What Was Section 89 of the Tax Code?

Section 89 of the Internal Revenue Code was enacted as part of the Tax Reform Act of 1986. Its purpose was to create uniform nondiscrimination rules for employee benefit plans, such as health insurance and group-term life insurance. The goal was to ensure the tax-favored status of these benefits was justified by broad coverage for a company’s workforce, not just its executives. The rules were designed to prevent employers from offering significantly better benefits to their highest-paid employees while providing minimal coverage to lower-paid workers.

However, the law’s complexity created significant administrative challenges for businesses of all sizes. This opposition led to a legislative reversal, and in 1989, Congress passed legislation to fully repeal Section 89. The repeal was made retroactive, as if the law had never been included in the 1986 Act.

The Nondiscrimination Tests

At the heart of Section 89 were basic qualification standards and a series of nondiscrimination tests. The qualification standards required that all plans be in writing, legally enforceable, and established for the exclusive benefit of employees. The more challenging component was the set of tests designed to measure if a plan unfairly favored a “highly compensated employee” (HCE). An HCE generally included 5% owners, employees earning above a specific indexed salary threshold, certain high-earning officers, and the top-paid 20% of the workforce.

To comply, an employer’s health or accident plan had to pass a multipart analysis. One option was the 80% coverage test, a standalone test that allowed a plan to avoid more complicated evaluations. To satisfy it, a plan had to show that the number of non-HCEs who benefited from the plan was at least 80% of the number of HCEs who benefited.

If a plan could not satisfy the 80% test, it was subjected to other evaluations. The 50% eligibility test required that at least 50% of the employees eligible to participate in a plan must be non-HCEs. This test focused on who was eligible to participate, not who actually enrolled.

Another layer of analysis was the 90%/50% eligibility test. This two-part test required that at least 90% of all non-HCEs be eligible for a benefit that was at least 50% as valuable as the most valuable benefit available to any HCE. This forced employers to perform complex valuations of their different health plans to compare their relative worth.

Finally, plans that passed the eligibility hurdles still had to face the 75% benefits test. This test looked at the average benefit actually provided to non-HCEs and required it to be at least 75% of the average benefit provided to HCEs. This meant that even if lower-paid employees were eligible for good benefits, if they disproportionately chose not to enroll or selected less expensive plans, the employer could still fail the test.

Consequences of Noncompliance

Failing the nondiscrimination tests under Section 89 carried direct financial consequences, primarily for the highly compensated employees. The law did not penalize the company directly with a fine for having a discriminatory plan. Instead, it targeted the tax benefits received by the HCEs by taxing the “discriminatory excess” benefit, which was the portion of the employer-paid benefit deemed to be unfair.

Calculating this discriminatory excess was a complex process. It involved determining the value of the benefit an HCE received and subtracting the highest possible benefit that would have allowed the plan to pass the nondiscrimination tests. For example, if an HCE received a fully paid family health plan valued at $10,000, but the plan failed the tests, a calculation would determine the maximum compliant benefit value. If that value was $7,000, the $3,000 difference would be the discriminatory excess.

This excess amount was then treated as taxable income to the HCE for that year. The employer was responsible for this calculation and for reporting the amount on the employee’s Form W-2, Wage and Tax Statement. This process converted a previously tax-free fringe benefit into taxable cash compensation for this group of employees.

Furthermore, employers faced their own penalties if they failed in their reporting duties. If an employer did not correctly calculate and report the discriminatory excess on the HCEs’ W-2s, the employer itself could be subject to an excise tax. This penalty was calculated at the highest individual income tax rate on the total value of the benefits in question.

The Repeal of the Rules

The repeal of Section 89 in November 1989 was a direct result of overwhelming public and political pressure driven by the law’s complexity. Small and medium-sized businesses, in particular, found themselves buried under administrative work. They often lacked the specialized staff or resources to perform the data collection, employee classification, and statistical testing required to prove compliance.

This complexity translated into significant costs for employers. Businesses had to invest in new accounting systems, hire consultants, or dedicate substantial employee hours just to navigate the law. Many business owners argued that the cost of proving their benefit plans were fair was more burdensome than the potential tax increase on their highest-paid employees. This narrative fueled a lobbying campaign that led Congress to repeal the law.

The repeal was made retroactive, effectively erasing Section 89 from the tax code as if it never existed. With it gone, the legal landscape for employee benefits reverted to the rules that were in place prior to the Tax Reform Act of 1986. The nondiscrimination rules for certain benefits, such as self-insured medical reimbursement plans under Section 105(h) and group-term life insurance under Section 79, were reinstated.

However, the modern compliance landscape is more complex. While the rules for self-insured health plans apply, the Affordable Care Act (ACA) created similar nondiscrimination provisions for fully-insured health plans. The IRS has since issued guidance stating that enforcement of the ACA’s rules is delayed indefinitely until further regulations are issued. Additionally, if an employer allows employees to pay for benefits on a pre-tax basis through a cafeteria plan, the plan must pass a separate set of nondiscrimination tests.