HEADNOTE: Proposed regulations for this complex legislation are now issued and drawing heavy criticism. The authors explain the new requirements and present an overview of these regulations, the qualification rules and employer's concerns. They also deal with nondiscrimination tests to be made each year. Editor's Note: Shortly before this article was sent to press, Secretary of the Treasury Brady announced that the Treasury will not require employers to begin testing employee benefit plans for compliance with Sec. 89 nondiscrimination until October 1, 1989. The Secretary called in Congress to work with the Administration to find ways to revise the law reducing the compliance burden, but he offered no support for repeal efforts. In the House of Representatives, a bill has been introduced by Rep. Rostenkowski to rewrite the nondiscrimination rules. Other legislators are making efforts to repeal Sec. 89 or delay its effective date through the end of 1989.

Since it is likely that some changes will be enacted which will affect this article, readers should be alert to developments. Nevertheless, the editors believe our readers will find this material useful in delineating requirements as of the date of its preparation.

Following the customary practice of The CPA Journal, many references to regulations and other authoritive sources are not presented in this article. Such information is available from the authors if desired. The TRA 86 significantly changed the rules governing discrimination in employee welfare and fringe benefit plans. Sec. 89 provides new "qualification" and "nondiscrimination" rules for those plans. The goal of Sec. 89 is simple. Companies must "test" their employer-sponsored benefit plans to ensure that benefits are distributed fairly to all levels of employees--whether or not they are highly compensated. The qualification rules require employers to formalize their benefit programs so as to operate uniformly and objectively. The nondiscrimination rules impose restrictions on the extent to which benefits may vary between highly compensated employees and non-highly compensated employees and still be "fair."

In March 1989, the IRS released Proposed Regulations (Prop. Regs.) concerning the application of Sec. 89, but the guidance provided is only partial. The IRS has stated that employers may rely on the new Regulations even though they are only "proposed" regulations. This article explains the various tests and requirements imposed by Sec. 89, as well as the consequences of noncompliance. `The Prop. Regs. are integrated' throughout the discussion.

Qualification Rules: Scope of Coverage

Sec. 89(k) identifies a wide array of employee benefit plans and programs for which the qualification rules apply. They are:

* Any "statutory" employee benefit plan, defined in Sec. 89(i) to include an accident or health plan within the meaning of Sec. 105(e); a group-term life insurance plan within the meaning of Sec. 79; and, if the employer so elects, a qualified legal services plan within the meaning of Sec. 120(b), an educational assistance program within the meaning of Sec. 127(b), and a dependent care assistance program within the meaning of Sec. 129(d).

* A qualified tuition reduction program within the meaning of Sec. 117(d).

* A cafeteria plan within the meaning of Sec. 125.

* A fringe benefit program providing no additional cost services, qualified employee discounts, or employer-operated eating facilities excludable from gross income under Sec. 132.

* A voluntary employee beneficiary association (VEBA) which qualifies as a Sec. 501(c)(9) trust.

Special Rules for Certain Plans

The Prop. Regs. contain several special rules for the plans and programs identified in Sec. 89(k). First, an accident and health plan is not subject to Sec. 89(k) unless the employer-provided benefits under the plan are, or are intended to be, excludable from gross income under Sec. 105(b) or (c). Thus, sick pay and disability plans--which have benefits includable in gross income--generally are not subject to these qualification rules.

Second, accidental death and dismemberment (AD&D) plans and business travel accidental death plans are subject to the provisions of Sec. 89(k), because employer contributions under these plans are eligible for exclusion under Sec. 106 (employer contributions to accident and health plans) and the benefits provided pursuant to these coverages are excludable under Sec. 101 (certain death benefits) and 105(c) (amounts received under accident and health plans). The coverages and benefits under these plans--like other accident or health plans the coverage of which is excludable, or of a kind that is excludable, under Sec. 106--may not be excluded under Sec. 132 (fringe benefits). If a death benefit under an AD&D plan is not conditioned on the accidental death of the employee, the death benefit is not part of an AD&D plan.

Finally, a plan that is part of an organization described in Sec. 501(c)(9) (a VEBA) or 501(c)(17) (a trust for payment of supplemental unemployment compensation benefits) must meet the requirements of Sec. 89(k).

