } CAUTION—Based upon the percentages identified above,the Plan's ratio percentage is less than
the safe harbor%but greater than or equal to the unsafe harbor%. You should review the "facts
and circumstances"test with your tax or legal advisor to determine if you pass. Some factors to be
considered are:
• The underlying business reasons for the classification. The greater the business reason,the
more likely the eligibility classification is nondiscriminatory;
• The percentage of the employer's employees eligible for the plan. The higher the
percentage the more likely the classification is nondiscriminatory;
• Whether the number of employees benefiting under the Plan in each salary range is
representative of the number of employees in each salary range of the employer's workforce;
• The difference between the Plan's ratio percentage and the safe harbor percentage. The
smaller the difference,the more likely the classification is nondiscriminatory.
{ } FAIL Based upon the percentages identified above, the plan fails the safe harbor test because the
ratio percentage is less than both the safe harbor%and the unsafe harbor%.
IF"FAIL"IS MARKED ABOVE,THE ENTIRE ELIGIBILITY TEST IS FAILED. See "III.
Consequences of Failing the Code Section 105 Nondiscrimination Tests" below for information
concerning tax consequences to HCEs and possible adjustments to avoid failing the test.
IL Benefits Test
Part One: All benefits provided for participants who are highly compensated individuals must be
provided for all other participants.
Under the health plan, all employees (both highly compensated and non-highly compensated) who
participate in the plan receive the same benefits,i.e., are subject to the same copays,maximum out-of-
pocket expenses, maximum lifetime plan benefit, etc.21
Part Two:The maximum limit for benefits must be uniform for all participants and may not be based on
a participant's age,years of service, or compensation.
Under the health plan,the maximum lifetime benefit for the plan is the same for all participants and is
not based on the participant's age,years of service or compensation.22
Testing Maybe Conducted on a Disaggregated Basis In certain circumstances,benefit offerings(e.g.,
coverages or credits) may vary by business unit or geographic location. If this is the case, the most
conservative course of action is to create a separate cafeteria plan. Alternatively,based upon analogous
qualified plan authority, you may choose to test each group separately under the eligibility test (and
thereby avoid the uncertainty of cross-testing for contributions and benefits). Consult your legal counsel
14
s
410 0
for further guidance on this issue. If you have authorized testing on a disaggregated basis,the results for
each sub-plan are shown on the attached appendices A, B, etc.
You should consult with your legal or tax advisor to determine if you pass or fail this test.
III. Consequences of Failing the Code Section 105 Nondiscrimination Tests and Potential
Adjustments
Under Code Section 105,if a plan is discriminatory,HCEs will have to include"excess reimbursements"
income. Non-HCEs are not affected. The amount of"excess reimbursements"depends on the type of
discrimination involved. Generally, if the plan fails the Eligibility Test, the amount of excess
reimbursements to each HCE will be a percentage of the reimbursement received by that HCE for the
plan year. The percentage is based on the percentage of plan benefits received by all HCEs compared to
benefits received by all employees. For example, if HCEs receive 50% of all benefits under the
reimbursement Plan, 50% of all reimbursements received by HCEs will be taxable.
If the plan fails the Benefits Test,excess reimbursements will equal the total amount of reimbursements
made to an HCE that are not otherwise received by non-HCEs. For example,if management employees
are eligible for the Plan on the date of hire but rank and file are not eligible until they have completed 30
continuous days of employment, then all benefits received by HCEs during the rank and file's waiting
period would be includable in income.
If a self-insured medical reimbursement plan discovers that it fails the nondiscrimination tests after the
end of the plan year has ended, the tests cannot be satisfied through corrective election adjustments.
Therefore, each HCE will be taxed on their entire excess reimbursement amount for the previous plan
year. Excess reimbursements are includible in gross income,but are not taken into account for purposes
of withholding, FICA or FUTA tax.
If the discriminatory nature of the plan is discovered before the end of the plan year,the employer may
be able to satisfy the nondiscrimination tests for that plan year by making adjustments to the elections of
HCEs. The following is a list of potential adjustments for the two nondiscrimination tests:
Test Potential Adjustments
1.Eligibility Test Terminate the pre-tax participation of HCEs,
beginning with the highest paid participant, until the
Eligibility Test is passed.
2.Benefits Test Separate the different classifications of employees into
separate plans. For example,if full-time employees are
required to contribute less than full-time employees,
separate full-time employees into their own plan.
BEWARE: This approach can result in the failure of
the Eligibility Test.
Mid-year adjustments are not specifically provided for in the statute or regulations;however,the IRS has
informally indicated mid-year corrections are acceptable. Such an adjustment could prevent either
adverse tax consequences for all HCEs or limit the consequences to only a few. The plan document must
15
e •
permit the plan administrator to adjust HCE elections in order for adjustments to be made. In addition,
employers should note that it is not clear that corrective adjustments will cure nondiscrimination
problems. However, the IRS has informally indicated that this type of correction is acceptable.
