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For over thirty years, self-funded health plans have been subject to a health plan nondiscrimination test – one which is often poorly understood and sometimes ignored. This test – found in Section 105(h) of the Internal Revenue Code (the “Code”) – is summarized below, so that employers and their advisers can understand how it works.

Introduction – What is Code Section 105(h)?

Benefits under an employer-sponsored health plan generally are not taxable due to a special section of the Code which excludes the value of those benefits from taxation. However, in order to ensure that employers do not improperly discriminate in favor of highly compensated individuals (“HCIs”), Congress created nondiscrimination rules under Code Section 105(h).

What Plans are Subject to the Code Section 105(h) Health Plan Nondiscrimination Test?

Currently, Code Section 105(h) only applies to self-funded health plans. A plan is generally treated as self-funded even if the plan has stop-loss insurance.

In addition, the Affordable Care Act (“ACA”) provides that non-grandfathered, fully-insured health plans will also be subject to rules “similar” to Code Section 105(h). It is not clear when this rule will become effective for such plans. The rule was supposed to have become effective in 2011, but the federal government delayed its effective date until an unknown date in the future. Note that the delayed effective date only applies for fully-insured health plans – self-funded health plans are currently subject to the rule, as they have been for several decades.

Common Health Plans That Can be Self-Insured

  • Major medical plan
  • Dental plans
  • Vision plans
  • PPOs
  • Health flexible spending arrangements (“Health FSAs”)
  • Health reimbursement arrangement (“HRA”)
  • Hospital indemnity coverage

What Health Plan Nondiscrimination Test Designed to Do?

The 105(h) Test is designed to verify two things. First, that “enough” non-HCIs “benefit” under the health plan, in comparison to the number of HCIs who “benefit.” Second, to verify that the health plan’s benefits (e.g., deductible levels and covered benefits) do not favor HCIs.

Who is an “HCI,” Exactly?

There are three typical definitions of who is an HCI. First, an “officer” of the employer will be an HCI – but only if the officer is one of the five highest-paid officers. Second, an individual who owns more than 10 percent of a corporation is generally an HCI. Finally, an individual who is among the highest-paid 25 percent of all employees (other than certain excluded employees who are not participants in the health plan), is generally an HCI. Some of these definitions are a little inexact, such as the year for when compensation is determined and what happens if ownership or officer status changes during the year.

Two Tests.

There are two tests which both must be satisfied in order to pass the 105(h) Test. Those two tests are described in the next two sections.

Test #1 of 2: Eligibility Test

  • What Does the Eligibility Test Generally Require?
    The Eligibility Test focuses on whether enough non-HCIs “benefit” under the health plan. The term “benefit” is not well-defined but seems to mean that the employee is actually enrolled in the plan (and not merely eligible to enroll). The Eligibility Test will be passed if one of three tests is satisfied.
  • 70 Percent Test (Test #1 of 3 for Eligibility Test)
    The 70 Percent Test is satisfied if the plan benefits 70 percent or more of all employees.
  • Example: Sample Co. has a self-funded health plan. Sample Co. has 250 employees. All the employees are eligible to participate, but only 200 are actually enrolled. The plan will pass the Eligibility Test because 80 percent of the employees (200 / 250 = 80%) benefit under the plan.
  • 70 Percent / 80 Percent Test (Test #2 of 3 for Eligibility Test)
    Under the 70 Percent / 80 Percent Test, the employer must first verify that 70 percent or more of all employees are “eligible” to benefit under the plan. If so, the plan must actually benefit 80 percent or more of all those eligible employees.
  • Nondiscriminatory Classification Test.
    The Nondiscriminatory Classification Test is passed if, based on certain “facts and circumstances,” the plan does not discriminate in favor of HCI eligibility. It is somewhat unclear how to run this test.

Test #2 of 2: Benefits Test

The Benefits Test is generally passed if the same benefits are provided to both HCIs and non-HCIs. The Benefits Test generally would be violated if an employer offered better eligibility terms for HCIs than non-HCIs (e.g., immediate eligibility versus 90-day waiting period). It also would be violated if benefits increase with years of service or compensation (e.g., if an HRA provided $100 in benefits for each year of employment).

Conclusion on Health Plan Nondiscrimination Test & Rules

Employers should periodically examine their plan structure and actual participation rates in order to verify that they pass the 105(h) Test. Failing to do so can cause HCIs to have some of their benefits become taxable. And, for fully-insured, non-grandfathered health plans, those plans apparently could become subject to certain excise taxes if the test is failed (although the exact penalty remains unclear due to the lack of guidance for such plans).


Legislation Self-Funding


Members & Employers


Legislation Self-Funding


Members & Employers
Brandt Dietry

Brandt Dietry
Guest Blogger, Associate at Michael Best Strategies LLC

Brandt Dietry was an Associate with Michael Best Strategies and worked closely with the firm’s Business & Community Solutions group, assisting with research, communications, logistics, and project management. Brandt worked especially closely with the firm’s healthcare startup clients to develop go-to market strategy and facilitate clients’ business development.

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