Effect of Plan Alternatives

Under Sec. 89, each option or level of a plan is considered a separate plan. Therefore, the number of plans that a company offers, and thus must apply the qualification rules to, may be far in excess of the number the employer believes are offered. Consider the following example:

Assume an employer offers a basic health plan, as well

as a health maintenance organization (HMO) plan, to

employees. Each plan has three levels of coverage:

employee only; employee plus spouse; and employee plus

two or more dependents. According to Sec. 89, the

employer has six plans to be tested (two plans multiplied)

by three levels of coverage). If each of these plans has

three different deductible limits, the employer has 18

different plans (two plans multiplied by three levels of

coverage multiplied by three deductible limits), and the

employer must perform tests on every level of every

plan to ensure compliance with Sec. 89.

Treatment of Part-Time Employees

In the testing process, part-time employees are not included. The employer's definition of "part-time," however, may vary from the Sec. 89 definition. Employers often consider employees working up to 30 hours each week as part-time. Under Sec. 89, however, part-time employees are defined as those working less than 17 1/2 hours per week.

Qualifying Rules: Plan Characteristics

Sec. 89(k) has the following five basic requirements essential to the qualification of a benefit plan:

1. The plan or program must be in writing.

2. The employees' rights under the plan or program must be legally enforceable.

3. Employees must be provided reasonable notification of the benefits available to them.

4. The plan must be maintained for the exclusive benefit of the employees.

5. The plan must be established with the intention that it will be maintained for an indefinite period of time.

Written Plan

All of the material terms of a plan must be contained in a single written document. However, the document may incorporate material terms by reference to other documents, rather than setting forth the full terms within the single document. In addition, where multiple options or levels of coverage exist, the Proposed Regulations provide that a single written document is sufficient as long as it refers to the different options or plans.

Dates for Complying with Written Requirements. The Prop. Regs. provide that a plan must be in writing prior to the first day on which coverage or benefits are available under the plan. Under a transition rule, employers do not have to meet this requirement before the later of: 1) the beginning of the first day of the second plan year beginning after December 31, 1988; and 2) the end of the 12-month period beginning on the first day of the first plan year that the plan is subject to Sec. 89.

Plan Year Must be Identified. Employers, at least by the end of the 1990 plan year, must designate and include in their documentation a plan year for each plan. A "testing year," as well as a "testing date," must be designated in writing for each plan. Both the testing year and the testing date must be the same for all plans of the same type.

The testing year is the 12-month period the employer selects for purposes of applying the nondiscrimination test. It may be any convenient 12-month period (i.e., it need not be the same as any of the plan years of the plans being tested). However, the designation of the testing year may not result in any part of a plan year being disregarded. Once established, the testing year cannot be changed without the consent of the Secretary of the Treasury. If no period is selected, the testing year is the calendar year.

The "testing date" is the particular date within the testing year on which most of the statistical data used for the nondiscrimination tests are tabulated. The testing date is significant because only the benefit data attributable to this one day during the testing year are used for testing purposes.

As with the testing year, the employer may choose the date most convenient for the company. The designation of the date may be either: 1) a certain date (e.g., January 1 of each year); or 2) a fixed point in time (e.g., the last day of the first pay period ending in the testing year). Except for one "free" switch in 1990, the testing date cannot be changed without the Secretary's consent.

Legally Enforceable Rights

Ensuring that an employee's rights will be legally enforceable requires that the provision of benefits under each plan not be at the discretion of the employer--either in operation or under the terms of the plan. For example, if the plan provides that medical expenses will be reimbursed at the company's sole discretion, the plan is not legally enforceable. The Prop. Regs. provide that, in general: 1) the conditions required for an employee to participate in or obtain a benefit under a plan must be definitely determinable; and 2) the employee must be able to compel the coverage or payment of benefits described in the plan. Thus, a plan should include a provision that requires an employer terminating a plan to pay all claims prior to the date of termination.

Limited Discretion Allowed. The legal enforceability requirement does not mean that the employer is totally barred from exercising discretion. The Prop. Regs. permit employer discretion relating to certain administrative acts. In general, provision of benefits in a given situation may depend on subjective factors, as long as the judgments involved are legally reviewable and not committed to the sole discretion of the employer or its representative.