Please contact us for further information regarding election adjustments and the consequences of failing
the nondiscrimination tests.
16
•
TEST RESULTS AND COMPUTATIONS FOR CODE SECTION 129-DCSA
General
There are four (4) nondiscrimination tests required by Code Section 129 (e.g. Dependent Care Spending
Account-DCSA):
1. Eligibility Test23 (objective)
2. Contributions and. Benefits Test24 (subjective)
3. 55%Average Benefits Test25 (objective)
4. 5%+ Shareholder Concentration Test26 (objective)
Overview of the Results
The following is a general summary of the test results of each objective test identified above. The details of how
we conducted each test and the results are described below. We explain below the mechanics of the subjective
Contributions and Benefits test;however,we do not indicate whether you pass or fail this test due to its subjective
nature. We will be glad to discuss the Contributions and Benefits Test with you separately to assist you in
determining whether any potential discrimination issues exist.
Objective Test Results
1.Eligibility Test Pass
2.55%Average Benefits Test Pass
3. 5%+Shareholder Concentration Test Pass
Details of the Tests
I. Eligibility Test
Code Section 129(d)(3) provides that an employer's classification regarding who qualifies for benefits
cannot discriminate in favor of Highly Compensated Employees (HCEs).27 To pass the Code Section
129 Eligibility Test, the plan must pass the "Nondiscriminatory Classification Test". There are two
parts to the Nondiscriminatory Classification Test. First, the classification(s) of employees eligible for
the plan must be "reasonable." Second, the classification(s) must be nondiscriminatory under a"safe
harbor test". We have discussed these two parts in more detail below.
(a)Reasonable Classification
A reasonable classification is established by the employer if and only if the classification is reasonable,
based on all the facts and circumstances,and is established under"objective business criteria"that identify
the category of employees who benefit under the plan. Examples of"objective business criteria"are as
follows:
17
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• Salaried
• Hourly
• Full-time
• Part time
• Type of job (e.g. mechanics, management, etc)
• Geographic location
Although this portion of the test requires"objective"business criteria,it is still a subjective test. Because
this is a subjective test,we cannot conclusively indicate whether you have passed or failed this portion of
Condition#3. However,if the eligibility classifications under the Plan do not fall under one of the above
mentioned"objective business criteria"you should consult with your legal or tax advisor.
(b)Safe Harbor Test
The reasonable classification is nondiscriminatory if it passes the Safe Harbor Test. The Safe Harbor
Test compares the percentage of non-excludable non-highly compensated employees who are eligible
under the Plan with the percentage of non-excludable highly compensated employees who are eligible
under the Plan.28
1. Determine the eligibility percentages for each group of employees.
The eligibility percentage for each group is determined by dividing the number of non-
excludable employees in the group that are eligible to participate in the Plan by the total number
of non-excludable employees in that group.
•
EMPLOYEE GROUP BENEFITING PERCENTAGE
Highly Compensated Employees HCEs Eligible =HCE%
Total HCEs
Non-highly Compensated Employees NHCEs Eligible = NHCE%
Total NHCEs
2. Determine the plan's"ratio percentage". A Plan's ratio percentage is:
NHCE Eligibility% = Ratio percentage for the Plan
HCE Eligibility%
3. Determine the plan's"non-highly compensated employee concentration percentage",which is
the percentage of the employer's non-excludable employees that are non-highly compensated.
(Again, employees who are excludable for purposes of testing are not taken into account.)
# (Eligible NHCEs) = NHCE concentration%
# (All Eligible Employees)
18
110
4. Once the plan's non-highly compensated employee concentration percentage has been
determined, the Safe Harbor and Unsafe Harbor Percentage is identified using the Non-
Discriminatory Classification Chart(see Exhibit A). The Safe and Unsafe Harbor percentages
correspond to the plan's NHCE Concentration Percentage. If the plan's ratio percentage is
equal to or greater than the safe harbor percentage, then the plan's employee classification is
deemed nondiscriminatory. If the ratio percentage is less than the safe harbor percentage but
more than the unsafe harbor percentage, then the Plan may still pass if it passes the"facts and
circumstances"test (described in more detail below).
The following is a summary of the applicable percentages generated by the information that you provided
on the Request Form and the results of each test,which are found on the data you provided.
Item Percentage
Highly Compensated Employee Eligibility% 100.00%
Non-highly Compensated Employee Eligibility% 100.00%
Ratio Percentage% 100.00%
Non-Highly Compensated Employee Concentration% 86%
Safe Harbor% 30.50%
Unsafe Harbor% 20.50%
{X} PASS—Based upon the percentages identified above,the Plan passes the safe harbor test because the
ratio percentage is greater than or equal to the safe harbor%.
