Employee Benefits Compliance, Nondiscrimination Rules, Penalties

Nondiscrimination Rules for Self-Funded Plans: Updated Summary

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This article updates and replaces the prior version, which was posted 11-24-14


The Affordable Care Act (ACA) provides that non-grandfathered insured group health plans will be subject to nondiscrimination rules similar to those that currently apply to self-insured group health plans, except that the penalties will be different. (ACA section 10101(d) added section 2716 to the Public Health Service Act.)   In late 2010, the Administration delayed the enforcement date until the first plan year beginning after regulations are issued (IRS Notice 2011-1), which at this point probably means no sooner than January 1, 2017 (or even 2018) for calendar year plans. It’s possible regulations will be issued on Thanksgiving Eve (as the IRS often does), but it’s also possible they will be delayed indefinitely. In either case, employers who sponsor insured plans might want to become familiar with the 105(h) nondiscrimination rules. This article provides a short summary of the nondiscrimination rules under IRC section 105(h) and the difference in penalties for insured versus self-funded plans.

For 2016 (and probably also 2017), insured plans are not subject to these nondiscrimination rules, so for now at least, there is no penalty for noncompliance. However, employers who sponsor an insured health plan sometimes have a self-insured plan as well, such as a Health Reimbursement Account (HRA), and that self-insured plan IS subject to the non-discrimination rules. Also, if an employer who offers insured health coverage allows employees to pay on a pre-tax basis through a cafeteria plan for their premiums for the coverage, the cafeteria plan nondiscrimination rules will apply, so employers who offer shorter waiting periods or lower premiums to highly compensated employees should check with their cafeteria plan administrator to see if such arrangements meet cafeteria plan nondiscrimination rules (these are under Code section 125).

Overview of Section 105(h) Nondiscrimination Tests

Code section 105(h) contains the rules applicable to self-insured plans. It does not prohibit all types of discrimination. It prohibits self-insured group health plans from discriminating in favor of “highly compensated individuals” (HCIs) and against non-HCIs as to Eligibility to participate and as to Benefits available under the plan. The two nondiscrimination tests under 105(h) are:

  • The Eligibility Test, which is stated in Code §105(h)(2)(A), is intended to ensure that “enough” non-HCIs benefit from the plan.
  • The Benefits Test, which is stated in Code §105(h)(2)(B), is intended to ensure that all participants are eligible for the same benefits and that HCIs are not getting better benefits or are not required to make lower contributions than non-HCIs.

The Following Individuals are Defined as “Highly-Compensated Individuals” (HCIs)

  • The highest-paid 25% of all non-excludable employees,
  • The five highest-paid officers, and
  • The more-than-10% shareholders

Thus, by definition, at least 25% of all non-excludable employees are HCIs.

“Excludable” employees are defined as:

  • Employees who have not completed three years of service
  • Employees under age 25
  • Part-time or seasonal employees
  • Non-resident aliens with no U.S. source income.

However, if an employer does not exclude all employees in an excludable category, then no employees in that category are considered to be excludable. For example, an employer could not exclude some employees who have less than three years of service but not others, and it could not exclude some employees who are under age 25 but not others.

The Eligibility Test

There are three alternative ways a self-insured plan can pass the Eligibility Test. The first test below is the easiest to apply but the hardest to pass. The third test below is the most complex to apply, but an employer who cannot meet the first two tests will have to see if it can pass the third test.

  • 70% test: The plan benefits 70% or more of all non-excludable employees.
  • 70/80% test: 70% or more of all non-excludable employees are eligible to benefit under the plan, and the plan benefits 80% or more of those employees who are eligible to benefit (i.e., the plan benefits 56% of non-excludable employees).
  • Nondiscriminatory Classification Test: The plan benefits a classification of employees that is both “reasonable” and “nondiscriminatory.”
    • A “reasonable” classification is one that is based on objective business criteria. Examples in the regulations include:
      • job categories – such as full-time vs part-time
      • nature of compensation – such as hourly vs salaried
      • geographic location
      • The regulations specify it is not reasonable to list excluded employees by name or by other specific criteria having the same effect.
    • A “nondiscriminatory” classification is one that satisfies either a numerical/ mathematical “safe harbor percentage test” (from IRC section 410(b)(1)(B)) or a facts and circumstances test. The 410(b) test applies to qualified retirement plans also. Under the first mathematical test, a comparison is made of the percentage of HCIs who benefit under the plan and the percentage of non-HCIs who benefit, and the resulting percentage is what must meet the “safe harbor percentage test.” This is not a test where the employer merely “eyeballs” it and confirms that both HCIs and non-HCIs benefit; rather, it requires several specific mathematical calculations.

The Benefits Test

To pass the Benefits test, a self-insured plan must provide all benefits to non-HCIs that it provides to HCIs who are participating in the plan. The plan cannot be discriminatory on its face or in operation.