Transition Rule. As with the writing requirement, the Prop. Regs. contain a transition rule for implementing legal enforceability. A plan is not required to satisfy the enforceability rules outlined in the proposed regulation before the first day of the second plan year in which the plan is subject to Sec. 89.

Reasonable Notification of Benefits

Prop. Regs. relating to the requirement that employees be provided reasonable notification of benefits available in a plan identify employees to whom the notification must be given as well as the party responsible for providing notification. In general, the employees to whom a plan or program must be communicated are those who are eligible to participate in the plan (i.e., notification of participants is not enough). Employees who are not eligible do not have to be notified (e.g., hourly employees with regard to a salaried employee plan).

The Prop. Regs. state that the employer must provide the notice. In the case of a multi-employer plan, the plan administrator assumes this responsibility. Additionally the notice requirements are satisfied if an insurance company or other health care insurer or provider (e.g., a health maintenance organization) provides the notice.

Purpose and Contents of Notification. The purpose of this requirement is to inform eligible participants of a plan's essential features. Therefore, the Prop. Regs. require that individuals eligible for coverage or benefits under a plan be provided with a summary explanation of these features, including how to receive more information. The notice must be given to an individual prior to the initial availability of coverage or benefits.

Transition Rule. Under the Prop. Regs. the employer is not required to provide notice to employees for plan years commencing in 1989 until July 1, 1989. Similarly, for a plan that uses a September 1 through August 30 plan year, notice is first required by September 1, 1989. This transitional rule for a delay in notice is independent of any other transitional relief.

Exclusive Benefit of Employees

The purpose of the exclusive benefit requirement is to preclude an employer from extending its plan to individuals who have no current or prior employment-type relationship with the employer. Thus, the plan may not be a subterfuge for a distribution of profits to shareholders or other individuals. The exclusive benefit rule, however, does not require that the plan provide benefits to all employees--only that all beneficiaries must be employees or dependents. A plan may fail the exclusive benefit requirement by its terms or through its operations.

Meaning of Employees. The Prop. Regs. provide that a plan must be maintained for the exclusive benefit of eligible employees. Only individuals who are or who are treated as, employees (or former employees) or who otherwise perform services for the employer, may participate under an employer's plan.

The Prop. Regs. do not affect any other existing or future eligibility rules. Thus, for example, a self-employed individual described in Sec. 401(c)(1) (i.e., self-employed individual treated as an employee) cannot be a participant in a cafeteria plan even though the individual is treated as an employee for purposes of Sec. 89(k).

Transition Rule. The Prop. Regs. provide that an employer is not required to meet the exclusive benefit requirement until the first day of the second plan year in which the plan is subject to Sec. 89. Thus, the delay in the release of the regulations again resulted in a delayed implementation date for a qualifying characteristic.

Intent to Maintain Plan for Indefinite Period of Time

Establishing a plan with the intent of maintaining it indefinitely does not mean that the plan may never be terminated--only that upon establishment, it is not intended to be temporary. Under this standard, the employer may reserve the right to amend or terminate the plan, or even to state that coverage is guaranteed only for a fixed period, but that the company expects to renew coverage at the end of that period.

The Prop. Regs. focus up on the operation of the plan, as opposed to the plan terms, in determining whether the employer intends to maintain a plan indefinitely. Accordingly, if a plan is materially amended or terminated and the coverage has been in effect for at least a consecutive 12-month period, the indefinite time period requirement is satisfied--regardless of any terms of the plan that give the employer the right to change or terminate it. However, if a plan is materially amended or terminated before the coverage has been in effect for a consecutive 12-month period, the plan is considered to have been established with the intent of being temporary, unless the employer can demonstrate that there is a substantial business purpose for the termination or amendment. Employers must keep in mind that the abandonment of a plan, for any reason other than unanticipated business necessity, may be closely scrutinized.

ERISA and Other Requirements

Under the Prop. Regs., the reporting, notification, and written plan requirements of Sec. 89(k) are in addition to, and not in lieu of, reporting, disclosure, notification, and written plan requirements of Title I of the Employee Retirement Income Security Act of 1974 (ERISA) or any other law.