{ } CAUTION—Based upon the percentages identified above,the Plan's ratio percentage is less than
the safe harbor%but greater than or equal to the unsafe harbor%. You should review the "facts
and circumstances"test with your tax or legal advisor to determine if you pass. Some factors to be
considered are:
• The underlying business reasons for the classification. The greater the business reason,the
more likely the eligibility classification is nondiscriminatory;
• The percentage of the employer's employees eligible for the plan. The higher the
percentage the more likely the classification is nondiscriminatory;
• Whether the number of employees benefiting under the Plan in each salary range is
representative of the number of employees in each salary range of the employer's workforce;
• The difference between the Plan's ratio percentage and the safe harbor percentage. The
smaller the difference, the more likely the classification is nondiscriminatory.
{ } FAIL Based upon the percentages identified above, the Plan fails the safe harbor test because the
ratio percentage is less than both the safe harbor%and the unsafe harbor%.
IF "FAIL" IS MARKED ABOVE, THE ENTIRE ELIGIBILITY TEST IS FAILED. See "V.
Consequences of Failing the Code Section 129 Nondiscrimination Tests" below for information
concerning tax consequences to HCEs and possible adjustments to avoid failing the test.
19
•
II: 55%Average Benefits Test29
The average benefit provided to non-excludable non-highly compensated employees must be at least 55%
of the average benefit provided to non-excludable highly compensated employees.30 The following is a
summary of the data that you provided on the Request Form and the results of the test.
Data Amounts
Total number of non-excludable highly compensated employees 6
Total amount of benefits provided to highly compensated 0
employees during the year31
Average Benefit for highly compensated employees 0
Total number of non-excludable non-highly compensated 36
employees
Total amount of benefits provided to non-highly compensated 1300
employees during the year
Average Benefit for non-highly compensated employees 36
Percentage of NHCE Average Benefits to HCE Average Benefits 100.00%
Maximum annual amount of HCE benefits to pass 393.94
{X} PASS—The average benefit of non-highly compensated employees is 55%or more of the average
benefit of highly compensated employees.
{ } FAIL—The average benefit of non-highly compensated employees is less than 55%of the average
benefit of highly compensated employees.
IF"FAIL"IS MARKED ABOVE,THE 55%AVERAGE BENEFITS TEST IS FAILED. See"V.
Consequences of Failing the Code Section 129 Nondiscrimination Tests" below for information
concerning tax consequences to HCEs and possible adjustments to avoid failing the test.
Note: There are two interpretations on who to include in the 55% average benefits test. The literal
language of the statute suggests that all non-excludable employees must be included,even if they are not
eligible to participate. The Request Form asks for all such employees. An alternative interpretation
suggests that only those employees who are eligible should be included in the test. Although not
consistent with a literal reading of the statute,this approach seems to be more consistent with the nature
of this test, which is a utilization test. If you fail this test, you should consider testing using the
alternative approach described above. You should discuss this issue with your tax or legal advisor.
III: 5%+Shareholder Concentration Test
Not more than 25%of the amounts paid for or incurred by the employer for dependent care assistance
during a year may be provided to individual shareholders or owners (or their spouse or dependents)who
own (on any day of the year) more than 5% of the stock, or of the capital interest of the employer.
Failure to satisfy this test impacts all highly compensated employees, not merely the 5%owners.
20
. .
1111
The following is a summary of the data that you provided on the Request Form and the results of the
test.
Item Amounts
Dependent Care Benefits Provided to All Employees 1,300
Dependent Care Benefits Provided to More Than 5%Shareholders 0
Percentage of all benefits provided to more than 5%shareholders. 0.00%
{X} PASS - Not more than 25%of the amounts paid for or incurred by the employer for the dependent
care assistance during a year are provided to individual shareholders or owners (or their spouse or
dependents)who own(on any day of the year)more than 5%of the stock,or of the capital interest of
the employer.
{ } FAIL- More than 25%of the amounts paid for or incurred by the employer for the dependent care
assistance during a year are provided to individual shareholders or owners (or their spouse or
dependents)who own(on any day of the year)more than 5%of the stock,or of the capital interest of
the employer.
IF "FAIL" IS MARKED ABOVE, THE SHAREHOLDER CONCENTRATION TEST IS
FAILED. See"V.Consequences of Failing the Code Section 129 Nondiscrimination Tests"below for
information concerning tax consequences to HCEs and possible adjustments to avoid failing the test.
IV. Contributions and Benefits Test
Contributions or benefits provided under the plan shall not discriminate in favor of employees who are
highly compensated or their dependents. There is little guidance provided for this test but presumably it
operates much like the Code Section 125 Contributions and Benefits Test. 32 This test is based on
subjective facts and circumstances; therefore, we cannot provide a conclusion as to whether this test
passes or fails.
You should consult with your legal or tax advisor to determine if you pass or fail this test
V. Consequences of Failing the Code Section 129 Nondiscrimination Tests and Potential
Adjustments
Under Code Section 129,if a dependent care spending account plan is discriminatory,HCEs will have to
include benefits received under the plan in their gross income. Non-HCEs are not affected. The
employer is not obligated to deduct withholding or employment taxes if it was reasonable for the
employer to believe that the dependent care spending account benefits would be excludable from income.