  • Nondiscriminatory on its face. Some examples of how this applies:
    • Plan cannot charge non-HCIs more than HCIs for the same benefits or coverage
      • E.g., HCIs pay 50% of the premium and non-HCIs pay 80%
      • E.g., Deductible is $500 for HCIs and $1,000 for non-HCIs
    • The same type of benefits available to HCIs must be available to non-HCIs
      • This is not a “utilization” test. It does not matter, for example, if HCIs actually have more surgeries than non-HCIs. The test is whether all benefits are available by plan design.
    • Plan cannot impose longer waiting period on non-HCIs than on HCIs
      • If HCIs have no waiting period and non-HCIs have a 90-day waiting period, HCIs will be taxed on reimbursements for (or cost of) expenses incurred during the first 90 days of coverage.
      • However, IRS officials have informally said that if an employer imputes income to the HCIs equal to the “fair market value” of the premium cost during the longer waiting period applicable for non-HCIs, the plan will not violate 105(h) and the benefits would be tax-free to the HCIs.
  • Nondiscriminatory in operation. This is a “facts and circumstances” determination.
    • A plan would be discriminatory in operation if it covers a benefit for a period when an HCI (or family member) needs it and then is amended to exclude that coverage once the HCI or family member no longer needs it.
    • A plan would not be discriminatory merely because HCIs utilize benefits at a higher rate than do non-HCIs.

Penalties for Noncompliance Differ for Insured vs Self-Insured Plans

Although the same substantive nondiscrimination rules will apply for insured plans as now apply for self-insured plans, the penalties for noncompliance will differ.

Self-insured plans. The penalty under section 105(h) for failure to meet the nondiscrimination tests is that highly compensated individuals will have to include in taxable income the value of “excess benefits” they receive. The non-highly compensated individuals in the plan will not have to include any amount in taxable income, nor will the plan sponsor have to pay a penalty, nor will the self-insured health plan cease to be a valid plan under Code §105 The penalty amount for HCIs varies depending on whether the plan failed the Eligibility or Benefits Test.

  • Eligibility Test failed: Failing the Eligibility test results in discriminatory coverage. The result is that amount of the “excess reimbursement” for a particular HCI is determined by multiplying the total amount reimbursed to the HCI by a fraction, the numerator of which is the total benefits paid during that plan year to or for all HCIs, and the denominator of which is the total benefits paid during that plan year to or for all participants.
  • Benefits Test failed: Failing the benefits test results in discriminatory benefits. The result is that the amount of the “excess benefit” for a particular HCI is the amount paid for or reimbursed to that HCI for the discriminatory benefit. If a particular benefit is available only to an HCI and not to all other participants, then the taxable amount for that HCI is the total amount paid for or reimbursed to the HCI for that benefit. On the other hand, if a particular benefit available to non-HCIs is a lesser benefit than what is available to HCIs, then the amount available to the HCI will be offset by the amounts available to the non-HCIs.

Important Note: The tax consequences for HCIs could be more severe if the self-insured plan fails the Benefits Test (which may result in 100% taxation of discriminatory benefits reimbursed to each HCI) than if it fails the Eligibility Test (which results in taxation of a pro rata share of benefits that were reimbursed to an HCI).

Insured plans. The penalty for failure to meet the nondiscrimination tests is that the plan sponsor must pay an excise tax equal to $100 per day per non-highly compensated employee who is discriminated against, to a maximum of $500,000 per taxable year for inadvertent failures. Thus, for each employee affected, the annual penalty on the employer will be $36,500, subject to the annual cap of $500,000.  Additionally, a plan sponsor of an ERISA plan could be sued by participants to enforce the nondiscrimination requirements, since the new nondiscrimination requirement is in ERISA as well as under the Code. The plan sponsor also must file a form 8928 to self-report that they have failed to meet the nondiscrimination requirements. See below for additional information on Form 8928.

Penalty Examples for Insured Plans

  • E.g. 1: Employer pays 100% of the premium for 10 executives but only 80% for the other 100 employees. Excise tax equals $10,000 per day (100 x $100) for as long as the discriminatory practice continues. But 50 days = $500,000, so it’s capped at that.
  • E.g. 2: Employer offers the same coverage to all eligible employees and makes a uniform contribution toward coverage. Executive’s health coverage is offered as of the date of hire, but other employees must complete a 90-day waiting period before they are eligible to enroll for coverage. The plan sponsor will have to pay $9,000 for each nonexecutive who must wait 90 days before enrolling in the plan (i.e., 90 days x $100/day).

IRS Form 8928 to Self-Report Excise Tax

Insured employers who owe an excise tax due to discrimination (or certain other compliance failures) are required to self-report this tax on IRS Form 8928, which is due by the date the employer’s federal income tax return is due. The excise tax requirement was in the Code even prior to the enactment of the ACA, but regulations specifically requiring employers to file excise tax returns were only issued in November 2009. This means affected employers now have a formal obligation to file the excise tax return, and an employer who fails to timely file or pay could be subject to late or non-filing penalties and also interest on late payment of the excise tax due. This is in addition to the excise tax amount due.