IRC Section 105(h) Nondiscrimination Rules for Self-Funded Plans

The IRC Section 105(h) nondiscrimination rules require every self-insured medical reimbursement plan to pass two tests, an eligibility test and a benefits test, or the highly compensated individuals who received benefits under the plan lose the tax exclusion on some or all of their reimbursements. The employer’s deduction is not affected, and rank-and-file employees keep tax-free treatment. The cost falls entirely on the executives, officers, and owners the rules are designed to police.

Which Plans Have to Be Tested

Section 105(h) applies to self-insured medical reimbursement plans: any written arrangement where the employer pays medical claims from its own assets or a trust rather than buying an insurance policy that bears the claims risk.1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan Traditional self-funded health plans, standard Health Reimbursement Arrangements, and supplemental medical or dental reimbursement accounts all fall inside the definition.2Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans

Fully insured group health plans are not currently subject to 105(h). The Affordable Care Act added a parallel nondiscrimination requirement for insured plans, but Treasury, the IRS, and the Departments of Labor and Health and Human Services jointly determined that compliance is not required until formal regulatory guidance is issued, and that guidance has never been released.3Internal Revenue Service. Notice 2011-1 – Affordable Care Act Nondiscrimination Provisions Applicable to Insured Group Health Plans

Two HRA variants sit at the edges. An Individual Coverage HRA that reimburses only insurance premiums is treated as an insured plan and falls outside 105(h) altogether. An ICHRA that reimburses other medical expenses stays subject to the rules but gets safe harbors that allow reimbursement amounts to vary by permitted employee class and by age.4Federal Register. Application of the Employer Shared Responsibility Provisions and Certain Nondiscrimination Rules to ICHRAs A Qualified Small Employer HRA (QSEHRA) is carved out of the group health plan definition entirely and instead carries a statutory “same terms” requirement for all eligible employees, using a 90-day service threshold rather than the three-year threshold that applies under 105(h).5Office of the Law Revision Counsel. 26 USC 9831 – General Exceptions

Who Counts as a Highly Compensated Individual

Both tests turn on identifying the highly compensated individuals (HCIs) in the workforce. The statute names three categories:2Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans

  • The five highest-paid officers of the employer.
  • Any employee who owns more than 10 percent of the employer’s stock by value.
  • The highest-paid 25 percent of all employees, excluding those who do not participate in the plan.

The 10-percent ownership category picks up shares held by close family members through the constructive ownership rules of IRC Section 318. Stock owned by a spouse, children, grandchildren, or parents is attributed to the employee, so a rank-and-file worker whose parent owns the company can end up classified as an HCI.6Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock Closely held businesses need to check family ownership before ruling anyone out.

The Eligibility Test

The eligibility test asks whether enough rank-and-file employees have access to the plan. A plan passes by meeting any one of three alternatives:1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan

  • The plan benefits at least 70 percent of all employees.
  • At least 70 percent of employees are eligible, and at least 80 percent of eligible employees actually participate.
  • The plan covers employees under a classification the IRS determines is not discriminatory in favor of HCIs, applying the same facts-and-circumstances standards used for qualified retirement plans under Section 410(b)(1)(B).

The classification test gives more flexibility than the bright-line percentages but less certainty. Eligibility based on job location, division, or salaried-versus-hourly status can all work if the resulting group does not skew toward HCIs.

Employees You Can Leave Out of the Count

Several categories drop out of the denominator before you run the math, which is often what makes a plan pass:1eCFR. 26 CFR 1.105-11 – Self-Insured Medical Reimbursement Plan

  • Employees with fewer than three years of service.
  • Employees under age 25.
  • Employees who customarily work fewer than 35 hours per week.
  • Employees whose customary annual employment is less than nine months.
  • Employees covered by a collective bargaining agreement where health benefits were subject to good-faith bargaining.

These exclusions are optional but come with a catch: an employer cannot exclude a category from the denominator while covering some employees inside it. The exclusion applies only if the excluded employees are also kept out of the plan.

The Benefits Test

Passing eligibility is not enough. Every benefit available to an HCI participant must also be available to every other participant on the same terms.2Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans That means identical reimbursement caps, matching deductibles, uniform categories of covered medical expenses, and the same waiting periods for new hires.