If one or more of the tests are failed, discuss the withholding issues with your tax or legal advisor.
If a dependent care spending account plan does not discover that it fails the nondiscrimination tests after
the Plan Year has ended,the tests cannot be satisfied through corrective election adjustments. Therefore,
each HCE will be taxed based on the total amount of benefits received during the previous plan year.
If the discriminatory nature of the plan is discovered before the end of the plan year,you may be able to
satisfy the nondiscrimination tests for that plan year by making adjustments to the elections of HCEs.
21
II/
For example,the employer can limit the elections of HCEs downward for the rest of the plan year. In
some cases,it may be appropriate to stop elections made by HCEs altogether. Here are some examples
of potential adjustments for the various tests:
Test Potential Adjustments
1.Eligibility Test Terminate the pre-tax participation of HCEs,
beginning with the highest paid participant, until
the Eligibility Test is passed.
2.55%Average Benefits Test Reduce the HCE's dependent care contributions
for the remainder of the year to the point where
NOTE: We have provided above the neximum the non-HCEs benefits equal or exceed 55%of the
aggregate amount of HCE contributions that will average benefit for HCEs.
allow you to pass.
3. Contributions and Benefits Test Separate the different classifications of employees
into separate plans. For example, if full-time
employees are required to contribute less than full-
time employees, separate full-time employees into
their own plan. BEWARE: This approach can
result in the failure of the Eligibility Test.
4.Shareholder Concentration Test Determine the amount of dependent care benefits
for 5%+ shareholders that exceeds the 25%
NOTE:We have provided above the total amount of requirement.Divide that amount by the number of
nontaxable benefits that may be provided to Key 5%+shareholders and reduce or stop the ongoing
Employees for the year to pass. pre-tax contributions for dependent care benefits of
5%+ shareholder by that amount. Alternatively,
you may be able to base the allocation of reductions
on the amount elected by each Shareholder.
Mid-year adjustments are not specifically provided for in the statute or regulations;however,the IRS has
informally indicated mid-year corrections are acceptable. Such an adjustment could prevent either
adverse tax consequences for all HCEs and/or 5%+Shareholders or limit the consequences to only a few.
The plan document must permit the plan administrator to adjust HCE and shareholder elections in order
for adjustments to be made.
Please contact us for further information regarding election adjustments and the consequences of failing
the nondiscrimination tests.
22
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• 0
EXHIBIT A-COMPARATIVE COVERAGE RATIOS
NHCE Concentration Unsafe Harbor Percentage Unsafe Harbor Percentage
Percentage
g g
0-60
61 50.00 40.00
62 49.25 39.25
63 48.50 38.50
64 47.75 37.75
65 47.00 37.00
66 46.25 36.25
67 45.50 35.50
68 44.75 34.75
69 44.00 34.00
70 43.25 33.25
71 42.50 32.50
72 41.75 31.75
73 41.00 31.00
74 40.25 30.25
75 39.50 29.50
76 38.75 28.75
77 38.00 28.00
78 37.25 27.25
79 36.50 26.50
80 35.75 25.75
81 35.00 25.00
82 34.25 24.25
83 33.50 23.50
84 32.75 22.75
85 32.00 22.00
86 31.25 21.25
87 30.50 20.50
88 29.75 20.00
29.00
89 20.00
90 28.25 20.00
91 27.50 20.00
26.75
92 20.00
26.00
93 20.00
94 25.25 20.00
24.50
95 20.00
96 23.75 20.00
23.00
97 20.00
98 22.25 20.00
21.50
99 20.00
20.75 20.00
23
• •
• •
APPENDIX A-NONDISCRIMINATION TEST
Non-Discrimination Testing
Worksheet
2008
Company Name: City of Rancho Palos Verdes Prepared by: Daniel Grant
Client No: 3468
Date Prepared: 3/18/2008
Data Entry for Discrimination Testing
Code Section 125 Cafeteria Plan Tests
A. Code Section 125 Eligibility Test Summary
Test Result
1 50 Sec 125 Eligibility Test: Pass
2 6 Key Emp Concentration: Pass
3 6 70%: Go To 111.2
4 44 70%/80%; Go To 111.3
ND Class w Part: Pass
B. Key Employee Concentration Test ND Class w Elig: Pass
Sec 129 Eligibility Test: Pass
1 310,319 55%Avg Benefits Test: Pass
2 0 Sec 129 5% Owners: Pass
Code Section 105 Tests Details
Test Result
Code Section 105 Eligibility Test Key Emp Concentration: Pass
Percentage:
1 50 New Max:
2 10
3 50 55%Avg Benefits Test: Pass
4 13 Percentage:
5 2 New Max:
6 8
7 13
8 37
Code Section 129 Tests
A. Code Section 129 Eligibility Test
24
• _ s
1 42
2 6
3 6
4 36
B. Code Section 129 55%Average Benefits Test
1 42
2 6
3 0
4 1300
C. Code Section 129 25% Concentration Test
1 1300
2 0
I. Code Section 125 Eligibility Test
A. HCE Eligibility Percentage
(I). Number of non-excludable HCEs eligible to participate in the Plan 6
(ii). Number of non-excludable HCEs of the employer 6
A. HCE Eligibility Percentage 100.00%
B. Non-HCE Eligibility Percentage
(I). Number of non-excludable NHCEs eligible to participate in the Plan 44
(ii) Number of non-excludable NHCEs of the employer
