# Section 105(h) nondiscrimination testing. Who it covers, the two tests, and what a failure costs.

Source: https://ethosbenefits.com/benefits-101/section-105h-nondiscrimination-testing
Type: Benefits 101
Topic: Compliance rules and deadlines
Author: Donovan Ryckis, Founder and CEO
Reviewed by: Patrick Ansara, Partner and Director of Client Operations
Publisher: Ethos Benefits
Published: 2026-03-09
Last updated: 2026-11-03
Cite as: "Section 105(h) nondiscrimination testing," Ethos Benefits, https://ethosbenefits.com/benefits-101/section-105h-nondiscrimination-testing, updated 2026-11-03.

**Short answer:** Section 105(h) nondiscrimination testing checks that an employer's self-insured medical reimbursement plan, including a self-funded health plan, HRA or health FSA, does not favor highly compensated individuals in eligibility or benefits. If the plan fails, the plan stays in place, but some or all reimbursements to those individuals become taxable income to them.

## By the numbers

- **70%** of all employees must benefit to pass the simplest eligibility test
- **Top 25%** of earners count as highly compensated individuals
- **Over 10%** ownership of the employer makes a shareholder highly compensated
- **2011** the year IRS Notice 2011-1 paused the rule for insured plans

## What is Section 105(h) nondiscrimination testing?

Section 105(h) of the Internal Revenue Code says a self-insured medical reimbursement plan cannot favor highly compensated individuals (HCIs) in who can join or in what the plan pays. Each plan year it has to pass two tests:

1. **The eligibility test,** which checks that enough employees who are not HCIs are covered.
2. **The benefits test,** which checks that every benefit offered to HCIs is offered to all other participants on the same terms.

Normally, reimbursements for medical care under an employer plan are tax free to the employee. Section 105(h) takes that exclusion away from HCIs, in whole or in part, when the plan discriminates. Employees who are not HCIs keep their tax-free treatment either way.

## Which plans does 105(h) apply to?

Section 105(h) applies to any employer plan that reimburses medical expenses that are not covered by an insurance policy. In practice that includes:

- **Self-funded health plans,** whatever the network design (PPO, EPO or other).
- **Health reimbursement arrangements (HRAs).**
- **Health flexible spending accounts (FSAs).**
- **Self-insured dental or vision plans** that reimburse medical care.

A plan is treated as insured only if a licensed insurer or a regulated prepaid arrangement, such as an HMO, actually takes on the risk. Under the regulation, a policy that does not shift risk to an unrelated third party, such as a cost-plus or administrative services only arrangement, counts as self-insured. If an insured plan has a self-insured piece, such as an HRA that pays deductibles, that piece is tested.

**Fully insured plans are not tested under 105(h).** The Affordable Care Act added Public Health Service Act Section 2716 to apply similar rules to insured, non-grandfathered plans. In Notice 2011-1, the IRS and the Departments of Labor and Health and Human Services said compliance would not be required until they issue regulations or other guidance. As of October 2026 they have not, so the insured rule is still not enforced. If you are on a [level-funded plan](https://ethosbenefits.com/benefits-101/level-funded-vs-fully-insured), check how much risk your contract actually shifts to the carrier before assuming you are exempt.

## Who is a highly compensated individual?

A highly compensated individual (HCI) under Section 105(h) is any employee who is:

- **One of the five highest paid officers.**
- **A shareholder who owns more than 10%** of the value of the employer's stock, counting stock attributed from family members and related entities under Section 318.
- **Among the highest paid 25% of all employees,** a group that includes the top five officers. Employees you may exclude from the eligibility test (below) who are not in the plan are left out of this count. The 25% group is rounded up.

Compensation is measured for the plan year, and officer and shareholder status is checked when the benefit is provided. All employees of a controlled group or affiliated service group under Section 414(b), (c) or (m) are treated as working for one employer, so subsidiaries and sister companies count together.

This definition is not the same as the "highly compensated employee" definition used for 401(k), cafeteria plan and dependent care testing, which has no 25% rule. Using the wrong list is a common mistake.

## What is the 105(h) eligibility test?

A plan passes the eligibility test if it meets any one of these three:

| Test | What it requires |
|---|---|
| **70% test** | The plan benefits 70% or more of all employees |
| **70% of 80% test** | 70% or more of all employees are eligible, and 80% or more of the eligible employees benefit |
| **Nondiscriminatory classification** | The plan benefits a class of employees that the IRS finds does not favor HCIs, using the standards in Section 410(b)(1)(B) |

"Benefits" means employees actually covered, not just eligible. Low enrollment among rank-and-file employees, often because their share of the premium is too high, is a common reason plans fail the 70% of 80% test.