Failures often look like a richer reimbursement maximum for officers, expense categories reimbursed only for management, or shorter waiting periods for senior staff. The written plan is not the only thing tested. The IRS can find a benefits-test failure based on how the plan actually operates, so if reimbursement administration consistently favors HCIs in practice, the plan is discriminatory regardless of what the document says. Reimbursement limits also cannot be tied to salary bands or years of service in a way that channels more dollars to HCIs.

What It Costs When a Plan Fails

Only the HCIs pay the price. Each affected HCI must include an “excess reimbursement” amount in taxable income, reported on Form W-2.2Office of the Law Revision Counsel. 26 USC 105 – Amounts Received Under Accident and Health Plans How much becomes taxable depends on which test the plan failed.

For a benefits-test failure, the entire reimbursement tied to the discriminatory benefit is taxable to each HCI who received it. If executives received $8,000 in reimbursements for a type of expense not covered for other employees, the full $8,000 is excess reimbursement for each of them.

For an eligibility-test failure without a distinct discriminatory benefit, excess reimbursement is calculated by a pro-rata fraction. Multiply the HCI’s total reimbursements for the year by a fraction whose numerator is total reimbursements paid to all HCIs and whose denominator is total reimbursements paid to all employees. Any amount already treated as an excess reimbursement under the benefits-test calculation drops out of both sides of the fraction so it is not counted twice. If HCIs received $50,000 out of $200,000 in total plan reimbursements, the fraction is 25 percent, and an HCI who personally received $10,000 has $2,500 of excess reimbursement.

Medical reimbursements paid under a self-insured plan are generally not treated as wages for Social Security, Medicare, or federal unemployment tax purposes.7Internal Revenue Service. Publication 15 (2026), (Circular E), Employer’s Tax Guide When part of a reimbursement becomes taxable to an HCI under 105(h), it is added to gross income and reported on the W-2 but is generally not subject to FICA or FUTA.

Controlled Groups and Retirees Change the Denominator

Two structural issues quietly wreck a lot of tests. The regulations require all employees of businesses treated as a single employer under IRC Section 414(b) and (c) to be aggregated for 105(h) purposes, and affiliated service groups fall under the same principle.8Office of the Law Revision Counsel. 26 USC 414 – Definitions and Special Rules A holding company might cover its 50 headquarters employees under a generous self-funded plan while a related subsidiary employs 300 uncovered workers. Those 300 count in the eligibility denominators, and ignoring them can turn an apparently compliant plan into one that fails badly. Map the full controlled group before testing.

Retirees can distort the numbers the other way. If retired employees are treated as employees for purposes of the tax-free exclusion under Section 106, they must be included in the total count of non-excludable employees when running the eligibility percentages, regardless of their age or years of service at retirement.9Internal Revenue Service. Technical Assistance Request – Section 105(h) Nondiscrimination Rules Leaving retirees out inflates the eligibility percentages and can make a failing plan look compliant.

When to Test, and How to Fix Problems

Testing is performed as of the last day of the plan year, using all non-excludable employees who worked at any point during the year. Once the plan year closes on a discriminatory plan, the tax consequences for HCIs are locked in. Unlike qualified retirement plans, self-insured health plans have no formal IRS correction program, and retroactive corrective distributions after year-end do not cure a failure.

That makes a mid-year preliminary test the standard practice. A mid-year check gives room to broaden eligibility, reduce or eliminate benefit tiers that favor HCIs, or restructure the plan into separate arrangements so the tested group passes on its own. Corrections improve the numbers only going forward from the date of the change, so catching a problem early is what actually saves the executives’ tax exclusion.

Section 125 Testing Is a Separate Problem

Most employers wrap a self-funded plan inside a Section 125 cafeteria plan so employees can pay their share with pre-tax dollars. That triggers a second layer of nondiscrimination testing with its own eligibility test, benefits test, and a key-employee concentration test that 105(h) does not have. Passing 105(h) does not mean the cafeteria plan passes.

The biggest gap is which employees you can exclude. Section 125 does not allow the short-service, under-25, part-time, or seasonal exclusions that 105(h) permits. Only collectively bargained employees, nonresident aliens with no U.S.-source income, and COBRA participants come out of the Section 125 count. A plan that clears 105(h) by leaning on those excludable categories can fail Section 125 when the same workers get added back into the denominator. Section 125 also applies to both self-insured and fully insured plans offered through the cafeteria plan, so employers with fully insured medical coverage still face nondiscrimination obligations at the cafeteria plan level. The penalties compound: a 105(h) failure taxes the HCIs, and a Section 125 failure can force key employees to include their pre-tax elections in income as well. Run both analyses together.