Nondiscrimination and Taxation Considerations

Section 105(h) Testing


There are two main sets of nondiscrimination rules for group health plans: Internal Revenue Code (IRC) Section 105(h) and IRC Section 125. This section focuses on Section 105(h).

As background, Section 105(h) nondiscrimination currently applies to self-insured plans. Under the Patient Protection and Affordable Care Act (PPACA), Section 105(h) applies to fully insured, non-grandfathered plans. However, the Internal Revenue Notice (IRS) in Notice 2011-1 delayed the effective date of that provision of PPACA until the IRS issues guidance on how Section 105(h) applies in the fully insured context. So for now, non-grandfathered fully insured plans do not need to be concerned with Section 105(h). Importantly, though, if the plan allows employees to pay premiums on a pretax basis through salary reductions, then the plan would still be subject to the Section 125 nondiscrimination rules.

Generally, Section 105(h) prohibits plans from discriminating in favor of highly compensated individuals (HCIs) as to plan eligibility and benefits. An HCI is defined as a top-five paid officer, a more-than-10 percent shareholder and the top 25 percent of all employees, with respect to compensation. The top 25 percent category is important, since it means that every plan, regardless of the compensation structure and amounts, will have employees who are considered HCIs.

Under Section 105(h), there are two tests that the plan must satisfy: the Eligibility Test and the Benefits Test. Before getting into the tests themselves, though, it is important to note that the controlled group and affiliated services group rules of IRC Section 414(b), (c) and (m) are expressly applied to Section 105(h) nondiscrimination. This means that all employees of a controlled group (i.e., those businesses or companies that are under common control) will be included in determining the HCI group and in performing the nondiscrimination tests.

Also, generally speaking, the plan may exclude the following employees for testing purposes (although if any of these are actually participating in the plan, they may not be excluded):

  • Employees with fewer than three years of service
  • Employees who have not attained age 25
  • Part-time employees (generally defined as those who work fewer than 25 hours per week)
  • Seasonal employees (generally defined as those who work less than seven months per year)
  • Employees covered by a collective bargaining agreement
  • Non-resident aliens with no U.S. source of income

Under the Eligibility Test, a plan may not discriminate in favor of HCIs as to eligibility to participate. A plan may actually satisfy any one of three tests to satisfy the eligibility test. The three tests are:

  • The plan must actually benefit 70 percent or more of all employees (i.e., 70 percent or more of all employees must be enrolled in the plan).
  • Seventy percent or more of all employees must be eligible to participate in the plan, and of those eligible to participate, at least 80 percent must actually benefit under the plan.
  • The plan must be set up to benefit a classification of employees that is found by the Secretary of the Treasury not to be discriminatory in favor of HCIs.

While the first and second tests are fairly straightforward, the third is a bit more complicated. Basically, though, the classification of employees must be based upon a bona fide employment classification consistent with the employer’s usual business practice. Examples of such bona fide classifications include full-time versus part-time status, current versus former employee status, different geographic location, occupation type, date of hire and length of service.

That said, the classification of employees must also be considered nondiscriminatory based on a certain safe harbor percentage rate determined in IRS regulations. Since this test involves making a subjective determination based on the facts and circumstances of each particular case, outside counsel should be consulted by a plan seeking to satisfy the third test.

With respect to the Benefits Test, generally speaking both HCIs and non-HCIs must be provided with the same benefits. The Benefits Test tests whether the plan is discriminatory on its face and in operation. Generally, to pass the Benefits Test as it relates to discrimination on the plan’s face, employee contribution levels must not favor HCIs; maximum benefit and employer contribution levels may not vary based on age, compensation or years of service; types and amounts of reimbursable medical expenses must not favor HCIs; and waiting periods that favor HCIs may not be imposed. As for penalties for noncompliance with Section 105(h), the penalties for self-insured plans are slightly different than for fully insured plans. For self-insured plans, a discriminatory plan design results in adverse tax consequences to the HCIs, who are taxed on their “excess reimbursements.” For non-grandfathered fully insured plans, the penalty is assessed against the plan, and is based on each individual discriminated against (in the form of $100 per day per individual discriminated against). No such excess reimbursement is taxed to the HCIs of a fully insured plan.

