8798 / What nondiscrimination requirements apply to self-insured health plans?

Benefits received pursuant to a self-insured plan are generally excludable from an employee’s gross income. Despite this, if a self-insured medical expense reimbursement plan or the self-insured part of a partly-insured medical expense reimbursement plan discriminates in favor of highly compensated individuals, certain amounts paid to the highly compensated individuals will be taxable to those highly compensated individuals.

A medical expense reimbursement plan cannot be implemented retroactively because, if this were permitted, the nondiscrimination requirements of IRC Section 105 would be ineffective.¹

A self-insured plan may not discriminate in favor of highly compensated individuals either with respect to eligibility to participate or benefits.

Eligibility

A plan discriminates as to eligibility to participate unless the plan benefits:

(1)  70 percent or more of all employees, or 80 percent or more of all the employees who are eligible to benefit under the plan if 70 percent or more of all employees are eligible to benefit under the plan; or

(2)  employees who qualify under a classification set up by the employer and found by the IRS not to be discriminatory in favor of highly compensated individuals.²

For purposes of these eligibility requirements, an employer is not required to consider those employees who:

(1)  have not completed three years of service at the beginning of the plan year; however, years of service during which an individual was ineligible under (2), (3), (4), or (5) below must be counted for this purpose;

(2)  have not attained age 25 at the beginning of the plan year;

(3)  are part-time or seasonal employees;

(4)  are covered by a collective bargaining agreement if health benefits were the subject of good faith bargaining; or

(5)  are nonresident aliens with no U.S.-source earned income.³

Part-time and Seasonal Workers

Part-time employees include those employees who are customarily employed for fewer than 35 hours per week. Seasonal employees are those who are customarily employed for fewer than nine months per year. In determining whether an employee is part-time or seasonal, the IRS will consider whether similarly situated employees of the employer (or employees in the same industry or location as the employer) are employed for substantially more hours or months, as applicable. A safe harbor rule provides that employees customarily employed for fewer than 25 hours per week or seven months per year may automatically be considered part-time or seasonal.⁴

Benefits

A plan discriminates as to benefits unless all benefits provided for participants who are highly compensated individuals are provided for all other participants.⁵ If some participants become eligible for benefits immediately and others only after a waiting period, benefits are not considered to be available to all participants.⁶ Benefits available to dependents of highly compensated employees must be equally available to dependents of all other participating employees. The test is applied to benefits subject to reimbursement, rather than to actual benefit payments or claims.

Any maximum limit on the amount of reimbursement must be uniform for all participants and for all dependents, regardless of years of service or age. Further, if the type or amount of benefits subject to reimbursement is offered in proportion to compensation and highly compensated employees are covered by the plan, the plan will be found to discriminate with regard to benefits.

A plan will not be considered discriminatory in operation merely because highly compensated participants use a broad range of plan benefits to a greater extent than other participants.⁷

The nondiscrimination rules are not violated merely because benefits under the plan are offset by benefits paid under a self-insured or insured plan of the employer, of another employer, or by benefits paid under Medicare or other federal or state law. A self-insured plan may take into account benefits provided under another plan only to the extent that the benefit is the same under both plans.⁸ Benefits provided to a retired employee who was highly compensated must be the same as benefits provided to all other retired participants.

For purposes of applying the nondiscrimination rules, all employees of a controlled group of corporations, or employers under common control, and of members of an affiliated service group are treated as employed by a single employer.⁹

Highly Compensated Individual

An employee is a highly compensated individual if the employee falls into any one of the following three classifications:

(1)  The employee is one of the five highest paid officers.

(2)  The employee is a shareholder who owns, either actually or constructively through application of the attribution rules, more than 10 percent in value of the employer’s stock.

(3)  The employee is among the highest paid 25 percent, rounded to the nearest higher whole number, of all employees other than excludable employees who are not participants and not including retired participants.¹⁰ Fiscal year plans may determine compensation on the basis of the calendar year ending in the plan year.

A participant’s status as officer or stockholder with respect to a particular benefit is determined at the time when the benefit is provided.¹¹ See Q 8799 for a discussion of the tax consequences to a self-insured plan that is found to be discriminatory under these rules.