a. Number of non-exludable employees of the employer 50
b. Number of non-excudable HCEs of the employer 6
c. Total non-excludable NHCEs of the employer 44
B. NHCE Eligibility Percentage 100.00%
C. Ratio Percentage (Divide B by A)
C. Ratio Percentage 100.00%
D. NHCE Concentration Percentage
(I). Number of non-excludable NHCEs 44
25
•
•
(ii). Number of non-excludable employees of the employer 50
D. NHCE Concentration 88%
E. Identify safe harbor% associated with D. 29.00%
F. Identify unsafe harbor% associated with D. 20.00%
G. If C is > E,the Test is Passed; If C is<than E, Go to H Pass
H. If C is<E but > F,then go to facts and circumstances test N/A
I. If C is < F, then test is Failed N/A
II. Key Employee Concentration Test
A. Code Section 125 Benefits provided to all employees 310319
B. Code Section 125 benefits provided to Key Employees 0
C. Key Employee Concentration 0%
D.If C is <25%,the test Passes; if C is>25%,the test Fails Pass
E. If"Fail", maximum Key Employee contribution amount to pass 103440
III. Section 105 Eligibility Tests
1. 70% Test
A. Total Number of Employees of the Employer 50
B. Total number of employees participating in the Plan 10
c. Participating Percentage 20.00%
D. If C is > 70%,the test passes; if C is< 70%, Go to 111.2 Go To 111.2
2. 70/80% Test
A. Total Number of Employees of the Employer 50
26
i
410 •
B. Total Number of Employees eligible to participate in the Plan 50
C. Total Number of employees participating in the Plan 10
D. Percentage Eligible to Participate in the Plan 100.00%
E. Percentage of eligible employees participating in the Plan 20.00%
F. If D is >70% and E is >80%, the test Passes. Otherwise, go to 111.3 Go To 111.3
3a. Non-Discrimination Classification Test(using number of participants)
A. HCE Participating Percentage
(I). Number of non-excludable HCEs participating in the Plan 2
(ii). Number of non-excludable HCEs of the employer 13
A. HCE Benefitting Percentage 15.38%
B. Non-HCE Benefitting Percentage
(I). Number of non-excludable NHCEs participating in the Plan 8
(ii). Number of non-excludable NHCEs of the employer
(a). Number of non-exludable employees of the employer 50
(b). Number of non-excudable HCEs of the employer 13
(c). Total non-excludable NHCEs of the employer 37
B. NHCE Benefitting Percentage 21.62%
C. Ratio Percentage (Divide B by A)
C. Ratio Percentage 140.54%
D. NHCE Concentration Percentage
(I). Number of non-excludable NHCEs 37
(ii). Number of non-excludable employees of the employer 50
D. NHCE Concentration 74%
E. Identify safe harbor% associated with D. 39.50%
27
I'
F. Identify unsafe harbor% associated with D. 29.50%
G. If C is > E,the Test is Passed; otherwise Go to H Pass
H. If C is< E, but>F,then go to facts and circumstances test N/A
I. If C is < F, then test is Failed N/A
3b. Non-Discrimination Classification Test(using number of eligible employees)
A. HCE Participating Percentage
(I). Number of non-excludable HCEs eligible to participate in the Plan 13
(ii). Number of non-excludable HCEs of the employer 13
A. HCE Benefitting Percentage 100.00%
B. Non-HCE Benefitting Percentage
(I). Number of non-excludable NHCEs eligible to participate in the Plan 37
(ii). Number of non-excludable NHCEs of the employer
(a). Number of non-exludable employees of the employer 50
(b). Number of non-excudable HCEs of the employer 13
(c). Total non-excludable NHCEs of the employer 37
B. NHCE Benefitting Percentage 100.00%
C. Ratio Percentage (Divide 8 by A)
C. Ratio Percentage 100.00%
D. NHCE Concentration Percentage
(I). Number of non-excludable NHCEs 37
(ii). Number of non-excludable employees of the employer 50
D. NHCE Concentration 74%
E. Identify safe harbor%associated with D. 39.50%
F. Identify unsafe harbor% associated with D. 29.50%
G. If C is > E,the Test is Passed; otherwise Go to H Pass
28
, •
11111 111,
H. If C is< E, but > F,then go to facts and circumstances test N/A
I. If C is < F, then test is Failed N/A
IV. Code Section 129 Eligibility Test
A. HCE Eligibility Percentage
(I). Number of non-excludable HCEs eligible to participate in the Plan 6
(ii). Number of non-excludable HCEs of the employer 6
A. HCE Eligibility Percentage 100.00%
B. Non-HCE Eligibility Percentage
(I). Number of non-excludable NHCEs eligible to participate in the Plan 36
(ii) Number of non-excludable NHCEs of the employer
a. Number of non-exludable employees of the employer 42
b. Number of non-excudable HCEs of the employer 6
c.Total non-excludable NHCEs of the employer 36
B. NHCE Eligibility Percentage 100.00%
C. Ratio Percentage (Divide B by A)
C. Ratio Percentage 100.00%
D. NHCE Concentration Percentage
(I). Number of non-excludable NHCEs 36
(iii). Number of non-excludable employees of the employer 42
D. NHCE Concentration 86%
E. Identify safe harbor% associated with D. 30.50%
F. Identify unsafe harbor% associated with D. 20.50%
G. If C is >E, the Test is Passed; Otherwise Go to H Pass
H. If C is< E but> F,then go to facts and circumstances test N/A
29
•
I. If C is < F, then test is Failed N/A
Circle G,H or I,whichever applies.