Recent Developments

There has been no guidance issued on Section 105(h)’s application to fully insured plans since the IRS issued Notice 2011-1, which delayed the effective date indefinitely. Until new guidance is issued, fully insured non-grandfathered plans do not need to concern themselves with Section 105(h). Remember, though, that the Section 125 nondiscrimination rules may still apply to the fully insured plan. In addition, self-insured plans are currently subject to Section 105(h).

Employer Action Required

Employers should consider the nondiscrimination rules when designing or amending their benefit plan strategies, particularly with respect to plan eligibility and employer contribution levels. Waiting periods, eligibility terms and benefits overall should not favor HCIs.

Employers that sponsor self-insured medical plans (e.g., major medical, HRAs, health FSAs, etc.) should engage a vendor that can perform the nondiscrimination tests now, since Section 105(h) applies to self-insured plans currently. Testing should be performed during and at the end of the plan year, just to ensure that the plan is operating in a nondiscriminatory manner. While corrections to the plan may be made throughout the year, no corrections may be made after the end of the plan year. Thus, the tests should be monitored throughout the year so that any adjustments can be made prior to year-end.

Employers that sponsor fully insured plans do not yet need to worry about Section 105(h). However, employers should be considering how 105(h) might affect their plan designs now, so that once the IRS issues guidelines, they can move quickly to comply with the rules.


Civil penalties for noncompliance generally include an action to compel the plan to provide nondiscriminatory benefits and a civil monetary penalty civil of $100 per day per individual discriminated against. The penalties for non-grandfathered fully insured plans are slightly different than for self-insured plans. For a self-insured plan, a discriminatory plan design results in adverse tax consequences (i.e., HCIs are generally taxed on their “excess reimbursements”). For a fully insured plan, the penalty is assessed based on each individual discriminated against (in the form of the $100 per day per individual penalty), but no such excess reimbursement is taxed to the HCIs.

Frequently Asked Questions

Q1: An employer has a fully insured, non-grandfathered policy and pays 75 percent of the premiums for all hourly employees and 90 percent of the premiums for all salaried employees. The premiums paid by the employees are all paid on a pretax basis. Will this plan design be considered discriminatory?
So long as the employer contribution strategy overall does not favor HCIs, the plan design will not be considered discriminatory. An employer may have different eligibility criteria, waiting period or contribution levels for different employee classifications, if the employee classification is based on a “bona-fide employment classification.” Under the regulation, bona fide employment classifications include full-time versus part-time status, current versus former employee status, different occupations, different geographic location, date of hire, length of service and membership in a collective bargaining unit. While the variance here is based on a bona fide employment classification, testing would have to be performed to determine if the variance in employer contribution levels favors HCIs. Also, since the plan is allowing the payment of pretax premiums, the plan will be subject to nondiscrimination under both Sections 105(h) and 125.

Q2. If a plan remains grandfathered, do the Section 105(h) rules apply to it?
If the plan is fully insured and remains grandfathered, the Section 105(h) rules do not apply. If the plan is self-insured, then the Section 105(h) rules already apply under existing law. Finally, if the plan allows any portion of the premiums to be withheld on a pretax basis through employee salary reductions, the plan is subject to nondiscrimination testing under Section 125, regardless of whether it is self-insured or fully insured.

Q3: Is a fully insured, supplemental executive carve-out plan, which offers benefits only to HCIs, subject to the Section 105(h) nondiscrimination requirements under PPACA?
Possibly, depending on if the plan is exempt from PPACA and 105(h.) If the plan is grandfathered, the plan is not subject to the Section 105(h) nondiscrimination requirements under PPACA. If the plan is not grandfathered and provides “supplemental health coverage” that is considered an excepted benefit under HIPAA, the plan will not be subject to such requirements.

However, for this exception to apply, the supplemental health coverage must:

  • Be issued by an entity that does not provide primary coverage to the plan.
  • Be designed to fill gaps in primary coverage, such as coinsurance and deductibles. The coverage should not become secondary or supplemental solely as a result of a coordination of benefits provision.
  • Not exceed 15 percent of the cost of primary coverage, calculated in the same manner as the applicable COBRA premium.
  • Not differentiate among individuals as to eligibility, benefits or premiums based on any health factor of an individual or dependent.

If the executive carve-out plan fails to meet any of these requirements, it will not be considered an excepted benefit under HIPAA and will be subject to the Section 105(h) nondiscrimination requirements under PPACA once those requirements become effective.

Additional Resources

This page was last reviewed or updated July 2014.

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