Section 105(h) Non-Discrimination Testing
Self-insured health plans are required to comply with the non-discrimination requirements set forth in Internal Revenue Code Section 105(h). These requirements prohibit a self-insured health plan from discriminating in favor of highly compensated individuals with respect to eligibility to participate in the plan or benefits provided under the plan.
Section 105(h) non-discrimination testing is a two-part process that requires the plan to satisfy an eligibility test and a benefits test. If the plan fails either test, at least a portion of the benefits provided to highly compensated individuals becomes taxable.
Eligibility Test
The first test a self-insured health plan must pass is the eligibility test. The eligibility test determines if enough non-highly compensated individuals can participate in the plan to prevent the plan from discriminating in favor of highly compensated individuals when it comes to eligibility. There are three alternative tests that can be used to pass the overall eligibility test.
70% Test
To pass the 70% test, 70% or more of all non-excludable employees must participate in the plan. If a plan passes the 70% test, it passes the eligibility test.
70%/80% Test
The 70%/80% test is a two-part test.
- First, the plan must determine if at least 70% of all non-excludable employees are eligible to participate in the plan.
- If at least 70% are eligible, the plan must determine if at least 80% of those who are eligible participate in the plan.
If a plan satisfies both these requirements, it passes the eligibility test.
Nondiscriminatory Classification Test
A plan passes the nondiscriminatory classification test, and therefore the eligibility test, if it can demonstrate that employees qualify under a classification set up by the employer that the Internal Revenue Service (IRS) finds to not discriminate in favor of highly compensated individuals. This test is more subjective, and it may be best saved for situations where the 70% test or 70%/80% test cannot be satisfied.
Important Definitions for the Eligibility Test
Highly Compensated Individual- Section 105(h) non-discrimination testing focuses on whether the health plan discriminates in favor of highly compensated individuals (HCIs). HCIs are:
- One of the five highest paid officers;
- A shareholder who directly or indirectly owns more than 10% of the value of the employer’s stock; and
- The top 25% paid employees (not counting employees that can be excluded).
Excludable Employee – Certain employees can be excluded from employee counts when performing the eligibility test. These excludable employees are:
- Employees who have not completed three years of service;
- Employees who are younger than 25 at the beginning of the plan year;
- Part time and seasonal employees;
- Employees covered by a collective bargaining agreement that are not eligible to participate in the plan; and
- Non-resident aliens with no U.S. source earned income.
Benefits Test
The second of the two tests a self-insured health plan must pass is the benefits test. The benefits test examines whether the plan discriminates in favor of HCIs when it comes to benefits provided under the plan. The benefits test is passed if the plan can show it does not discriminate on the face of the plan and does not discriminate in operation.
No Discrimination on the Face of the Plan
Plan design will determine whether the plan discriminates in favor of HCIs on the face of the plan. Certain plan design decisions such as requiring HCIs to contribute less to the premium than non-HCIs or providing certain benefits only to HCIs can cause a plan to be discriminatory on the face of plan therefore failing the benefits test.
No Discrimination in Operation
If a plan is not discriminatory on its face, it still must not discriminate in favor of HCIs in operation. Whether a plan discriminates in operation is based on the facts and circumstances surrounding each plan. For example, if a plan provides a certain benefit while it is being used by an HCI and then ceases to cover that benefit when the HCI stops using the benefit, that is an indication the plan is discriminatory in operation by favoring the HCI.
Consequences of Failing Section 105(h) Non-Discrimination Testing
The consequences of failing Section 105(h) non-discrimination testing depends on whether the eligibility test or benefits test was failed. Regardless of which test is failed, only HCIs will be impacted by the failure; non-HCIs will be unaffected. HCIs will have the value of the benefits considered “excess reimbursements” assessed as taxable income. The amount of excess reimbursement depends on which test was failed. Plan sponsors may be well served to work with a tax advisor to determine the exact tax consequences for failure of either the eligibility or benefits test.
Key Takeaways:
Employers who sponsor a self-funded health plan would be well served to review their obligation to conduct non-discrimination testing under Section 105(h). If you need more information about nondiscrimination testing for a self-funded health plan, please contact your M3 team.
The information provided is a summary of laws and regulations relating to employee benefit plan compliance. This information should not be construed as legal advice. In all cases, employers should consult with their own legal counsel.
