Short answer: A Section 125 cafeteria plan, which lets employees pay premiums and fund FSAs with pre-tax dollars, must pass nondiscrimination tests showing it doesn’t disproportionately favor highly compensated or key employees. Failing the tests makes those individuals’ pre-tax benefits taxable.
Because cafeteria plans give a tax break, the IRS requires they be offered fairly. Section 125 testing generally looks at three things: eligibility (do enough non-highly-compensated employees have access?), benefits and contributions (are they available on comparable terms?), and a key-employee concentration test (key employees can’t receive more than 25% of the total pre-tax benefits).
If a plan fails, the consequence falls on the favored group: highly compensated or key employees lose the pre-tax treatment and are taxed on the benefits, while rank-and-file employees are unaffected. Plans should test each year, especially owner-heavy small employers where concentration is easy to trip.
Sources
- IRC §125 nondiscrimination rules.
Content history
Originally published: June 16, 2026
Last reviewed: June 16, 2026