IRC Section 105(h) nondiscrimination testing applies to every self-insured medical reimbursement plan and asks two questions each plan year: does the plan cover enough non-highly-compensated employees, and are the benefits it offers the same for everyone? A plan that fails either test doesn’t lose its status or trigger an employer penalty. Instead, the highly compensated individuals covered by it lose the tax exclusion on some or all of their reimbursements, which get added to their W-2 wages. Rank-and-file employees keep their tax-free treatment either way.
Which Plans Have to Be Tested
The test applies when the employer bears the risk of paying claims rather than transferring that risk to a licensed insurance carrier.1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan Buying stop-loss coverage doesn’t change that classification, because stop-loss caps the employer’s exposure without shifting the obligation to pay individual claims.
That pulls in more arrangements than employers sometimes realize:
- Health Reimbursement Arrangements that pay medical expenses out of employer funds.
- Level-funded plans, where the employer makes fixed monthly payments but still carries the claims risk up to the stop-loss attachment point.
- Individual Coverage HRAs, but only when they reimburse medical expenses beyond individual insurance premiums. An ICHRA that reimburses premiums only is treated as insured and sits outside 105(h).
Fully Insured Plans Are Not Tested
A fully insured plan, where a carrier assumes liability for all covered claims in exchange for a fixed premium, is not subject to Section 105(h). The Affordable Care Act’s Section 2716 of the Public Health Service Act tried to extend similar nondiscrimination rules to non-grandfathered insured plans, with penalties of up to $100 per day per affected individual, but the IRS suspended enforcement in Notice 2011-1 pending formal guidance.2Internal Revenue Service. IRS Notice 2011-1 – Nondiscrimination Provisions of Section 2716 No such guidance has been issued, so insured plans remain outside testing obligations for now.
Who Counts as a Highly Compensated Individual
Section 105(h) uses its own definition of HCI, narrower than the one used for 401(k) testing. Three categories capture the group: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 company size.
- Anyone owning 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 from testing and who do not actually participate.
Someone who falls into any one of the three categories is an HCI for the whole plan year. There is no fixed dollar threshold. Everything is relative to the workforce.
Employees You Can Leave Out of the Count
Before running either test, the employer may remove certain employee groups from the denominator:3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans
- Employees with fewer than three years of service.
- Employees under age 25 at the start 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, and who 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 the math easier to pass, the employer can leave them in.
The Eligibility Test
The eligibility test asks whether enough non-HCI employees are actually covered. A plan needs to satisfy only 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 70% or more of all employees in the testing population.
- The 70/80% test: at least 70% of the testing population is eligible to benefit under the plan, and at least 80% of those eligible actually do.
- The nondiscriminatory classification test: the plan covers an employer-established classification of employees that the IRS would not consider discriminatory in favor of HCIs. This is a facts-and-circumstances analysis.
The first two are bright-line numerical tests. The third is softer, which is why most employers try to satisfy one of the numerical alternatives when they can.4Internal Revenue Service. Internal Revenue Service – Technical Assistance Request Regarding Section 105(h)
The Benefits Test
Passing eligibility is not enough. Every benefit provided to HCIs must be provided to all other participants on the same terms.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 annual reimbursement cap for executives and $2,000 for everyone else. It cannot cover a category of services for HCIs that non-HCIs cannot access. Deductibles, co-payments, and coverage limits have to apply on the same basis. Shorter waiting periods for HCIs fail this test just as clearly as bigger dollar benefits.
The test has two prongs. The plan document cannot contain discriminatory terms, and the plan cannot operate in a discriminatory way. A document that reads clean on paper can still fail if, for instance, an amendment adding or removing a benefit is timed in a way that favors HCIs in practice. Tiered coverage is permitted, but every tier has to be available to all employees on the same basis. What matters is equal availability, not equal use.
Controlled Groups Have to Be Tested Together
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 a single employer for 105(h) testing.5eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan A parent that passes on its own can fail once a subsidiary’s workforce is added. The aggregation hits both tests: if one entity offers a benefit that employees of a sister entity cannot access, the benefits test fails for the combined group. Map the corporate structure before running any numbers.
What Failure Costs the HCIs
When a plan fails, the highly compensated individuals lose the tax exclusion on some or all of their reimbursements. The reclassified amount, called excess reimbursement, is added to their taxable income for the year.3Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans Non-HCI participants are unaffected. The employer isn’t fined. The statute defines excess reimbursement two ways, depending on the nature of the violation.
Discriminatory Benefits
If the plan provides a benefit to HCIs that isn’t available to all other participants, the full amount reimbursed under that benefit is excess reimbursement. Reimburse executive physicals only for officers, and every dollar paid for those physicals becomes taxable wages for the officers who received them.
Pro-Rata Excess Reimbursement
When the plan fails the eligibility test but benefits are uniform, or when it fails the benefits test based on operation rather than plan terms, a fraction applies. Multiply the HCI’s total reimbursement for the year by a fraction whose numerator is the total reimbursed to all HCIs and whose denominator is the total reimbursed to all participants. Amounts already treated as discriminatory benefits under the first category drop out of the fraction to avoid double-counting.
W-2 Reporting and What Doesn’t Apply
The excess reimbursement is reported on the HCI’s Form W-2 for the year in which the plan year ends. The employer calculates the amount and withholds payroll taxes as it would on any other compensation. The $100-per-day excise tax under Section 4980D does not apply. That excise tax targets Chapter 100 group health plan violations, and 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 The only consequence is income inclusion for the affected HCIs.
Fixing a Discriminatory Plan
Testing runs 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 comparable to the one that exists for retirement plan errors. Two practical options remain.
The first is prospective correction: amend the plan before the plan year ends to fix the discriminatory feature. Extend the shorter waiting period to everyone. Open the executive-only benefit tier to all employees. The timing of the amendment itself will be scrutinized under the operational prong of the benefits test, so document the business reason.
The second is to accept the failure, include the excess reimbursement in the affected HCIs’ income, and pay the associated taxes. For open tax years, some practitioners have noted that an employer may retroactively impute the value of the discriminatory coverage into the HCI’s income. Keep documentation of the testing methodology, results, and any corrective steps. There is no requirement to report 105(h) testing on Form 5500, but the records will matter on audit.