As an employer, offering a self-insured health plan to your employees is a way to increase plan flexibility and potentially reduce the total cost of coverage, depending on claims experience, stop-loss structure, and plan design.
However, establishing a self-insured health plan also increases your regulatory compliance requirements.
One of the most critical and often overlooked requirements is Section 105(H) nondiscrimination testing. Internal Revenue Code (IRC) Section 105(H) is a provision intended to protect employees enrolled in self-insured plans from discrimination.
In this article, we shall define Section 105(H) nondiscrimination testing and highlight its key components, explain to you how to perform the nondiscrimination tests, examine common causes of failure, and address the consequences of non-compliance.
Let’s begin!
What is 105(H) Nondiscrimination Testing?
Section 105(H) of the IRC is an IRS-mandated, two-part annual test that requires self-insured medical, dental, or Health Reimbursement Arrangement (HRA) plans not to discriminate in favor of highly compensated individuals (HCIs).
The two tests are:
- An Eligibility Test: Verifies whether enough non-HCIs benefit from an organization’s health plan.
- A Benefits Test: Organizations pass the benefits test if they provide the same benefits for both HCIs and non-HCIs. As such, scenarios such as benefits increasing with years of service or compensation would be considered a violation.
The same applies when an employer offers non-HCIs eligibility requirements that are more stringent than those for HCI employees.
The IRS wants to ensure that company executives and business owners do not receive tax-free medical benefits that are better than those of lower-ranking employees.
If a self-funded health insurance plan fails the 105(H) test, it does not lose its tax-qualified status. However, HCIs lose some of the tax benefits they receive from their health plans. That means the IRS may consider a portion of the benefits paid to HCIs as taxable income.
Is 105(H) Nondiscrimination Testing Required for Self-Insured Health Plans?
Yes, the IRC Section 105(H) applies specifically to self-insured health plans.
Section 105(h) applies to self-insured medical plans, including self-funded major medical arrangements (regardless of whether the plan is PPO, EPO, etc.), as well as certain self-insured dental/vision plans, HRAs, and health FSAs.
Section 105(h) does not apply to fully insured health plans. The ACA includes nondiscrimination concepts that were intended to extend similar rules to insured coverage, but enforcement and practical application depend on regulatory guidance. Employers should consult counsel on current applicability.
Therefore, if your organization funds its own medical claims rather than purchasing a fully insured policy from an insurance provider, then Section 105(H) likely applies.
Who is Considered a Highly Compensated Individual (HCI)?
The Eligibility and Benefits tests mandated by Section 105(H) ensure self-insured health plans do not favor employees who are HCIs.
Under the mandate, HCIs are described as:
- Individuals who are among the five highest-paid employees in an organization.
- Individuals who own more than 10% of the value of an employer’s stock.
- Individuals who are among the highest-paid group of employees (as defined under Section 105(h) rules), in addition to the five highest-paid employees and more-than-10% owners.
Examples of HCIs include CEOs, CFOs, business owners, and senior executives, such as division heads. Determining who qualifies as an HCI in your organization is a crucial first step in performing nondiscrimination testing.
Aside from HCIs, it is also vital to understand excludable employees. These are individuals you can exclude from employee counts when conducting eligibility tests. They include:
Certain employees may be excludable for eligibility testing purposes under Section 105(h) rules (for example, based on age, length of service, collective bargaining status, or nonresident alien status), depending on how the plan is structured. Employers should apply exclusions consistently and document the basis.
However, as an employer, you can still include employees if it will help you pass the tests even if they are eligible for exclusion.
Key Components of 105(H) Nondiscrimination Testing
Section 105(h) comprises two key components. Both components are tests that your organization must pass to be considered nondiscriminatory towards non-HCIs.
The two tests are:
1. Eligibility Test
The eligibility test determines whether enough non-HCIs in your organization qualify to participate in your self-insured health plan.
To pass the eligibility test, your organization must satisfy one of the following:
- 70% Test: 70% or more of your employees must benefit from the plan.
- 70/80 Test: 70% or more of your employees must be eligible for your health plan, and the plan should actually benefit 80% or more of those eligible employees.
- Nondiscriminatory Classification Test: The plan’s eligibility classification satisfies IRS nondiscrimination requirements and does not favor HCIs.
2. Benefits Test
The benefits test evaluates whether your organization offers better health benefits to HCIs than to non-HCIs, or whether HCIs receive benefits unavailable to non-HCIs.
As such, the test will evaluate factors such as:
- Coverage tiers
- Waiting periods
- Reimbursement limits
- Employer contribution levels
- Availability of optional benefits
Therefore, to pass this test, you must provide the same benefits for HCIs and non-HCIs. Even the slightest design differences can lead to failure.