V. 55% Average Benefits Test
A. Average Benefits Provided to HCEs
(I).Total benefits provided to HCEs 0
(ii). Number of non-excludable HCEs of the employer 6
A. Average Benefits Provided to HCEs 0
B. Average Benefits Provided to NHCEs
(I).Total benefits provided to NHCEs 1300
(ii). Number of non-excludable NHCEs of the employer
a. Number of non-excludable employees of the employer 42
b. Number of non-excludable HCEs of the employer 6
c.Total non-excludable NHCEs of the employer 36
B. Average Benefits Provided to NHCEs 36
C. Average Benefits provided to NHCEs must be at least 55% of the average benefits provided to HCEs
C. Divide B by A 100.00%
D.If C is > 55%, the Test is Passed;otherwise the Test is Failed Pass
E. If"Fail", maximum HCE benefit amount to Pass 393.94
VI. Concentration Test for 5% Owners
A. Total amount of Dependent Care FSA benefits provided to>5% owners 0
B. Total Amount of Dependent Care FSA benefits provided to all employees 1,300
C. The total amount of dependent Care FSA benefits provided to >%5 owners cannot exceed
25% of dependent care benefits provided to all employees
C. Divide A by B 0.00%
30
0 I
D. If D is > 25%,the test is passed; otherwise the Test is failed Pass
31
410 •
ENDNOTES
"Highly compensated individual"is defined for Code Section 125 purposes as any person who is:an officer,a shareholder
owning more than 5%of the voting power or value of all classes of stock of the employer,highly compensated,or a spouse or dependent
of any of the above individuals. "Highly compensated participant"is defined as a participant meeting the same criteria. "Highly
compensated"for these purposes is not defined and therefore,as a proxy for this definition,Creative Benefits,Inc.uses the Code Seel
414(q)definition of"highly compensated employee"to determine who is highly compensated for the 125 tests. Code Section 414(q)
defines highly compensated employee as a 5%owner of the employer at any time during the current or preceding plan ar an employee
with compensation in excess of$100,000(and,if elected,the employee was in the top 20%of all employees). Note that,if an employer
has elected to use the top-paid group election for its qualified plans(or any other plan),it also must use this election for all other
employee benefit plans. Thus,if your company has elected to use the"top-paid group"election,you must notify Creative Benefits,Inc.
accordingly. Otherwise,Creative Benefits,Inc.will not assume that you have elected the top-paid group election.
2 "Key employee"is defined in Code Section 416(i)as any employee(or former employee,including a deceased employee)who,
during the plan year was one of the following:
(i) An officer of the employer,whose annual compensation for the plan year being tested exceeded$70,000 in 2001 or
$130,000 in 2002 or$135,000 in 2005 or$140,000 in 2007 or$150,000 in 2008(Treasury Regulation Section
1.416-1, Q/A T-13 and T-14 defines who is an officer.)However,no more than 50 employees(or if less,the
greater of 10%,or three employees),are considered officers.
(ii) For 2001 Only:Any one of top-ten employee-owners,defined as those employees who:
(a) own during the current plan year or any of the preceding four years more than a 0.5%ownership interest
in any employer within the Code Section 414(b), (c),or(m)control group;
(b) are one of the top-ten employee-owners,when ranked by their percentage ownership;and
(c) earn more than$35,000 for the calendar year in which the plan year ends.
(iii) A more than 5%owner of the employer. If the employee's ownership percentage changes during the year,use the
largest ownership interest held at any time during the year.
(iv) A more than 1%owner of the employer earning more than$150,000.
You should consult with your legal counsel to determine which employees qualify as key employees of your company.