Failure to Meet Qualification Rules

If a plan fails to satisfy the qualification rules, each employee who receives benefits under the plan during the year must include in income an amount equal to the value of the benefits (payments, reimbursements, services, and products) received--not the value of the coverage provided--even though the benefits are otherwise excludable. For example, a nonqualifying health and accident plan generally will negate the exclusions in Sec. 101 (certain death benefits) and Sec. 105 (amounts received under accident and health plans). This sanction applies to all employees receiving benefits under the plan, not just highly compensated employees, as defined in Sec. 414(g).

Limits on Employee Sanction and Coordination with Sec. 89(a)

An employee hospitalized with a serious illness during a year that a plan is nonqualifying could wind up having hundreds of thousands of dollars of taxable income for the year. The Prop. Regs., however, limit the amount that must be included in an employee's taxable income because of the employer's failure to comply with Sec. 89(k). The amount included is limited to sum of the following dollar amounts indexed in accordance with Sec. 414(q)(1)(c): 10% of the first $50,000 of the employee's compensation; 25% of the compensation in excess of $50,000 and up to $100,000; 75% of compensation in excess of $100,000 and up to $150,000; and 100% of compensation in excess of $150,000. In addition, the IRS is authorized to adjust these amounts where appropriate and not inconsistent with the purposes of Sec. 89(k). Sec. 213 (deductions for medical and dental expenses) determines whether the amount includable in income under Sec. 89(k) is deductible.

The Prop. Regs. limit the scope of the Sec. 89(k) sanction by allowing the failed portion of a health plan--to the extent that the coverage may reasonably be separated from other plan coverage--to be treated as a separate plan. Similar separations are permitted for other benefits covered by Sec. 89(k).

If a Sec. 89(k) sanction is imposed relative to coverage determined under Sec. 89(a) to discriminate in favor of highly compensated employees, the Prop. Regs. provide for coordination of the two sanctions. In general, the higher of the two taxable amounts must be included in the gross income of the highly compensated employees.

Employer Reporting Responsibility and Correction of Failure

If an employer's plan is found to be nonqualifying, the employer must include the taxable benefits on employees' W-2 forms. Failure to do so may result in a penalty tax assessed against the employer. The penalty tax is equal to the amount of the unreported benefits multiplied by the highest individual tax rate for the year in which the incomplete W-2 forms apply.

The Prop. Regs. contain a rule that allows correction of failures to comply with Sec. 89(k) in certain circumstances. If there is a de minimis failure, the employer may correct the failure within 90 days. If the employer timely corrects the failure the plan does not fail Sec. 89(k) merely because of that failure. A failure is not de minimis if a correction requires amendment of the plan document to reduce coverage on a retroactive basis to conform the document to the operation of the plan.

Applicability of Nondiscrimination Tests

The nondiscrimination tests of Sec. 89(a) apply only to statutory employee benefit plans (i.e., accident or health plans and group-term life insurance plans). Accident or health plans include medical, dental, vision, and hearing plans, as well as annual physical plans and health care reimbursement accounts. Accident or health plans also may include accidental death and dismemberment insurance. However, disability plans are not covered by the nondiscrimination rules of Sec. 89(a). Employers must also elect to apply the nondiscrimination rules to qualified group legal services plans, educational assistance programs, and dependent care assistance programs.

Nondiscrimination Tests to be Satisfied

A statutory employee benefit plan generally will be required to satisfy three eligibility tests and a 75% benefits test. The three eligibility tests are: 1) a 50% test; 2) a 90%/ 50% test; and 3) a nondiscriminatory provision test. Alternatively, a plan will be considered to have met the requirements of both the eligibility tests and the benefits test for any plan year in which it satisfies: 1) an 80% coverage test; and 2) the nondiscriminatory provision test. The alternative tests apply only to health plans and group-term life insurance plans.

50% Eligibility Test

Under the 50% eligibility test, non-highly compensated employees must constitute at least 50% of the group of employees eligible to participate. As an alternative, the 50% eligibility test may be met by ensuring that the percentage of highly compensated employees eligible to participate does not exceed the percentage of non-highly compensated employees eligible to participate. See the following example:

Company X has 400 highly compensated employees and

only 200 non-highly compensated employees. A plan

available to 320 of the highly compensated employees

(80% of all highly compensated employees) and at least

160 of the non-highly compensated employees (80% of

all non-highly compensated employees) will satisfy the

50% eligibility test, even though more highly

compensated employees than non-highly compensated

employees are eligible to participate in the plan.

