IRC Section 105(h) nondiscrimination testing is the annual check that keeps a self-insured medical reimbursement plan from steering tax-free health benefits disproportionately to owners and top executives. Every self-insured plan must pass two tests each year: an eligibility test that looks at who is covered, and a benefits test that looks at what those people get. When a plan fails, only the highly compensated individuals lose the tax exclusion on their reimbursements. Rank-and-file employees keep their tax-free treatment either way.
Which Plans Have to Be Tested
The dividing line is who bears the financial risk of paying claims. If the employer pays claims out of its own funds instead of shifting that risk to a licensed insurance carrier, the plan is self-insured and Section 105(h) applies.1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan Buying stop-loss coverage to cap catastrophic exposure does not change the classification. The employer still owes the underlying claims up to the attachment point.
Health Reimbursement Arrangements funded by the employer are self-insured by design. Level-funded plans, common among mid-size employers, are treated as self-insured for this purpose because the employer still carries the claims risk beneath the stop-loss layer. An Individual Coverage HRA that reimburses only individual health insurance premiums is treated as insured and sits outside the 105(h) framework; an ICHRA that reimburses other medical expenses is self-insured and must be tested.
Fully insured plans, where a carrier assumes liability for all covered claims in exchange for a fixed premium, are not subject to 105(h). The Affordable Care Act’s Section 2716 tried to extend similar nondiscrimination rules to non-grandfathered insured plans, but the IRS suspended enforcement in Notice 2011-1 pending regulations that have never been issued.2Internal Revenue Service. IRS Notice 2011-1 – Nondiscrimination Provisions of Section 2716 For now, insured plans stay outside the testing world.
Who Is a Highly Compensated Individual
Section 105(h) uses its own definition, narrower than the Section 414(q) definition used in retirement plan testing. Three categories of employees are HCIs:3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
- The five highest-paid officers, regardless of employer size. A company with 200 officers still only flags five here.
- Shareholders who own more than 10% of the employer’s stock by value, including stock attributed through family members and related entities under the Section 318 constructive ownership rules.
- The highest-paid 25% of all employees, calculated after removing employees who are excludable under Section 105(h)(3)(B) and who do not participate in the plan.
Anyone in any one of these categories is an HCI for the whole plan year. There is no fixed dollar threshold. Unlike the 401(k) HCE definition, which uses a set compensation line, the 105(h) definition is entirely relative to the rest of the workforce.
Employees You Can Leave Out of the Count
Before running either test, the employer may remove certain groups from the testing population:3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
- Employees who have not completed three years of service.
- Employees who have not reached age 25 before the beginning of the plan year.
- Part-time and seasonal employees, defined by regulation as those working fewer than 35 hours per week or fewer than nine months per year.1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan
- Employees covered by a collective bargaining agreement where health benefits were the subject of good-faith bargaining, if they are not in the plan.
- Nonresident aliens with no U.S.-source earned income from the employer.
These exclusions are optional. If keeping a group in the count makes testing easier to pass, the employer can do that. The employees left after any exclusions form the population for both tests.
The Eligibility Test
The eligibility test checks whether the plan covers enough non-HCI employees. A plan only needs to satisfy one of three alternatives:3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
- The 70% test: the plan benefits at least 70% of all employees in the testing population.
- The 70/80% test: at least 70% of the population is eligible, and at least 80% of those eligible actually benefit.
- The nondiscriminatory classification test: the plan covers a classification of employees the IRS would not view as favoring HCIs. This is a facts-and-circumstances analysis, and most employers rely on it only when the numerical tests won’t work.4Internal Revenue Service. Internal Revenue Service – Technical Assistance Request Regarding Section 105(h)
The Benefits Test
Clearing the eligibility test is not enough. Every benefit provided to highly compensated participants must also be provided to all other participants.3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans A plan cannot set a $5,000 reimbursement cap for executives and $2,000 for everyone else. It cannot cover a category of services for HCIs that other employees cannot access. Deductibles, co-payments, coverage limits, and waiting periods all have to apply on the same terms. A shorter eligibility window for HCIs fails the test just as clearly as a bigger dollar benefit.
The test has two dimensions. The plan document itself cannot contain discriminatory terms, and the plan cannot operate in a discriminatory way. A clean-looking document can still fail if, say, the timing of a mid-year amendment adding or dropping a benefit happens to favor HCIs in practice. Different tiers of coverage are fine, as long as every tier is available to all employees on the same basis. What matters is equal availability, not whether every employee chooses the richer option.
Controlled Groups and Affiliated Service Groups
Employers that are part of a controlled group or affiliated service group under Section 414(b) and (c) must treat all employees across the entire group as if they work for a single employer when performing 105(h) testing.5eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan This is one of the most commonly overlooked requirements. A parent company might pass testing on its own headcount but fail once subsidiary employees are folded in. The aggregation reaches both the eligibility test and the benefits test: if one entity offers a benefit that sister-entity employees cannot access, the benefits test fails for the combined group. Employers with layered corporate structures should map controlled group relationships before running any analysis.
What a Failure Costs
When a self-insured plan fails, the tax hit falls on the highly compensated individuals. The employer does not pay a penalty. Non-HCI participants keep their tax-free treatment. Affected HCIs lose the exclusion on some or all of their reimbursements, which are reclassified as “excess reimbursement” and added to taxable income.3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
How much becomes taxable depends on the nature of the failure. If the plan provides a benefit available to HCIs but not to all other participants, the entire amount reimbursed to the HCI under that benefit is excess reimbursement. Reimburse an executive physical only for officers, and every dollar paid for those physicals becomes taxable to the officer who received it.
If the plan fails the eligibility test, or fails the benefits test based on how it operates rather than what the document says, a pro-rata formula applies. The HCI’s taxable amount equals total reimbursements received during the year multiplied by a fraction: total reimbursements to all HCIs over total reimbursements to all participants. Amounts already treated as discriminatory-benefit excess reimbursement are excluded from the fraction so they are not double counted.
Excess reimbursement is included in the HCI’s taxable wages on Form W-2 for the year the plan year ends, and the employer withholds payroll taxes on it like any other compensation. The $100-per-day excise tax under Section 4980D does not apply here; that penalty targets Chapter 100 group health plan violations, and Section 105(h) is not one of them.6Office of the Law Revision Counsel. 26 U.S. Code 4980D – Failure to Meet Certain Group Health Plan Requirements Income inclusion for the affected HCIs is the whole consequence.
Fixing a Discriminatory Plan
Testing is done on a plan-year basis, and results are generally final once the year closes. There is no formal IRS correction program for 105(h) failures like the one that exists for retirement plans.
The first option is prospective correction. Amending the plan before the plan year ends to remove the discriminatory feature may cure the violation. If HCIs had a shorter waiting period, extending the same shorter period to everyone going forward can work. If a benefit tier was executive-only, opening it to all employees before year-end may fix the problem for that year, though the timing of the amendment itself will be examined under the operational prong of the benefits test.
When prospective correction is not possible, the fallback is to include the excess reimbursement in the affected HCIs’ income and pay the associated payroll taxes. Some practitioners impute the value of the discriminatory coverage into the HCI’s income for open tax years. Employers should keep documentation of the testing methodology, results, and any corrections. There is no requirement to report 105(h) results on Form 5500, but those records will matter in an IRS audit.