Complying with Internal Revenue Code Section 105 h

Internal Revenue Code Section 105(h) establishes nondiscrimination rules for certain employer-sponsored health plans to prevent them from favoring a company’s highest-paid employees and owners. The rules ensure that the tax benefits associated with these health plans are available broadly across the workforce. Section 105(h) operates by setting specific standards for both eligibility and benefits within a plan. If a plan fails to meet these standards, the preferential tax treatment for the favored group is lost, and certain health benefits become taxable.

Applicability to Self-Insured Medical Plans

Section 105(h) applies to self-insured medical reimbursement plans. In a self-insured plan, the employer assumes the direct financial risk for employee medical claims. Instead of paying a fixed premium to an insurance carrier, the employer pays for claims as they are incurred, often from a dedicated trust or general corporate assets.

Common examples include Health Reimbursement Arrangements (HRAs) and medical expense reimbursement plans (MERPs). An HRA is an employer-funded account that employees use for out-of-pocket medical expenses and is considered a self-insured plan subject to these rules.

Conversely, these nondiscrimination rules do not apply to fully insured health plans. Although the Affordable Care Act (ACA) intended to apply similar rules to fully insured plans, the IRS has indefinitely delayed their implementation, so they are not currently enforced.

Defining a Highly Compensated Individual

To apply the nondiscrimination tests, a plan must first identify its “Highly Compensated Individuals” (HCIs). Section 105(h) provides a precise definition for who falls into this category, which is distinct from definitions used in other areas of the tax code. An employee is considered an HCI if they meet the criteria of any one of three specific groups.

The first group consists of the five highest-paid officers of the company. The second category includes any shareholder who owns more than 10% of the value of the employer’s stock, which can be direct or attributed from certain family members. The final group captures employees who are among the highest-paid 25% of all employees.

The Nondiscrimination Tests

A self-insured plan must pass two separate tests to maintain its tax-favored status for HCIs: the Eligibility Test and the Benefits Test. Failure of either test triggers negative tax consequences for the plan’s highly compensated participants.

The Eligibility Test focuses on whether a sufficient number of non-HCIs benefit from the plan. A plan can satisfy this requirement in one of three ways. The first is the “70% test,” where the plan must benefit at least 70% of all non-excludable employees. The second is the “70%/80% test,” passed if at least 70% of all non-excludable employees are eligible and at least 80% of that group participates. The third way is through a “nondiscriminatory classification,” where the employer establishes a classification of employees that the IRS finds reasonable and not structured to favor HCIs.

For these tests, certain employees may be excluded from the calculation. This includes those with less than three years of service, those under age 25, and certain part-time or seasonal workers.

The Benefits Test examines the actual benefits provided under the plan. This test is failed if the benefits available to HCIs are not available on the same terms to all other plan participants. This applies to the types of medical expenses reimbursed, the amount of reimbursement, and any limits or conditions.

For example, a plan would be discriminatory if it required lower employee contributions from HCIs than from other workers for the same benefits. It would also be discriminatory if it offered a $5,000 reimbursement limit for executives but only a $1,000 limit for all other employees.

This test looks at discrimination in both the plan document and its operation. A plan might appear fair in its written terms but be operated in a way that favors HCIs, for instance, by adding coverage for a procedure only when an HCI needs it. All benefits available for the dependents of HCIs must also be equally available for the dependents of non-HCI participants.

Tax Treatment of Discriminatory Plans

When a self-insured medical plan fails the nondiscrimination tests, the consequences are targeted at the HCIs. Reimbursements received by non-HCI employees remain tax-free, and the plan itself is not disqualified. However, the favorable tax treatment for HCIs is lost for the plan year in which discrimination occurred.

The tax impact on an HCI depends on which test the plan failed. If the plan fails the Benefits Test by providing a benefit to an HCI that is not available to others, the entire reimbursement for that specific benefit becomes taxable income. For example, if an executive is reimbursed $3,000 for a medical service not covered for other employees, that full $3,000 is added to their taxable wages.

If the plan fails the Eligibility Test but not the Benefits Test, the taxable amount is calculated with a formula. The total amount reimbursed to the HCI is multiplied by a fraction. The numerator is the total reimbursement paid to all HCIs, and the denominator is the total reimbursement paid to all plan participants. The resulting amount is the excess reimbursement that must be included in the HCI’s gross income.