3 Code Section 415 prescribes maximum benefit amounts that participants in qualified Code Section 401(a)retirement plans
can accrue. For instance,the maximum annual amount that can be credited to a participant's defined contribution plan account is the
lesser of 100%of a participant's compensation or $40,000.
4 This is not a complete list of cafeteria plan legal requirements. Consult your legal counsel for further information.
5 Code Section 125 (b)(1)(A))
6 Code Section 125 (b)(1)(B)
' Code Section 125 (b)(2)
8 For purposes of Code Section 125,Highly Compensated Employee for purposes of Code Section 125 is any of the following
any individual who is:
(i) An officer;
(ii) A shareholder owning more than 5%of the Employer during the testing year or preceding year;or
(iii) An employee who during the preceding year only received more than$100,000 in compensation*;or
(iv) a spouse or dependent of any of the foregoing.
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410
Please note that the definition of Highly Compensated Employee differs for purposes of Code Sections 105 and 129.
The Code provides definitions for the terms officer and compensation,as well as stock attribution rules for determining who is a
shareholder with more than 5%ownership. We will be glad to discuss these definitions with you if you would like more information or
you can refer to the instructions to the Request Form.
*In lieu of the$100,000 threshold identified in (iii) above, plan sponsors may, if elected for all employee benefit plans(including
pension plans),deem any employee a Highly Compensated Employee if the employee was both paid more than 100,000 andwasinthe
top 20%paid group during the preceding plan year. In identifying the top 20%paid group,the following employees may be excluded
from consideration:
(i) employees who have not completed 6 months of service
(ii) employees who normally work less than 17.5 hours per week
(iii) employees who normally do not work more than 6 months during the year(seasonal)
(iv) employees under the age of 21;and
(v) employees subject to a collective bargaining agreement.
9 Code Section 125(g)(3)(B)(i).
to Code Section 125(g)(3)(B)(ii).
Code Section 125(g)(3)(A).
12 Section 125 does not specifically exclude employees from this test. However,this test is based on the pension discrimination
rules set forth in Code§410(b). The 410(b)rules provide for several categories of Excludable Employees. Although§125 does not
explicitly incorporate these exclusions,it has become industry standard to utilize these exclusions for purposes of this test.
(i) Employees who are exduded from participating in the Plan as a result of an age requirement that is less than 21
years of age. Employees who satisfy the Plan's age requirement but are less than 21 years of age are not Exdudable Employees.
(ii) Employees who are exduded from participating in the plan as a result of failing to satisfy the Plan's waiting
period to the extent the waiting period is less than 1 year. Employees who satisfy the Plan's waiting period but have been
employed less than a year are not Excludable Employees.
(iii) Non-resident aliens(generally those without U.S.source earned income);or
(iv) Employees covered by a collective bargaining agreement;if there is evidence that the benefits were the subject of
good faith bargaining. If this(iv)is satisfied,it appears that you may exclude collective bargaining employees even if they are
otherwise eligible to participate or participating in the Plan.
13 The results of this test are based only on the terms of the plan. Creative Benefits,Inc.has no information as to whether the
test is passed in operation.
14 A Key Employee is defined in Code§416(i)as any employee who,during the current year,is
(i) An Officer(as defined below) that is expected to have compensation in excess of$150,000 in the testing year.
Compensation(as defined below)should be based upon amounts actually paid and should not be annualized for new
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411
hires or part-year employees. No more than 50 employees(or if lesser,the greater of 10%or three employees)must
be considered officers;
(ii) A more than 5%owner(using the Section 318 rules described below);or
(iii) A more than 1%owner(using the Section 318 rules described below)expected to have Compensation in excess of
$150,000 in the testing year.
15 The scope of"nontaxable"benefits required to be included in this test is not entirely clear. Many believe that only employee
pre-tax contributions should be included. Based in part on IRS informal statements, we have taken the position that employer
contributions for contributory coverage should also be included;however,employer contributions associated with non-contributory
coverage are not part of the cafeteria plan and do not have to be included.
16 Unlike certain Section 401(K)and pension plan tests that specifically allow for post year adjustments,no such adjustment is
provided for in Section 125.
" See Code Section 105(h)(3).
18 See Code Section 105(h)(4).
19 For purposes of Code Section 105,a Highly Compensated Employee is any individual who is:
(i) One of the five highest paid officers during the current year;or
(ii) A shareholder who owns more than 10%of the value of stock of the employer's stock(at the time a benefit is
provided during the year);or
(iii) An employee that is in the highest paid 25%of all non-excludable employees.
In determining employees in the top 25%of pay,one interpretation is that only the current year's compensation should be used for Code
§105(h)purposes. On the other hand,the legislative history to Code Section 105(h)indicates that a"look back"determination(as used
in the definition of Highly Compensated Employees for other code sections)is required. Employers should discuss with legal counsel
regarding the appropriate approach. The Code provides definitions for the terms officer and compensation,as well as stock attribution
rules for determining who is a shareholder with more than 10%ownership. We will be glad to discuss these definitions with you if you
would like more information or you can refer to the instructions to the Request Form.