Mandatory Aggregation of Plans. For the 50% test, if an employee is eligible for coverage under two or more health plans, the Prop. Regs. require plans to be aggregated into an additional, single health plan that provides all the coverage provided under any of the separate plans. The new, aggregated plan is treated as having an employer-provided benefit of each of the included plans with an appropriate adjustment to eliminate overlapping coverage. A non-highly compensated employee is treated as eligible for both the additional plan and the seperate plans. A highly compensated employee is treated as eligible only for the additional plan and is no longer eligible for the separate plans. This mandatory aggregation rule must be applied before applying the comparability rule discussed later.

Comparable Health Plans for 50% Eligibility Test. Under the Prop. Regs., two or more health plans included in a group of comparable plans may be treated as a single health plan. A group of plans is comparable if the smallest employer-provided benefit available to any employee in any plan in the group is at least 95% of the largest employer-provided benefit available.

90%/50% Eligibility Test

A plan will not satisfy the 90%/50% eligibility test unless at least 90% of the non-highly compensated employees are eligible for a benefit that is at least 50% as valuable as the most valuable benefit available to highly compensated employees. For purposes of this test, all benefits of the same type (i.e., excludable under the same Code section) must be aggregated. For example, plans providing medical or dental benefits will be aggregated.

Limited Coverage Under Two or More Plans. If an employee is eligible-- but to a limited extent--to be covered under two or more plans of different types, the Prop. Regs. provide that the employee cannot be treated as eligible for the full employer-provided benefit of each plan for purposes of the 90%/50% test. Instead, the employer must use a reasonable, uniform, and nondiscriminatory method to allocate to the employee only a reasonable portion of each plan's full employer-provided benefit. Whether a plan is available to an employee is determined under all of the facts and circumstances. For example, an HMO at a distant location from the employer might not, under the facts and circumstances, be reasonably available to employees at the location of the employer. Note the following example:

An employer has 12 employees, 10 of whom are

non-highly compensated. The employer maintains two health

plans which will be aggregated for testing purposes. Plan

A, a hospitalization plan, has an employer-provided

benefit of $1,000. It is available to nine of the 10

non-highly compensated employees and both of the highly

compensated employees. Plan B, a dental plan, has an

employer-provided benefit of $500. It is available only

to the two highly compensated employees. The health

plans meet the requirements of the 90%/50% eligibility

test because 90% of the non-highly compensated

employees (nine of 10) have available to them an employer-provided

benefit of $1,000, which is more than 50% of

$1,500 ($1,000 under Plan A, $500 under Plan B), the

largest employer-provided benefit available to any

highly compensated employee

Transition Rule. If an employer's health plans satisfy the 75% benefits test for the 1989 testing year, the employer may elect in writing to apply the 90%/50% eligibility test under a transition rule provided in the Prop. Regs. This rule, applicable only to the 1989 testing year, allows the employer to substitute an 80%/66% eligibility test for the 90%/50% test.

Nondiscriminatory Provision Eligibility Test

Under this test, a plan must not contain any provision that discriminates (by the provision's terms or otherwise) in favor of highly compensated employees. In making this determination, an employer must take into account all plans of the same type. This test is not intended to apply to plans with quantifiable discrimination provisions.

75% Benefits Test

A plan will not satisfy the 75% benefits test unless the average employer-provided benefit received by non-highly compensated employees under all plans of the same type is at least 75% of the average employer-provided benefit received by highly compensated employees under all plans of the same type. The average employer-provided benefit for each group of employees is determined by dividing the total employer- provided benefits, including benefits through pre-tax contributions to a cafeteria plan, for all employees in the group by the number of employees in the group (including employees who are not covered by the plans). For example:

An employer has five highly compensated employees

and 15 non-highly compensated employees. The

employer maintains only one health plan with an employer-provided

benefit of $1,500. All of the highly

compensated employees and 10 of the non-highly compensated

employees participate in the plan. The employer's health

plan does not meet the requirements of the 75% benefits

test because the average employer-provided benefit of

the non-highly compensated employees, $1,000 (10 x

$1,500)/15, is less than 75% of the average employer-provided

benefit of the highly compensated employees,

$1,125 (5 x $1,500)/5 x .75. To meet the requirements

of the 75% benefits test, the average employer-provided

benefit of the non-highly compensated employees must

be at least $1,125, or the average employer-provided

benefit of the highly compensated employees must be

less than or equal to $1,333.33 ($1,000 is 75% of

$1,333.33).