Keep in mind that the tests can be complex. However, the structure and design of your health plans and your employee demographics can contribute to the complexity of the tests.
It is therefore crucial to hire a professional service to guide you through the testing process to help you avoid pitfalls, especially in your plan’s design and implementation.
How to Perform 105(H) Nondiscrimination Testing for Self-Insured Health Plans
Performing the Section 105(H) nondiscrimination tests is vital to ensuring your employees receive fair and equitable health coverage regardless of their job classification and income level.
Below is a step-by-step overview of how you can conduct the tests:
1. Gather Employee Data
If your health plan is self-insured and subject to Section 105(H), begin by gathering your employees’ information. You will need to conduct a complete employee census and compile their compensation data. You will also need to determine the company’s ownership percentages and evaluate plan eligibility and enrollment data.
2. Identify HCIs and Excludable Employees
Using the code’s definition of HCIs, examine your employees’ data to separate the HCIs from non-HCIs. Proceed to determining which employees you can exclude from the testing based on the code guidelines. These actions can help your business pass the test.
3. Run the Eligibility Test
From your total number of employees, determine the number of employees who are eligible for your health plan. Then choose the participation rates among eligible individuals, and finally calculate the percentage of non-HCIs who benefit from the plan.
You should note that benefitting means employees who are actually enrolled in the plan, not those who are eligible but not enrolled.
4. Run the Benefits Test
Perform the benefits tests to ensure there is uniformity in benefits received by HCIs and non-HCIs. Some factors to review include employer contributions, reimbursement caps, waiting periods, deductibles, and benefits options.
The tests should also evaluate the plan’s design to ensure benefits are not decided based on age or years of service.
5. Document Results and Address Failures
If your company fails either the eligibility or benefits tests (or both), it is crucial to evaluate the areas that contributed to the failure and implement corrective actions to ensure compliance.
You should also:
- Maintain records of methodologies used in your tests, calculations, and results.
- Keep records of employee classifications and the plan provisions you reviewed. This data is vital in case of an IRS audit.
Performing Section 105(H) nondiscrimination testing requires more than just ticking boxes in your compliance checklist. It should help you determine your plan’s compliance status, avoid IRS penalties, and ensure you deliver premium, equitable benefits to your members.
Conducting a thorough process that includes identifying HCIs, running dual tests, and documenting results can be overwhelming for your HR team.
At Ethos Benefits, we are employee benefits consultants who leverage our fiduciary experience to help our clients handle benefits-related 105(H) nondiscrimination testing, ensuring the methodology is reproducible and defensible. Additionally, we keep our process transparent so that you can always check progress and compliance status.
Schedule a free consultation to learn how you can leverage the findings of your 105(H) nondiscrimination testing to keep your benefits plans compliant and equitable to your employees.
Common Reasons Employers Fail 105(H) Testing
Organizations fail the Section 105(H) nondiscrimination testing because they favor HCI in their self-insured health plans.
Some of the ways that employers unduly favor HCIs that contribute to failure include:
- Executive-Only Benefit Enhancements: Many companies fail the 105(H) tests because they offer their HCIs exclusive benefit terms that are not available to other employees. Examples of such enhancements include higher employer-paid premiums for executives, executive-only HRAS, and richer out-of-pocket reimbursement terms.
- Discriminatory Eligibility Rules: Some organizations have different eligibility standards for different employee groups, which disproportionately disadvantage non-HCIs. For example, some businesses impose longer waiting periods for non-HCIs than executives, while others exclude certain job classes from eligibility, with those most affected being non-HCIs.
- Contribution Structures Favoring HCIs: Many employers structure their contributions to self-funded health plans as a percentage of their employees’ salaries. Such structures disproportionately benefit high earners, thus ensuring that executives and general staff receive different levels of care.
Other factors that can cause an organization to fail Section 105 (H) testing include:.
- Low General Staff Participation: If a significant number of an organization’s non-HCIs refuse coverage under a self-funded plan. For example, due to high coverage costs, the organization may fail the eligibility test, specifically the 70/80 Test.
- Failure in Operational Testing: A self-funded health plan may seem fair when written as a policy. However, this may not hold in practice. If HCIs receive even slightly better terms than the general staff, the plan will fail the tests.
- Incorrectly Identifying HCIs: Section 105(H) has a strict definition of who should be considered an HCI. Therefore, businesses that misclassify their employees, especially to bypass regulations, are often found to fail the tests.
