Code Section 105(h)
Nondiscrimination Testing for Self-Insured Health Plans
A self-insured health plan (including a Health FSA) must pass the nondiscrimination tests of Code Section 105(h) to avoid adverse tax consequences to highly compensated participants.
For plan years after Sept. 23, 2010, PPACA mandates that non-grandfathered health plans which are insured must also pass these tests.
IRS Notice 2010-63 explains that the penalty for an insured plan that fails to comply with Code Section 105(h) is an excise tax of $100 per day for each participant discriminated against, plus liability for a civil action to halt the discrimination. The tax effects of a 105(h) failure, however, do not apply to an insured plan.
Notice 2011-1 delayed the application of 105(h) to fully insured plans until regulations are issued.
Code Section 105(h) applies to a self-insured medical expense reimbursement plans. A plan is self-insured if it is not funded solely through insurance policies.
A self-insured medical reimbursement plan satisfies Code Section 105(h) the only if:
- the plan does not discriminate in favor of highly compensated individuals as to eligibility to participate; and
- the benefits provided under the plan do not discriminate in favor of participants who are highly compensated individuals.
A plan does not discriminate as to eligibility if it passes:
- one of two numerical tests, or
- a nondiscriminatory classification test.
The numerical eligibility test is satisfied if the plan covers either (a) at least 70% of all employees or (b) at least 80% of all employees who are eligible to benefit under the plan if at least 70% of all employees are eligible to participate.
The nondiscriminatory classification test is met if the classification is determined by the IRS to not be discriminatory in favor of highly-compensated employees, based upon the facts and circumstances.
Under the benefits test, all benefits provided to highly-compensated employees (and their dependents) must be provided for all other participants (and their dependents). In other words, HCEs must not be provided better benefits (or the opportunity to elect better benefits) than NHCEs.
For testing purposes, employers may exclude from testing:
- employees who have not completed 3 years of service;
- employees who have not attained age 25;
- part-time or seasonal employees;
- employees not included in the plan who are covered by a collective bargaining agreement, if accident and health benefits were the subject of good faith bargaining between the employee representatives and the employer; and
- employees who are nonresident aliens and who receive no earned income (within the meaning of section 911(d)(2)) from the employer which constitutes income from sources within the United States (within the meaning of section 861(a)(3)).
Definition of Highly Compensated Individual
"Highly compensated individual" means an individual who is:
- one of the 5 highest paid officers,
- a shareholder who owns (with the application of section 318) more than 10 percent in value of the stock of the employer, or
- among the highest paid 25 percent of all employees (other than excludable employees who are not participants).
As with most nondiscrimination tests under the Tax Code, the Code Section 105(h) tests must be performed as if all employees throughout a controlled group are employed by a single-employer. This may cause problems for controlled group entities that maintain separate health plans.
Effect of Failing the Tests
Failing a Section 105(h) test causes adverse tax consequences only to highly compensated individuals. However, these consequences can be severe as these individuals generally comprise roughly 25 percent of the workforce, and are usually an employer's most senior and vital employees.
Eligibility Test Failure
Failing the eligibility test causes all highly compensated individuals to include their "excess reimbursements" in gross income. Excess reimbursements equals:
- all reimbursements to a highly compensated individual (except reimbursements that are fail the benefits test)
- the ratio of the sum of all reimbursements to all highly compensated individuals during the year to the sum of all reimbursements to all participants during the year.
Benefits Test Failure
Failing the benefits test causes all reimbursements that result from the discriminatory benefits to be taxable income to highly compensated individuals. In others words, if a highly compensated individual has coverage for (say) a double lung transplant but some other participants do not, the highly compensated individual would be taxed on the full value of the double lung transpant when the reimbursement is made. Obviously, discriminatory benefits can result in disastrous tax consequences to employees.