20 We assume that the data you provided on the Nondiscrimination Request Form excluded employees who may be excluded(in
accordance with the instructions provided on the Request Form). The following employees may be excluded from the data used to
conduct this test to the extent that they are actually excluded from participating in the Plan.
(i) Employees who have not completed 3 years of service prior to the beginning of the Plan Year;
(ii) Employees who have not attained age 25 prior to the beginning of the plan year;
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410
(iii) Part-time(less than 25 hours per week or up to 35 hours where full-time employees doing similar work in the same
industry and location work substantially more hours) or seasonal employees (less than 7 months per year or 9
months where similar employees work substantially more months);
(iv) Non-resident aliens with no U.S.source income;or
(v) Collective bargaining employees(may be excluded whether eligible to participate or not)
21 If your plan fails to meet these requirements,your plan is not necessarily discriminatory. It may be possible to offer different
benefits for different groups of employees if the two benefit structures are designated as separate "plans" for this purpose. The
regulations state that a single plan document may be used by an employer for two or more separate plans provided that the employer
designates the plans that are to be considered separately and the applicable provisions of each separate plan. The regulations suggest that
an employer could have different benefits that it considers different"plans,"so long as each plan passes the applicable Code Section
105(h)tests. Consult your legal advisor if you wish to pursue this approach.
22 These results are based only on the terms of the plan as you have represented them. The benefits test also requires that a plan
not be discriminatory in operation. Creative Benefits,Inc.does not provide any opinion on nondiscriminatory operation. Note that the
regulations state that a plan will not be considered discriminatory merely because highly compensated individuals utilize a broad range of
plan benefits to a greater extent than do other employees.
23 See Code Section 129(d)(3).
24 See Code Section 129(d)(2).
25 See Code Section 129(d)(8).
26 See Code Section 129(d)(4).
27 For purposes of Code Section 129,a Highly Compensated Employee means,a person who is:
(i) An officer;
(ii) A shareholder owning more than 5%of the Employer during the testing year or preceding year;or
(iii) An employee who during the preceding year only received more than$100,000 in compensation.*
The Code provides definitions for the terms officer and compensation, as well as stock attribution rules for determining who is a
shareholder with more than 5%ownership. We will be glad to discuss these definitions with you if you would like more information. *In
lieu of the$100,000 threshold identified in(iii)above,plan sponsors may,if elected for all employee benefit plans(including pension
plans),deem any employee a Highly Compensated Employee if the employee was both paid more than 100,000 andwas in the top 2(P/o
paid group during the preceding plan year. In identifying the top 20%paid group,the following employees may be excluded from
consideration:
(i) employees who have not completed 6 months of service
(ii) employees who normally work less than 17.5 hours per week
(iii) employees who normally do not work more than 6 months during the year(seasonal)
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(iv) employees under the age of 21;or
(v) employees subject to a collective bargaining agreement.
28 The following employees may be excluded from this test.
(i) Employees who are exduded from participating in the Plan as a result of an age requirement that is less than 21
years of age. Employees who satisfy the Plan's age requirement but are less than 21 years of age are not Excludable Employees
Employees who are exduded from participating in the plan as a result of failing to satisfy the Plan's waiting
period to the extent the waiting period is less than 1 year. Employees who satisfy the Plan's waiting period but have been
employed less than a year are not Excludable Employees.
(vi) Employees covered by a collective bargaining agreement if there is evidence that the benefits were the subject of good faith
bargaining.
29 All non-excludable employees are included. If an employee is eligible,but does not choose to contribute to his dependent care
FSA,his benefit is considered to be$0.
30 All non-excludable employees are included. If an employee is eligible,but does not choose to contribute to his dependent care
FSA,his benefit is considered to be$0. For purposes of the Code Section 129 55%Average Benefits Test,the following employees
may be excluded from the test:
(i) The same employees that may be excluded for purposes of the Code Section 129 Eligibility Test;and
(ii) Employees whose Compensation is expected to be less than$25,000 during the preceding Plan Year.(Using the
same definition of compensation).
31 The 55%Average Benefits Test measures actual benefits provided;however,there is no way to know the actual benefits
provided until the end of the run out period(which is during the next plan year). It is not advisable to wait until that time to test for the
plan year;therefore,the IRS has informally indicated that employers may assume that the annual election amount equals the benefits
that will be provided under the plan. We assume that the data you have provided is based on annual election amounts.
32 There is little guidance on this contributions and benefits test other than the fact that actual utilization rates alone will not
cause the plan to be discriminatory. As this test is likely based on facts and circumstances and ABC Corporation does not know all
relevant facts and circumstances of your workforce,the opinion provided in this document as to whether your plan passes this test should
not be deemed definitive.
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