May 02, 2023
A Guide to Non-Discrimination Testing for Self-Insured Group Health Plans
Most employer group benefit plans provide tax-advantaged benefits and are subject to non-discrimination rules to discourage employers from providing more generous benefits to Highly Compensated Individuals (HCIs) and/or Key Employees.
Self-Insured Health Plans
Self-insured (or self-funded and level funded) health plans are subject to IRC (Internal Revenue Code) §105(h) non-discrimination rules. To pass the tests, employers cannot provide more favorable eligibility, benefits, or contribution structures to HCIs. HCIs are define as follows.
- One of the five highest-paid officers;
- A shareholder who owns more than 10 percent in value of the employer’s stock; or
- Among the highest-paid 25 percent of all employees.
Plan design Issues that may be discriminatory under Section 105(h):
- Only certain groups of employees are eligible to participate.
- There are different employment requirements for plan eligibility.
- Plan benefits or contribution rates vary based on employment classification, years of service or amount of compensation.
The benefit plans that fall under the Section 105(h) non-discrimination rules are:
- Self-insured medical (including preferred provider organization (PPO) plans, health maintenance organization (HMO) plans and high deductible health plans (HDHPs);
- Level-funded medical;
- Self-insured dental and vision;
- Health FSAs; and
- Health Reimbursement Arrangements (HRAs)
The following tests apply:
- Eligibility Test
- Benefits Test
Eligibility Test
The eligibility test under Section 105(h) looks at whether a sufficient number of non-HCIs benefit under a self-insured health plan. If not enough non-HCIs are benefitting, the plan will fail this discrimination test.
The plan cannot discriminate in favor of HCIs regarding eligibility to participate.
- 70% test – the plan benefits 70% or more of all employees eligible to participate.
- 70%/80% test – the plan benefits 80% or more of all employees eligible to participate if 70% or more of employees are eligible to benefit under the plan.
- Non-discriminatory classification test – the plan: a) Benefits a non-discriminatory classification of employees using a bona-fide business criteria such as specified job categories, salaried vs hourly, or geographic location; and b) Has a sufficient ratio of benefitting non-HCIs to HCIs.
Note: Employees eligible to participate are considered non-excludable employees.
Excludable employees are defined as:
- Employees who have not completed three years of service;
- Employees who have not attained age 25;
- Part-time or seasonal employees;
- Employees covered by a collective bargaining agreement, provided that they are not eligible to participate in the plan; and
- Non-resident aliens with no U.S. source income from the employer
Benefits Test
The plan cannot provide better or richer benefits nor can the plan allow lower contributions to HCIs who participate in the benefits.
The health plan does not satisfy Section 105(h) non-discrimination testing unless all the benefits provided to participants classified as HCIs are provided for all other participants. In addition, all benefits available for the dependents of HCIs must also be available on the same basis for the dependents of all other employees who are eligible and participating in the plan.
The test will be satisfied if:
- The exact same benefits provided to HCIs are provided to non-HCIs.
- Contributions are identical for all eligible to participate for each benefit level (or the contributions ‘reverse discriminate’ meaning HCIs are required to pay more towards premium than non-HCIs).
- Benefit limits do not vary based on age, years of service, or compensation.
- A shorter waiting period is not allowed for HCIs; and
- The plan will not discriminate in favor of HCIs in actual operation. An example of this would be the plan will not allow certain claims to be paid for HCIs but denied for non-HCIs without a justifiable reason.
If the plan fails either test, reimbursements and/or benefits to HCIs are taxable above what non-HCIs would have received.
IRS guidance on specific plan design features
| Plan Design | IRS Guidance |
| Employee Contributions | The Section 105(h) rules suggest that employee contributions for HCIs and non-HCIs must be the same. These rules provide that a health plan that provides optional (elective) benefits to participants will satisfy the benefits test if:
|
| Benefit Limits | As a permissible design option, a self-insured health plan may establish a maximum reimbursement limit for any single benefit or combination of benefits. However, any maximum limit attributable to employer contributions must be uniform for all participants (and for all dependents of employees who are participants) and may not be modified by reason of a participant’s age or years of service. If a plan covers HCIs and the type or the amount of benefits subject to reimbursement under the plan are in proportion to employee compensation, the plan will fail the benefits test. |
| Waiting Periods | The IRS has suggested that having a longer waiting period for non-HCIs than HCIs will cause a self-insured health plan to fail the benefits test. |
Impact of Failed Testing
If a plan discriminates in favor of HCIs, HCIs will be taxed on excess reimbursements that would have otherwise been excluded from their income. The excess reimbursements should be included in the HCIs’ gross income and reported on their Forms W-2. Although excess reimbursements are includible in gross income, these amounts are not subject to income tax or employment tax (FICA or FUTA) withholding.
The method for determining the amount of excess reimbursements depends on whether the health plan failed Section 105(h) testing due to discriminatory coverage or discriminatory benefits. Also, if an HCI pays for coverage on an after-tax basis (or has his or her cafeteria plan contributions taxed due to a failed Section 125 nondiscrimination test), the HCI will only be taxed on the proportion of the discriminatory coverage or benefit that is attributable to employer contributions.
| Discriminatory Coverage | When a health plan fails the eligibility test, the amount of excess reimbursement is determined by multiplying the total amount reimbursed to the HCI by a fraction. The numerator is the total amount reimbursed during that plan year for all HCIs. The denominator is the total amount reimbursed that plan year for all participants. In computing this amount, any amount that is already included in the HCI’s income as a discriminatory benefit is excluded. |
| Discriminatory Benefit | In the case of a benefit available to HCIs, but not to all other participants (or which otherwise discriminates in favor of HCIs as opposed to other participants), the amount of excess reimbursement equals the total amount reimbursed to the HCI with respect to the benefit. If a discriminatory benefit is available to non-HCIs, the amount reimbursed to the HCI is offset by the amounts available to non-HCIs. |
Potential ways to satisfy the above rules If the self-insured health plan provisions cannot be modified to eliminate discriminatory provisions.
- Impute the FMV (fair market value) of the premium cost as ‘taxable’ to the HCIs
- Restructure the plan into separate plans so that each single plan can pass the Benefits Test. For example, if benefits vary by location, each location operates its own plan.
We recommend working with an ERISA attorney to set up non-discriminatory plan documents for all eligible employees to review.
While every effort has been taken in compiling this information to ensure that its contents are totally accurate, neither the publisher nor the author can accept liability for any inaccuracies or changed circumstances of any information herein or for the consequences of any reliance placed upon it. This publication is distributed on the understanding that the publisher is not engaged in rendering legal, accounting, or other professional advice or services. Readers should always seek professional advice before entering into any commitments.
