The primary discrimination concerns for self funded plans are the IRS 105(H) salary based discrimination, where plans are prohibited from discriminating in favor of highly compensated employees, and the HIPAA non-discrimination rules where plans cannot discriminate against an individual based on a health factor.
High-Level Overview of Internal Revenue Code Section 105(h) for a Self-Funded Health Plan
Under Internal Revenue Code Section 105(h), a self-funded health plan is prohibited from discriminating in favor of their “highly compensated” employees with respect to eligibility and/or benefits. Meaning, a group cannot provide greater benefits to their highly compensated employees then to their other employees. A highly compensated employee is defined as any of the following individuals:
- The 5 highest paid officers
- Greater than 10% shareholders (including attribution); and
- The top 25% of the payroll (other than excludable employees**).
**An excludable employee is anyone who: (1) has less than 3 years of service at the beginning of the plan year, (2) is less than 25 years old at the beginning of the plan year, (3) is deemed a part-time or seasonal worker (working less than 25 hours per week or who work less than 7 months per year), (4) is a collectively bargained employee, or is (5) is a nonresident alien who receives no U.S. source-earned income.
The 105(h) rules impose two tests a self-funded employer must pass: The Eligibility Test and the Benefits Test. Provided below is an overview of these tests and the consequences of failing either test.
The Eligibility Test
The Eligibility Test is intended to ensure the plan does not discriminate in favor of highly compensated individuals as related to their eligibility to participate. In order to determine if the plan passes the Eligibility Test, there are three tests that may be considered. The first test is to determine whether the Plan benefits 70% or more of all non-highly compensated employees in the employer's control group. The second test is to determine if the plan benefits 80% or more of all eligible, non-highly compensated employees in the employer's control group. The plan is deemed to pass this test, if 70% or more of all non-highly compensated employees are eligible to benefit. The third test is the fair cross-section test applicable to retirement plans.
The Benefits Test
The Benefits Test is intended to ensure the highly compensated employees are not receiving richer benefits. For example, are all participants eligible for the same benefits? Are there different premiums based on years of service or job position? Are different waiting periods imposed? If different benefits are offered, can all employees elect to participate in the benefit or are only certain employees allowed to participate?
In order to determine if a Plan passes the benefits test, first determine if all benefits provided are provided equally to highly compensated employees and non-highly compensated employees. Then ensure that none of the benefits discriminate in favor of any highly compensated employee.
How to Avoid 105(h) concerns
The cafeteria plan should give the plan administrator the authority to cut off any employee's salary reductions with respect to the plan and its component benefits if the administrator deems it necessary in order to comply with the nondiscrimination rules.
By monitoring the benefits provided to the prohibited group as compared to other employees, the plan administrator can judge during the year whether the plan risks violating the rules. If the risk seems great enough and the plan so provides, the plan administrator can revoke the HCEs' or Keys' salary reduction contributions under some or all components of the plan, thereby preserving the tax exclusion for all the HCEs and Keys. The IRS has informally indicated that cutbacks to prevent discrimination violations are permissible. However, the plan document must specifically allow such changes. And once the plan year has closed, it's too late to take any corrective action other than to impute income to the HCEs and Keys.
Benefits that fail the nondiscrimination test, both in eligibility and benefits, may be included in gross income, when they would have been nontaxable if the cafeteria plan benefits had passed the nondiscrimination tests. The reimbursements are taxable and must be reported on the employee’s W-2, and are exempt from FICA and FUTA.
This content is being provided as an informational tool. It is believed to be accurate at the time of posting and is subject to change. It is recommended that plans consult with their own experts or counsel to review all applicable federal and state legal requirements that may apply to their group health plan. By providing this information, Meritain Health is not exercising discretionary authority or assuming a plan fiduciary role, nor is Meritain Health providing legal advice.