## Which employees can you exclude?

Before running the eligibility test, an employer may leave out these employees:

- **Fewer than 3 years of service** before the plan year starts.
- **Under age 25** before the plan year starts.
- **Part-time employees** who customarily work fewer than 35 hours a week, if similar employees work substantially more. Under 25 hours a week always qualifies.
- **Seasonal employees** who customarily work fewer than 9 months a year, if similar employees work substantially more. Under 7 months always qualifies.
- **Union employees** in a bargaining unit where health benefits were the subject of good-faith bargaining.
- **Nonresident aliens** with no U.S.-source earned income from the employer.

These exclusions are optional. Apply the ones you use the same way every year and keep a record of the basis.

## What is the 105(h) benefits test?

The benefits test asks whether HCIs get anything other participants don't. Every benefit available to HCIs, and to their dependents, has to be available to all participants on the same basis. The regulation looks at the benefits the plan makes available, not the claims actually paid, so HCIs using the plan more does not cause a failure on its own.

What causes a benefits test failure:

- **Executive-only benefits,** such as an HRA, extra reimbursement or richer coverage tier offered only to leadership.
- **Limits tied to pay.** A plan discriminates if the type or amount of benefits rises with compensation, such as an HRA equal to a percentage of salary.
- **Limits tied to age or years of service.** Maximum reimbursement limits are allowed, but limits funded by the employer have to be uniform.
- **Different required contributions for the same option.** For an option to be treated as one benefit, employees either contribute nothing or contribute the same amount.
- **Operation that differs from the document.** A plan that looks fair on paper can still fail if, in practice, HCIs get longer coverage periods, faster claim approvals or exceptions others don't.

A few things are carved out. Reimbursements for an employee's routine diagnostic procedures, such as an annual physical, blood tests and X-rays, are not counted as part of the plan for testing. Retiree benefits are not discriminatory if retired HCIs get the same type and dollar limits of benefits as other retirees. An employer can also designate two or more plans as a single plan for testing, or test them separately.

## What happens if a plan fails 105(h) testing?

A failed test does not disqualify the plan. The tax hit falls on the HCIs, not the plan or the other employees. Their "excess reimbursement" becomes taxable income:

| Type of failure | Excess reimbursement for each HCI |
|---|---|
| **Benefits test** (a benefit only HCIs can get) | The full amount reimbursed to the HCI for that benefit |
| **Eligibility test** (coverage favors HCIs) | The HCI's total reimbursements for the year, multiplied by total reimbursements to all HCIs divided by total reimbursements to all participants |

The regulation's own example: if officers can be reimbursed up to $4,000 and everyone else up to $1,000, an officer who receives $4,000 has $3,000 of excess reimbursement.

The employer includes the excess in box 1 of the HCI's Form W-2. According to IRS Publication 15-B, these amounts generally remain exempt from Social Security, Medicare and FUTA taxes and from federal income tax withholding. If the plan runs through a cafeteria plan, an excess reimbursement under 105(h) can also make that benefit taxable under Section 125 for the affected HCI.

## When should you run 105(h) testing?

Every plan year. There is no IRS form or filing for 105(h) testing. The test applies to each plan year, and any excess reimbursement is taxed in the HCI's taxable year in which that plan year ends. Most employers test twice:

1. **Early in the plan year,** using expected eligibility and enrollment, so there is time to change the design or contributions.
2. **Near year end,** using actual enrollment, compensation and plan terms, before W-2s are prepared.

Retest mid-year after a merger, acquisition, new eligibility class or new HRA, since any of these can change the result. Keep your census, HCI list, exclusions used, calculations and the plan provisions you reviewed. Your [summary plan description](https://ethosbenefits.com/benefits-101/summary-plan-description) and plan document should match how the plan runs. An employer can hand the work to a TPA or advisor, but the employer remains responsible for the result. Ethos Benefits runs Section 105(h), Section 125 and dependent care testing as part of its [nondiscrimination testing](https://ethosbenefits.com/services/nondiscrimination-testing) service.

