Section 105(h) Nondiscrimination for Self-Insured Health Plans
If your plan pays claims from the employer’s own assets, the tax code asks whether it favors highly paid people. The test is old, specific, and easy to overlook.
How Section 105(h) Works
Treasury Regulation 1.105-11 sets out the details. These are the pieces that decide most plans.
It Applies to Self-Insured Plans
Section 105(h) governs self-insured medical reimbursement plans. A fully insured plan is outside it, and the ACA’s parallel rule for insured plans was postponed by IRS Notice 2011-1 until regulations are issued. Employers should check that the plan is truly self-insured before using this rule, since insured plans are treated differently. Counsel or a tax adviser can confirm which rules apply to each plan. The owner-focused version of these rules is in Self-Insured Plan Nondiscrimination Rules.
Who Is Highly Compensated
A highly compensated individual is one of the five highest-paid officers, a shareholder owning more than 10% of the employer by value, or a member of the highest-paid 25% of all employees. The count rounds up, so in a five-person company the top two qualify.
The Eligibility Test
The plan must benefit at least 70% of all employees, or at least 80% of eligible employees when 70% or more are eligible, or cover a classification of employees that is found not to favor the highly compensated. Employers should keep the headcount data that support the percentages, and review them each year. The classification route is more complex, so a tax adviser should look at any plan that depends on it.
The Benefits Test
Every benefit available to a highly compensated person must be available to every other participant, including dependent benefits. Employer-paid maximums must be uniform and cannot vary by age or years of service. Plan documents should show the same benefits and limits for all participants in the same group. Employers that add executive or owner benefits should have a tax adviser review them first.
Operation Matters Too
A plan that reads fairly can still fail if it discriminates in practice. Benefits that rise in proportion to compensation are treated as discriminatory. Employers should review how the plan works in practice, including how claims are paid and who receives benefits. A tax adviser can review actual results, not just the plan wording.
The Rule Is a Tax Rule
The consequence of failure is a tax consequence, not a coverage consequence, which is why it can go unnoticed until someone looks. Failures may not trigger any immediate notice, so employers should review the plan on a set schedule. Ask a tax adviser to look at the plan design before renewal and after any major workforce change.
Who You Can Leave Out of the Eligibility Test
The regulation lets certain groups be disregarded when counting.
Under Three Years of Service
Employees with less than three years of service may be excluded, measured by a reasonable and consistent method. Predecessor employer service counts. Employers should keep records of how service is measured and whether the method is applied evenly. A tax adviser can confirm how predecessor service and rehired employees should be handled.
Under Age 25
Employees under 25 may be excluded from the test. Employers can use this exclusion only if they apply it consistently and document the age check. A tax adviser can confirm the details and how they fit with the plan’s own eligibility rules.
Part-Time and Seasonal
Employees who customarily work under 35 hours a week or under nine months a year may be disregarded when similar workers work substantially more. Under 25 hours and under seven months can always be treated that way. Employers should look at actual schedules, not just job titles, and apply the rule evenly. Seasonal and part-time exclusions are technical, so a tax adviser should review them before they are used.
Union and Nonresident Alien Employees
Employees covered by a collective bargaining agreement where health benefits were bargained in good faith, and nonresident aliens with no U.S.-source earned income from the employer, may also be left out. These exclusions depend on the facts, so keep copies of the bargaining agreement language and income records. Ask a tax adviser to confirm that each group meets the conditions before leaving it out of the testing.
What Failing the Test Costs
The cost lands on the highly compensated participants, not the plan as a whole.
Excess Reimbursements Become Taxable
Reimbursements to a highly compensated individual under a plan that fails are taxable to that person. For a discriminatory benefit, the full amount reimbursed for that benefit is excess. For discriminatory coverage, a fraction of the individual’s reimbursements is excess.
Everyone Else Is Unaffected
Benefits paid to participants who are not highly compensated remain excludable even if the plan fails. This limits the effect of a failed test to the highly compensated individuals, but it can still be costly for them. A tax adviser can explain how it would apply to those participants.
When The Income Is Reported
Excess amounts are included in income for the taxable year in which the plan year ends. The reporting timing affects the individual’s tax return, so involve a tax adviser early and tell affected participants. Payroll teams should also confirm how the amount would be reported.
Common Ways Plans Drift
An executive-only supplemental reimbursement, a richer benefit for owners, or a plan that excludes a large hourly class can all create exposure. Review them before renewal rather than after. Ask a tax adviser to review any special benefits for owners or executives, along with eligibility rules that leave out large groups of employees. Make this review part of the annual renewal checklist.
Questions We Get About Section 105(h)
Does Section 105(h) apply to our insured plan?
No. It applies to self-insured plans. A parallel ACA rule for insured plans exists in the statute, but IRS Notice 2011-1 postponed its application until regulations are issued.
Does an HRA fall under Section 105(h)?
Employer-funded HRAs are generally self-insured reimbursement arrangements, so the rule is relevant to them. Individual coverage HRAs have their own same-terms requirements. See our ICHRA and QSEHRA guide.
Who is a highly compensated individual?
One of the five highest-paid officers, a shareholder owning more than 10% of the employer, or someone in the highest-paid 25% of employees.
Do we have to run the test every year?
The regulation tests the plan on its eligibility and benefits terms and how it operates, so any change in eligibility, benefits or employee mix is a reason to retest.
Can we offer an executive-only medical benefit?
An employer-paid, self-insured benefit limited to highly compensated people would fail the tests, and the reimbursements would be taxable to those individuals.
Who can be excluded from the eligibility count?
Employees under three years of service or under 25, certain part-time and seasonal employees, bargained employees and nonresident aliens with no U.S.-source income.
What is the tax result of failing?
Excess reimbursements to highly compensated individuals are included in their income for the year the plan year ends. Other participants are unaffected.
How does this interact with a stop-loss policy?
Stop-loss reimburses the employer, not participants, and does not change the plan’s eligibility or benefit terms, which are what the test examines.
Is this legal advice?
No. For your plan, involve your counsel or tax advisor. We can help you organize your documents and questions.
Related Guides
Related reading: Self-Funded Health Plans · Nondiscrimination Testing · Section 125 Cafeteria Plans · ICHRA and QSEHRA Guide · Controlled Group Rules
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Laws and rules referenced
26 U.S.C. § 105(h) and 26 C.F.R. § 1.105-11 — Nondiscrimination rules for self-insured medical reimbursement plans.
This page is general information, not legal or tax advice. Rules change and facts matter, so confirm your situation with counsel or a qualified advisor.
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