Employee health benefits can be an excellent way to attract and retain talent. However, companies must follow strict regulations to ensure fair treatment for all employees. The IRS monitors highly compensated employees and their eligibility, pre-tax contributions, or available benefits compared to lower compensation employees. For that reason, all health plans must undergo annual nondiscrimination testing. Learn more below.
What is Nondiscrimination Testing?
IRS rules state that self-insured health plans cannot discriminate in favor of Highly Compensated Employees (HCEs) concerning eligibility or benefits. The nondiscrimination test examines whether a benefits plan provides HCEs with better benefits than other employees regarding plan design or implementation.
An HCE is someone who falls into any of these categories:
- One of the company’s five highest-paid officers
- In the top 25% of all highest-paid employees
- Owns more than 10 percent (in value) of the employer’s stock
A self-insured plan can be considered discriminatory under these situations:
- Only certain groups of employees are eligible to participate in the plan
- The plan has different employment requirements for eligibility
- Plan benefits or contribution rates vary based on employment classification, the employee’s company service years, or the employee’s compensation
Self-insured benefits covered by Section 105(h):
- Medical benefits, including preferred provider organizations (PPO), health maintenance organizations (HMO), and high deductible health plans (HDHP)
- Dental and vision benefits
- Health Flexible Spending Accounts (FSAs)
- Health Reimbursement Arrangements (HRAs)
How to Pass the Nondiscrimination Test
Health plan design is a leading cause of nondiscrimination test failures. Allowing only certain employees, such as salaried or management, to participate in the plan or having different plan eligibility requirements (e.g., waiting periods, employment start dates, etc.) for other employee groups can be problematic.
A health plan will fail the discrimination test when plan benefits or contribution rates vary based on employment classification. An example would be if managers pay lower premiums or receive benefits that other employees don’t. Offering separate health plans for different groups of employees is also a violation.
Self-insured health plans can pass the nondiscrimination test in three different ways:
- The plan benefits 70 percent or more of all non-excludable employees
- Seventy percent or more of all non-excludable employees are eligible to benefit under the plan, and the plan benefits 80 percent or more of this group
- The plan benefits a classification of employees that does not discriminate in favor of HCEs. A plan satisfies this test if it meets two criteria – those having a legitimate business classification for any exclusions and a sufficient ratio of benefitting non-HCEs to HCEs
The simplest way to pass the test is to treat all employees equally.
Testing Exceptions
Currently, fully insured health plans do not have to abide by Section 105(h) nondiscrimination regulations. However, some health plan designs have fully insured and self-insured components. In this situation, the self-insured parts would be governed by the nondiscrimination rules, while the fully insured elements would not.
When to test and how to address failure
Employers with self-insured health plans should test for nondiscrimination at least once a year, before the following plan year’s start. If the plan fails, you can make corrective distributions during the current plan year but not after it has ended. The safe approach involves monitoring the plan throughout the year to identify and correct any problems.
If a plan does not pass the nondiscrimination test, HCEs will have to pay taxes on the excess benefits that would not have counted as income if the plan had passed. If the benefits are part of a Section 125 cafeteria plan, then the plan’s nondiscrimination rules will determine whether HCE plan contributions are taxable.
The regulations contained in Section 105(h) are complex, and so is the testing. Therefore, it’s a good idea for employers with self-insured plans to consult their benefits administrator when performing nondiscrimination testing.
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