- Controlled Group Overlook: Organizations that control other companies as subsidiaries may fail to aggregate employee data from those companies. As a result, they tend to misclassify employees, which affects eligibility test results and contributes to failures.
- Acquisitions and Mergers: Integrating new employees after a merger or acquisition can disrupt previously compliant classifications, leading to test failures.
Consequences of Failing 105(H) Nondiscrimination Testing
Failing Section 105(H) testing does not invalidate your self-funded health plan. However, the IRS imposes penalties on HCIs that benefit from unfair plans.
If your plan fails the tests:
- HCIs associated with your organization will be required to include the value of the discriminatory benefits, also known as excess reimbursements, in their gross income.
- As the employer, you will also have to report the taxable amount of your HCIs on Form W-2.
As the employer, you may be required to address the failures by implementing corrective measures. That may include expanding coverage retroactively to include non-HCIs or adjusting your employees’ contributions to be after tax.
Best Practices to Stay Compliant
To avoid the consequences of non-compliance with the IRC’s Section 105(H), you should consider implementing the following practices:
- Conduct Annual Tests: Run tests at the start and end of the health plan year to ensure compliance with regulations. You can also perform testing in the middle of the year if any significant changes occur that may affect compliance.
- Identify HCIs: Accurately determine your employees who qualify to be HCIs. This will improve your employee classification system and substantially help you when calculating the eligibility tests.
- Align Employee Contributions: Ensure the required employee contributions for premiums are consistent across your HCIs and non-HCIs. To do this, avoid using the percentage-of-salary contribution formula and executive carve-outs. Instead, focus on using a consistent employee contribution formula.
- Monitor Eligibility Classifications: Ensure the classifications you use to limit eligibility are job-related, business-justified, and nondiscriminatory when implemented.
- Track Participation Rates: Enrollment of non-HCIs in self-funded plans is crucial to staying compliant with Section 105(h). Therefore, encourage your general staff to enroll to avoid participation-related failures.
- Uniform Benefits Designs: Ensure your HCIs and non-HCIs have equal access to benefits to avoid favoritism.
- Uniform Waiting Periods: Standardize waiting periods across your organization to ensure no employee waits longer than others, regardless of classification.
- Manage Plans Separately: If you have different health plans for different employee groups, ensure each plan passes the tests independently.
- Engage Experienced Advisors: Consult benefits advisors, compliance firms, ERISA counsels, or third-party administrators (TPAs) for assistance with testing and documentation.
Frequently Asked Questions (FAQs)
Below are answers to some common questions we receive from our clients:
What is the Difference Between 105(H) Testing and 401(k) Nondiscrimination Testing?
Section 105(h) testing applies to self-insured health plans, ensuring benefits do not favor HCIs. In contrast, Section 401(k) nondiscrimination testing applies to retirement plans, ensuring that contributions do not favor highly compensated employees (HCEs).
How Often Must 105(H) Nondiscrimination Testing Be Conducted?
It is best practice to conduct nondiscrimination testing annually. You should perform the tests before the end of the plan year or shortly after. It is also advisable to conduct pre-plan year and mid-year tests to ensure your plan remains compliant and allows you to make necessary adjustments.
Are Part-Time Employees Included in 105(H) Testing?
No, part-time employees are generally not included in Section 105(H) testing. If you choose to exclude part-time employees, you must apply the exclusions consistently and carefully document them. Alternatively, if you allow any part-time employees into the plan, you must include all of them in the testing.
Can Employers Use Third-Party Vendors for Testing?
Yes, employers with self-funded health plans can use third-party vendors such as TPAs and payroll providers to conduct nondiscrimination testing. However, outsourcing testing does not absolve the employer of responsibility for compliance and documentation; it can reduce operational burden, but the employer remains accountable for the results.
Conclusion
Self-insured health plans offer employers several benefits, with the primary advantage being cost control. However, they require proactive governance to ensure compliance with mandates such as Section 105(H). Complying with Section 105(H) is straightforward; all you need to do is ensure your health plan does not disproportionately favor highly compensated individuals.
However, the process becomes complex when it comes to identifying HCIs in your organization, performing regular eligibility and benefits tests, and monitoring plan changes. At this point, it becomes smarter to consult a fiduciary expert than risk IRS penalties.
At Ethos Benefits, we bring our fiduciary-level expertise in ERISA compliance to help you structure health plans that pass both eligibility and equitability tests. Our data-driven approach helps you personalize the health benefits to your members to maximize outcomes. Additionally, we monitor your plan and relevant regulations regularly to catch classification changes early before they result in non-compliance.
Book a one-on-one call today so we can help you run defensible 105(h) testing, interpret results, and implement corrective actions if needed.
