Section 125 of the Internal Revenue Code allows employees to pay their share of qualified expenses with tax-free income. Self-employed individuals, partners, owners of Sub-Chapter S and their spouses and dependents may not participate, although they can benefit in an indirect sense from reduced FICA and FUTA taxes resulting from the participation of their employees.

Section 125 introduces two sets of nondiscrimination rules, in addition to the rules that govern the underlying benefits. One set of rules applies to Highly Compensated Employees and the other applies to Key Employees.

Highly Compensated Employees are officers, 5% (or greater) shareholders, and other highly compensated employees based on facts and circumstances. Spouses and dependents of these individuals are also considered Highly Compensated for the purposes of these rules. See Section 410(b) of the Internal Revenue Code if you need more information about this definition. Simply stated, the Section 125 plan's eligibility requirements may not discriminate in favor of the Highly Compensated Employees. If all employees are not treated the same, the differences must be based on a reasonable classification. The plan is also prohibited from discriminating in favor of Highly Compensated Employees with regard to benefits and contributions. The easiest way to avoid problems is to offer the same benefits to all employees for the same contributions and with the same eligibility requirements. Only collective bargaining units should be treated differently from all other employees, and then only as a result of such bargaining.

The other set of rules relates to Key Employees. Section 125 provides that 5% (or greater) owners, 1% owners with compensation exceeding $150,000 annually, and cetrain other highly paid officers and owners may not receive more than 25% of the total benefits received by employees. For the purposes of the Premium Conversion Plan, this would be 25% of the total premiums for all participants including the Key Employees.

The Section 125 Plan should be "tested" every year after open enrollment or whenever there is a change in participation which could cause the plan to become discriminatory. The BenefitsWorkshop Premium Conversion Plan includes an online Nondiscrimination Testing Module that can help you with this process and will allow you to document the test results.