FICA and FUTA Taxes
While discriminatory reimbursements are included in gross income (i.e., box 1 of Form W-2), they are not subject to FICA or FUTA taxes. See IRS Publication 15-B and Code Sections 3121(a)(2) and 3306(b)(2).
Impact of PPACA
PPACA incorporates the substantive nondiscrimination requirements of Code section 105(h) (but not the taxes on highly compensated individuals in section 105(h)(1)) and applies them to non-grandfathered insured group health plans.
An insured group health plan failing to comply with the nondiscrimination requirements of Code section 105(h) is subject to the taxes, remedies, and penalties that generally apply for a plan failing to comply with the requirements of chapter 100 of the Code (generally, an excise tax of $100 per day per individual discriminated against for each day the plan does not comply with the requirement), part 7 of ERISA (a civil action to enjoin a noncompliant act or practice or for appropriate equitable relief), or title XXVII of the PHS Act (civil money penalties of $100 per day per individual discriminated against for each day the plan does not comply with the requirement).
Thus, if a self-insured plan fails to comply with Code section 105(h), highly compensated individuals lose a tax benefit; if an insured group health plan fails to comply with Code section 105(h), the plan is subject to a civil action to compel it to provide nondiscriminatory benefits and the plan or plan sponsor is subject to an excise tax or civil money penalty of $100 per day per individual discriminated against.
The simplest way to avoid 105(h) issues with a self-insured plan is to maintain a uniform health plan across an entire controlled group.
Providing superior benefits to key employees need not be accomplished by automatically enrolling them in a fully-subsized coverage option with enhanced benefits. Instead, an employer may make the enhanced package available to everyone with no additional subsidy, and then increase the salary of key employees by the desired subsidy. If the additional premiums are paid with a cafeteria plan, the net tax effect is roughly the same as providing superior benefits.
Fully Insured Plans
Fully insured plans that are grandfathered under PPACA are not subject to Code Section 105(h). Therefore, an employer may avoid testing issues by maintaining one or more fully insured plans. An employer may also maintain fully insured plans in addition to a self-insured plan. This is primarily useful for benefiting groups of employees that are relatively small compared to the total employee population because employees covered by fully insured plans cannot be excluded from the eligibility test.
Treas. Reg. § 1.105-11(c)(4)(i) provides that a single plan document may be used for two or more self-insured plans, provided “that the employer designates the plans that are to be considered separately and the applicable provisions of each separate plan.” Based on this guidance, some employers divide their self-insured plans into multiple plans for testing purposes. Such an arrangement can overcome problems with the benefits test because benefits are only compared among participants in the same plan.
The key difficulty in performing disaggregation is passing the eligibility test. One or more of the disaggregated plans will be forced to pass the eligibility test using the "nondiscriminatory classification" method.
Under this method, the classification of participants for eligibility must meet standards similar to those of Code § 410(b)(1)(B).
Regulations for § 410(b) provide that a nondiscriminatory classification must be reasonable and established under objective business criteria that identify the category of employees who benefit under the plan. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria. In addition, the IRS will consider:
- The underlying business reason for the classification;
- The percentage of the employer’s employees benefiting under the plan.
- Whether the number of employees benefiting under the plan in each salary range is representative of the number of employees in each salary range of the employer’s workforce;
- The difference between the plan’s ratio percentage and the employer’s safe harbor percentage. The smaller the difference, the more likely the classification is to be nondiscriminatory; and
- The extent to which the plan’s average benefit percentage (determined under § 1.410(b)-5) exceeds 70 percent.
(The last two criteria are specific to retirement plans, and it is unclear how--or if--a medical plan may meet them.)
Disaggregation can be risky because it is unclear what criteria the IRS uses to determine whether multiple plans are truly separate. If the plans are administratively intertwined, backed by the same stop-loss policy, or otherwise operationally entangled, the IRS may disallow the disaggregation. A disallowed disaggregation will likely result in a failure to pass Code Section 105(h) and thus cause adverse tax consequences to highly compensated individuals.