## How it compares.

Employers often run 105(h) testing alongside cafeteria plan and dependent care testing. The three use different rules and different definitions of who is highly paid.

| | Section 105(h) | Section 125 cafeteria plan | Section 129 dependent care |
|---|---|---|---|
| **What it covers** | Self-insured medical reimbursement plans, HRAs and health FSAs | Pre-tax premium payments and the other benefits elected through the cafeteria plan | Dependent care assistance programs, such as a dependent care FSA |
| **Who is favored group** | HCIs: top five officers, more-than-10% shareholders, highest paid 25% | Highly compensated participants and key employees, including officers and more-than-5% shareholders | Highly compensated employees under Section 414(q) and more-than-5% owners |
| **Main tests** | Eligibility (70%, 70% of 80%, or classification) and benefits | Eligibility, contributions and benefits, and the 25% key employee concentration test | Eligibility, contributions and benefits, the 25% owner concentration test, and the 55% average benefits test |
| **If it fails** | Excess reimbursements are taxable to HCIs | Benefits become taxable to the highly compensated or key employees | Benefits become taxable to highly compensated employees; others keep the exclusion |

A health FSA offered through a cafeteria plan is subject to both 105(h) and Section 125 testing. A small employer that sets up a qualifying simple cafeteria plan under Section 125(j) is treated as meeting the nondiscrimination rules of Sections 125, 105(h) and 129 for the benefits offered through it.

## Frequently asked questions

### What is nondiscrimination testing for health plans?

Nondiscrimination testing checks that an employer's tax-favored health benefits do not favor its highest paid employees or owners. A self-insured medical plan, HRA or health FSA is tested under Section 105(h), pre-tax premium and cafeteria plan benefits under Section 125, and dependent care accounts under Section 129. Each uses its own tests and its own definition of who is highly paid.

### What is a self-insured medical reimbursement plan?

A self-insured medical reimbursement plan is any employer plan that reimburses medical expenses without shifting the risk to an unrelated insurer. Self-funded health plans, HRAs and health FSAs all qualify. Under the Treasury regulation, a policy that does not shift risk, such as a cost-plus or administrative services only arrangement, is also treated as self-insured and is subject to 105(h) testing.

### Do level-funded plans need 105(h) testing?

Often, yes. Many level-funded plans are self-funded plans with stop-loss coverage, so the employer still bears the claims risk and the plan is tested under Section 105(h). Whether yours is tested depends on how much risk the contract actually shifts to an insurer, so employers should read the funding agreement before assuming the plan is exempt.

### Does Section 105(h) apply to fully insured health plans?

No. Section 105(h) applies only to self-insured medical reimbursement plans. The Affordable Care Act extended similar rules to insured plans under Public Health Service Act Section 2716, but in Notice 2011-1 the IRS and the other agencies said compliance is not required until they issue guidance, and they have not issued it.

### Are part-time employees included in 105(h) testing?

The employer may exclude them. Employees who customarily work fewer than 35 hours a week can be excluded if similar employees work substantially more hours, and employees who customarily work fewer than 25 hours a week can always be treated as part-time. Apply any exclusion consistently and document it.

### What is the difference between 105(h) testing and 401(k) testing?

Section 105(h) testing applies to self-insured health reimbursement plans and uses its own definition of highly compensated individual. 401(k) testing applies to retirement plan contributions and uses the highly compensated employee definition in Section 414(q). Employers should keep separate lists for each, because the same person can fall into one group and not the other.

## Sources

1. [26 U.S. Code § 105(h), amounts paid to highly compensated individuals under a discriminatory self-insured medical expense reimbursement plan](https://www.law.cornell.edu/uscode/text/26/105), Legal Information Institute, Cornell Law School
2. [26 CFR § 1.105-11, self-insured medical reimbursement plans](https://www.law.cornell.edu/cfr/text/26/1.105-11), Legal Information Institute, Cornell Law School
3. [Notice 2011-1, delay of the nondiscrimination rules for insured group health plans](https://www.irs.gov/pub/irs-drop/n-11-01.pdf), Internal Revenue Service
4. [Publication 15-B, Employer's Tax Guide to Fringe Benefits](https://www.irs.gov/publications/p15b), Internal Revenue Service
5. [26 U.S. Code § 125, cafeteria plans](https://www.law.cornell.edu/uscode/text/26/125), Legal Information Institute, Cornell Law School
6. [26 U.S. Code § 129, dependent care assistance programs](https://www.law.cornell.edu/uscode/text/26/129), Legal Information Institute, Cornell Law School