Section 105(h) Nondiscrimination



Section 105(h) sets forth the nondiscrimination rules that apply to self-insured (or level-funded) medical reimbursement plans. These rules only affect whether reimbursements made under the plan are taxable. Plans that are offered under a cafeteria plan (which is generally the case) must also pass Section 125 nondiscrimination testing, which determines whether the salary reductions for coverage under these plans are taxable.

Please Note:

While this Geek Out! page provides an overview of nondiscrimination testing, the IRS regulations are very complex and failure to comply can result in significant tax consequences. The advice of a qualified legal or tax professional is required to determine application of these rules to a particular employer and its group health plans.

Under Section 105(h), plans may not discriminate in favor of highly compensated individuals as to eligibility to participate or benefits. If the plans are determined to be discriminatory, the value of the taxable benefit must be included in the gross income of what the regulation defines to be highly-compensated employees.

Plans Subject to Testing

Section 105(h) testing must be performed on self-insured (or level-funded) medical reimbursement plans. These are defined as a separately written plans for the benefit of employees, which provides for reimbursement of employee medical expenses under U.S. Code Section 213(d).

They may include the following plans:

Please Note: The ACA subjects Fully Insured Health Plans to nondiscrimination testing rules “similar to” section 105(h). However, the IRS announced in Notice 2011-1 that these rules will not be enforced until they issue additional guidance.

Health FSAs

Even though utilization rates may vary, a Health FSA need generally not be concerned with Section 105(h) rules if it treats all employees the same. For example, offering a Health FSA where there is no difference among employees in terms of:

Section 105(h) Nondiscrimination Tests

Employers must conduct two types of non-discrimination tests every year:

1. Eligibility Test: Determines whether a reasonable number of non-HCIs are eligible to benefit from the plan. It provides three ways of passing:

  1. 70% Test: the plan must benefit 70% or more of all employees;
  2. 70% / 80% Test: the plan must benefit 80% or more of all the employees who are eligible to benefit under the plan if 70% or more of all employees are eligible to benefit under the plan; or
  3. Classification Test: the plan must benefit such employees as qualify under a classification of employees set up by the employer which is found by the Internal Revenue Service not to be discriminatory in favor of highly compensated individuals.

A plan that satisfies any one of these three tests will pass the Eligibility Test.

Testing Group
Generally, all employees must be included in the testing group, with the exception of employees who:

However, if employees who are otherwise excludable are allowed to participate in the plan, the exclusions may not be available.

2. Benefits Test: This test determines whether all benefits provided for HCIs and their dependents are also available to all other participants and their dependents on the same basis. The plan must satisfy the following conditions to be nondiscriminatory:

Discrimination on the Face: The plan must satisfy the following conditions to be nondiscriminatory:

Discrimination in Operation: The plan must not discriminate in favor of such employees in actual operation.

Testing Group
Employees who are actually participating in the plan.

Highly Compensated Determination

When determining who is highly compensated and thus in the prohibited group, employers should note that there is a slight variation between Section 105(h) testing, which is described below, and section 125 testing and 401(k) plan testing rules.

An HCI is for purposes of section 105(h) testing is defined as:

Common Ownership

Because individuals may be included in the testing group because of their relationship with the plan sponsor, common ownership of other companies through stock ownership, a partnership, etc. should be carefully reviewed to ensure accurate testing. For example, all employees of all corporations which are members of a controlled group should be treated as a single employer for nondiscrimination testing.


Plans must determine compliance as of the last day of each plan year. In practice, a plan may find it useful to test prior to the start of the plan year and periodically during the course of the year. This will permit the employer to make any needed adjustments in HCI elections prior to the end of the plan year.

Corrections for a plan year cannot be made after the end of that plan year. With that in mind, the cafeteria plan document should be written to give the plan administrator the authority to change any employee’s salary reductions if it is necessary in order to comply with the nondiscrimination rules.