Special Rules for Health Plans. In applying the benefits test to health plans, the employer may check family coverage separately from employee coverage. The employer also may exclude an employee and/or an employee's dependent family members from the health plan testing if the company has a sworn statement from the employee indicating that the employee and/or dependents are covered by another employer's health plan.

Aggregation Provisions. In testing plans other than health plans, the company may elect to treat all plans of the types specified in the election as plans of the same type for the 75% benefits test. A health plan also may be aggregated with other types of plans to help them meet the benefits test. Other types of plans, however, cannot be used to help health plans meet the benefits test.

Transition Rule for 1989 and 1990 Testing Years. A transition rule for the 75% benefits test is available for the 1989 and 1990 testing years, if the following requirements are satisfied:

* The testing year ends in either the 1989 calendar year (the 1989 testing year) or the 1990 calendar year (the 1990 testing year);

* The employer elects in writing to use the transition rule for the testing year; and

* The employer-provided benefits under all health plans received by the applicable group of employees for the testing year are treated as excess benefits for the testing year--excess benefits are includible in gross income, as discussed later. The "applicable group of employees" for a 1989 testing year includes all active employees with more than a 5% ownership interest under Sec. 416(i) in the employer at any time between January 1 and the end of the testing year, plus the applicable number of highly compensated under Sec. 414(g)(7) active employees who receive the most compensation for the 1989 testing year. The "applicable number of highly compensated active employees" generally is 20% of the highly compensated active employees for the testing year. This number, however, may not be greater than 1,000 or less than 10, or the number of highly compensated employees if less than 10.

For a 1990 testing year, the applicable group of employees includes all highly compensated active employees with more than a 5% ownership interest under Sec. 416(i) at any time between January 1, 1989, and the end of the testing year, plus the applicable number of highly compensated active employees who receive the most compensation for the 1990 testing year. The applicable number of the highly compensated active employees is 40% for the testing year, but not greater than 2,000 or less than 50 employees, or the number of highly compensated employees if less than 50.

80% Coverage Test

This test provides an alternative to the 50% and 90%/50% eligibility tests and the 75% benefits test for group-term life and accident or health plans. Under this test, each plan must benefit at least 80% of all non-highly compensated employees and satisfy the nondiscriminatory provision eligibility test. As with the 75% benefit test, an employer may test family health plan coverage separately from employee coverage. For health plans, the employer also may exclude an employee and/or dependent family members if: 1) the employee presents a sworn statement indicating that the employee and/or dependents are covered by another employer's health plan; and 2) at least 80% (90% if the plans are grouped under the comparability rules discussed later) of the non-highly compensated employees are eligible to participate in the plan.

Mandatory Aggregation of Plans. For the 80% coverage test, if an employee receives coverage under two or more of the employer's health plans, the Prop. Regs. require the plans to be aggregated into an additional, single health plan that provides all the coverage provided under the separate plans. The additional plan is treated as having an employer-provided benefit equal to the sum of such benefits of each of the included plans, with an appropriate adjustment to eliminate overlapping coverage. A non-highly compensated employee is treated as covered under both the additional plan and the separate plans. A highly compensated employee is treated as covered under the additional plan, but not the separate plans. This mandatory aggregation rule must be applied before the comparability rule discussed later.

Comparable Health Plans for 80% Coverage Test. The Prop. Regs. allow two or more health plans included in a group of comparable plans to be treated as a single health plan for the 80% coverage test. A group of plans is comparable if the smallest employer-provided benefit available to any employee in any plan in the group is at least 90% of the largest such benefit available to any employee in any plan in the group.

At the employer's written election, a group of plans also is comparable for the 80% coverage test if the smallest employer-provided benefit available to any employee in any plan in the group is at least 80% of the largest employer-provided benefit available to any employee in any plan in the group. This alternative, however, is available only if the employer changes the 80% coverage test to a "90%" coverage test. In other words, at least 90% of the non-highly compensated employees must be covered under the health plan or group of comparable plans being tested before the alternative comparability rule applies.

