Health benefits are an effective tool for attracting and keeping talented employees, especially those in the upper ranks of a company. Health benefits are also a highly regulated industry, so it’s no surprise that the IRS wants to ensure that companies do not favor one group of employees over another.
In particular, the IRS wants to make sure health benefit plans don’t discriminate in favor of highly compensated employees with respect to plan eligibility, pre-tax contributions, or benefits. For that reason, the IRS requires all health plans to undergo nondiscrimination testing on an annual basis. Learn more below.
What is a Nondiscrimination Test?
IRS rules state that self-insured health plans cannot discriminate in favor of Highly Compensated Employees (HCEs) with respect to eligibility or benefits. The nondiscrimination test looks at whether a benefits plan provides HCEs with better benefits, either in terms of plan design or implementation, than other employees.
An HCE is someone who falls into any of these categories:
- One of the company’s five highest-paid officers
- Is 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, years of service with the company or the employee’s compensation.
Self-insured benefits covered by Section 105(h):
- Medical benefits, including preferred provider organization, health maintenance organization, and high deductible health plans
- Dental and vision benefits
- Health Flexible Spending Accounts (FSAs)
- Health Reimbursement Arrangements (HRAs)
Passing the Nondiscrimination Test
Health plan design is a leading cause of nondiscrimination test failures. For example, only allowing certain groups of employees, such as salaried or management, to participate in the plan, or having different plan eligibility requirements for different employee groups, can be problematic. Different eligibility requirements can include factors such as waiting periods or employment start dates.
When plan benefits or contribution rates vary based on employment classification – e.g., if managers pay lower premiums or receive benefits that other employees don’t – the plan will fail the discrimination test. 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: 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 the same.
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 components would be governed by the nondiscrimination rules while the fully-insured components would not.
When to test and what happens if the plan fails
Employers with self-insured health plans should test for nondiscrimination at least once a year, before the start of the next plan year. 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 offered through a Section 125 cafeteria plan, then the plan’s nondiscrimination rules will determine whether HCE contributions to the plan are taxable.
The regulations contained in Section 105(h) are complex, and so is the testing. Therefore, it’s recommended that employers with self-insured plans consult their benefits administrator when performing nondiscrimination testing.
Why risk negative tax consequences to your key employees? Keep your health benefits plan nondiscriminatory and everyone will be happy – including the IRS.
DataPath, Inc. is a leading provider of technology solutions for tax-advantaged benefits administration. Summit, the industry’s only cloud-based platform for seamless FSA and HRA management, offers nondiscrimination testing functionality. Contact (866) 638-7720 to talk to a representative.