Health benefits are an effective tool for attracting and keeping talented employees, especially those in a company’s upper ranks. Health benefits are also a highly regulated industry. It should come as no surprise then that the IRS wants to make sure that health plans don’t discriminate against any group of employees. In particular, the IRS works to ensure that health benefit plans don’t favor highly compensated employees (HCEs) over other employee groups with respect to eligibility, pre-tax contribution, or benefits.
To enforce these regulations, the IRS requires health plans to undergo annual nondiscrimination testing. The results can have a big impact on a company’s benefits plan and employees. Learn why nondiscrimination testing is important for employers and how it can affect your business and workforce.
Which Plans Must Undergo Nondiscrimination Testing?
All self-insured health plans are subject to IRS Code Section 105(h) nondiscrimination testing. Fully-insured plans are only subject to nondiscrimination testing if offered through a Section 125 cafeteria plan.
What Does the Nondiscrimination Test Involve?
Since self-insured health plans cannot discriminate in favor of HCEs with respect to eligibility or benefits, nondiscrimination testing looks at whether a benefits plan provides HCEs with better benefits, in terms of either 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
- In the top 25% of all highest paid company employees
- Owns more than 10 percent (in value) of the employer’s stock
According to Section 105(h), 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
Passing the Discrimination Test
The simplest way to pass the discrimination test is to treat all employees the same as to eligibility rules and benefit plans. Any time a plan treats some employees differently than others in terms of plan design or operation, it becomes harder to pass the test.
Self-insured health plans can pass the nondiscrimination test in three different ways:
- The plan benefits at least 70 percent of all non-excludable employees
- At least 70 percent of all non-excludable employees are eligible to benefit under the plan, and the plan benefits at least 80 percent of this group
- The plan benefits a classification of employees that does not discriminate in favor of HCEs; i.e., it has a legitimate business classification for any exclusions, and a sufficient ratio of benefitting non-HCEs to HCEs.
Fully insured health plans that are not offered through a cafeteria plan do not have to abide by Section 105(h) nondiscrimination regulations, which gives employers more flexibility to treat employees differently. If the plan is offered through a cafeteria plan however, the nondiscrimination rules apply.
If your health plan has fully insured and self-insured components, then self-insured components would be governed by the nondiscrimination rules while the fully-insured components, if not offered through a cafeteria plan, would not.
Failing the Nondiscrimination Test
Plan design issues are a leading cause of nondiscrimination test failures. Common reasons that a plan fails include:
- Only allowing certain groups of employees, such as salaried or management, to participate in the plan
- Having different plan eligibility requirements, such as length of waiting periods or employment start dates, for different employee groups
- Plan benefit or contribution rates that vary based on employment classification – for example, if managers pay lower premiums than lower-tier employees
- Offering separate health plans for different groups
If your plan fails the test, the benefits that HCEs receive under a discriminatory self-insured plan become taxable. If offered through a Section 125 cafeteria plan, the plan’s nondiscrimination rules determine whether HCE contributions to the plan are taxable.
In addition, the dollar value of the discriminatory benefits will need to be included in the gross incomes of the HCEs, and if W2 forms have already been issued, the employer will need to issue amended W2s and the HCEs will need to amend their tax filings. If the plan is found to be discriminatory for more than a single year, W2s and tax filings will need to be amended for every year the plan was out of compliance. Failure to pass the test can also cause problems for employers during a plan audit.
When to Test
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, employers can make corrective distributions during the current plan year, but not after it has ended. To be safe, employers should monitor their plan throughout the year to identify and correct any problems.
No employer wants to cause negative tax consequences to their key employees, and getting back into compliance can be time consuming and costly. Keep your health benefits plan nondiscriminatory and everyone will be happy – including the IRS.