A plan failing the 50% eligibility test may not be included with any other plan in a group of comparable plans under either of the comparability alternatives, unless two requirements are met. First, the employer-provided benefit of the group of comparable plans must be within at least 95% of the employer-provided benefit of the failed plan. Second, the failed plan and the group of comparable plans, considered together, must be comparable under the 80% coverage test comparability rules.

Highly Compensated Employees

All of the Sec. 89(a) nondiscrimination tests require the employer to classify its employees as highly compensated or non-highly compensated. Under Sec. 414(q), an employee is considered to be a highly compensated employee, for a year, if, at any time during the year or preceding year, the employee: 1) was a 5% owner of the employer; 2) earned more than $75,000 ($78,353 for 1989) in annual compensation from the employer; 3) earned more than $50,000 ($52,235 for 1989) in annual compensation from the employer and was a member of the top-paid group of the employer during the same year; or 4) was a company officer of any business in the controlled group and earned more than $45,000 ($47,012 for 1989) in compensation. An officer is any individual holding an office and receiving compensation more than 150% higher than the defined contribution plan dollar limit for the year. Generally, no more than 50 employees may be treated as officers. If the number of employees is less than 50, however, no more than the greater of three employees or 10% of all employees may be treated as officers.

Under the 1988 Revenue Act, employers may elect to determine their highly compensated employees under a simplified method. Under this method, an electing employer may treat employees who receive more than $50,000 in annual compensation as highly compensated employees in lieu of applying the $75,000 and $50,000 compensation tests in the rule. An employer is entitled to make the election with respect to a current testing year if, at all times during that year, the employer maintained business activities, and employees, in at least two geographically separate areas.

Measuring Compensation. Compensation generally means all taxable income plus elective or salary reduction contributions to a Sec. 125 cafeteria plan, a Sec. 401(k) plan, a Sec. 403(b) annuity, or a simplified employee pension plan. However, compensation does not include taxable income attributable to the exercise of a stock option or to the disqualifying disposition of an incentive stock option.

Family members (a spouse or lineal descendant or ascendant) of highly compensated employees who are 5% owners or one of the 10 highly compensated employees who received the most compensation during the year are not treated as separate employees. The compensation paid to the family member must be aggregated with the compensation, benefits, and contributions made on behalf of the highly compensated employee.

Significance of Failing Tests

What happens if, after the data is gathered and processed, the employer fails the nondiscrimination tests? Unlike the qualification rule sanction, where the employer and all employees are affected by noncompliance, only the highly compensated employees and the employers are affected by a company's failure to meet the nondiscrimination tests.

Employee Effect

If a statutory benefit plan is discriminatory, a highly compensated employee must include in gross income the excess of the employer- provided benefits (discriminatory excess). The highest permitted benefit that remains non-taxable is the one that the highly compensated employee would have received had plan benefits been reduced to the point where they met the eligibility and benefit tests. This discriminatory excess is includible in the employee's income in the tax year within which the plan year ends.

Employer Effect

Employers must report the income of a highly compensated employee on the employee's W-2 Form. If an employer, including an employer exempt from tax, does not report the discriminatory excess to the affected employees and the IRS on Form W-2 by the due date, with any extensions, all benefits of the same type provided to the employees are subject to an employer-level sanction without regard to whether the employees report some or all of the benefits as income. Under this sanction, the employer is liable for a tax at the highest individual rate on the total value of benefits of the same type provided to those employees of whom the employer failed to report the discriminatory excess. The tax applies in addition to any other penalties or taxes.

Conclusion

Data collection and plan revision to comply with the qualification rules and nondiscrimination standards of Sec. 89 will be costly to many employers. Compliance will be less costly, however, if employers appreciate the scope and complexity of Sec. 89 before designing a system to capture the data needed for compliance.

Ray A. Knight, JD, CPA, is an Associate Professor of Accounting at Mississippi State University. His professional affiliations include the AICPA, American Bar Association, Kentucky Bar Association, Mississippi Society of CPAs, Texas Society of CPAs, AAA, and the American Taxation Association. Mr. Knight has had tax articles published in numerous professional publications including The CPA Journal. Lee G. Knight, PhD, is an Associate Professor of Accounting at Mississippi State University. Her professional affiliations include the AAA and the American Taxation Association. Dr. Knight has had many articles published in professional journals including The CPA Journal.