Internal Revenue Code 105(h): Nondiscrimination Rules

Internal Revenue Code Section 105(h) establishes nondiscrimination rules for certain employer-sponsored health plans. The primary purpose is to prevent these arrangements from providing more favorable benefits to a company’s highest-paid employees and owners compared to other workers. If a plan provides tax-favored medical reimbursements, it must comply with these regulations to ensure the associated tax benefits are distributed broadly among the workforce.

Plans Subject to Section 105(h)

The regulations apply to self-insured medical reimbursement plans. A plan is self-insured when the employer assumes the financial risk of paying for employees’ medical claims directly, rather than paying a premium to an insurance carrier. This means the employer funds the plan from its own assets to cover anticipated healthcare costs.

These rules cover arrangements like Health Reimbursement Arrangements (HRAs), Medical Expense Reimbursement Plans (MERPs), and self-funded major medical plans. An employer offering a fully insured medical plan can have a self-insured plan subject to these rules, such as an HRA offered alongside the insured plan to cover deductibles.

A distinction exists between self-insured and fully insured plans. Fully insured plans, where an employer pays a fixed premium to an insurance company that then assumes the risk of paying claims, are not subject to these rules. The requirements apply to self-insured plans regardless of the employer’s business structure, affecting C-corporations, S-corporations, and LLCs.

The Nondiscrimination Tests

To maintain their tax-favored status, self-insured plans must pass nondiscrimination tests that prevent favoring a “Highly Compensated Individual” (HCI). An HCI is defined as one of the five highest-paid corporate officers, a shareholder who owns more than 10% of the employer’s stock, or an employee among the highest-paid 25% of all employees.

The first is the Eligibility Test, which assesses whether a sufficient number of non-HCIs benefit from the plan. A plan can satisfy this test by benefiting at least 70% of all employees. It can also pass by benefiting 80% or more of all eligible employees, if at least 70% of all employees are eligible. A plan can also pass if it benefits a classification of employees that the IRS finds is not discriminatory.

Employers may exclude certain groups of employees from these calculations. These employees include:

• Those who have not completed three years of service
• Those under the age of 25
• Part-time employees who work fewer than 35 hours per week
• Seasonal employees who work fewer than nine months per year
• Employees covered by a collective bargaining agreement if health benefits were a subject of good-faith negotiation
• Nonresident aliens with no U.S. source income

The second evaluation is the Benefits Test, which requires that all benefits available to HCIs must also be available to all other plan participants. This applies to the types of medical expenses eligible for reimbursement and the amount of reimbursement available. A plan cannot, for example, offer a higher reimbursement limit for executives than it does for other employees.

This test looks at both the plan’s written terms and its operation. A plan is discriminatory in operation if it favors HCIs based on the facts and circumstances. The benefits available for the dependents of HCIs must also be equally available for the dependents of all other participating employees.

Tax Consequences of a Discriminatory Plan

When a self-insured plan fails the nondiscrimination tests, the tax consequences are directed at the Highly Compensated Individuals. Reimbursements received by non-HCIs remain tax-free, but the penalty for HCIs is the inclusion of “excess reimbursements” in their gross income, making these amounts subject to income tax.

The method for calculating the taxable excess reimbursement 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 other participants, the entire amount of that specific reimbursement is considered excess and becomes taxable. For example, if a plan reimburses an executive for a cosmetic procedure not covered for other employees, the full reimbursement is taxed.

If the plan fails the Eligibility Test but the benefits are not discriminatory, the taxable amount is calculated on a pro-rata basis. The calculation involves determining a fraction where the numerator is the total amount reimbursed to all HCIs and the denominator is the total amount reimbursed to all employees. This fraction is then multiplied by the HCI’s total reimbursement to determine the taxable portion.

The employer is responsible for reporting the excess reimbursement amount correctly. The employer must include this amount as part of the HCI’s wages on their Form W-2 for the year, ensuring it is properly subjected to federal and applicable state income taxes.