Statutory Guide to IRC Section 105(h) Self-Insured Health Plan Nondiscrimination Testing
Internal Revenue Code (IRC) Section 105(h) and Treasury Regulation § 1.105-11 establish strict federal nondiscrimination standards for self-insured medical expense reimbursement plans. While fully insured group health plans have historically enjoyed an enforcement moratorium under ACA Section 2716 / IRS Notice 2011-1, self-insured plans, level-funded health arrangements, Health Reimbursement Arrangements (HRAs), and Individual Coverage HRAs (ICHRAs) are subject to active, unforgiving IRS enforcement under Section 105(h).
Why Section 105(h) Compliance is Critical for 2026
In recent years, employers across the United States have widely transitioned from fully insured health plans to level-funded arrangements and ICHRAs to manage escalating health insurance premiums. However, many plan sponsors mistakenly believe level-funded plans are treated as insured products. Under federal tax law, level-funded arrangements are legally self-insured plans and are fully subject to IRC § 105(h) nondiscrimination rules.
When a self-insured plan fails Section 105(h), non-highly compensated employees (Non-HCIs) remain completely unharmed—their medical reimbursements stay 100% tax-free under IRC § 105(b). Instead, the financial penalty falls directly upon the company's Highly Compensated Individuals (HCIs). All or a statutory fraction of the medical reimbursements paid to HCIs lose their income tax exclusion and are recharacterized as taxable gross wages on IRS Form W-2 Box 1, triggering federal, state, and FICA payroll tax liabilities.
Who Qualifies as a Highly Compensated Individual (HCI)?
The definition of an HCI under IRC § 105(h)(5) is distinct from the "Highly Compensated Employee" (HCE) definition used in 401(k) nondiscrimination testing under IRC § 414(q) and the "Key Employee" definition under Section 125/416(i). Under IRC § 105(h)(5), an individual is an HCI if they satisfy any one of three criteria:
- 1. Top 5 Officers: One of the five highest-paid officers of the sponsoring employer.
- 2. Greater Than 10% Shareholder:A shareholder who owns (directly or through the family attribution rules of IRC § 318) more than 10% in value of the employer's stock.
- 3. Highest-Paid 25%: An employee among the highest-paid 25% of all employees (other than excludable employees under § 105(h)(3)(B) who are not participants in any self-insured plan).
Permitted Statutory Census Exclusions (IRC § 105(h)(3)(B))
When determining the testing census and highest-paid 25% pool, the employer is legally entitled to exclude certain categories of workers:
| Exclusion Category | Statutory Citation | Legal Requirements |
|---|---|---|
| Service Under 3 Years | IRC § 105(h)(3)(B)(i) | Employees who have not completed three full years of service prior to the beginning of the plan year. |
| Age Under 25 | IRC § 105(h)(3)(B)(ii) | Employees who have not attained age 25 prior to the beginning of the plan year. |
| Part-Time Employees | IRC § 105(h)(3)(B)(iii) | Employees whose customary weekly employment is less than 35 hours (or less than 25 hours if customary in peer group). |
| Seasonal Employees | IRC § 105(h)(3)(B)(iv) | Employees whose customary annual employment is less than nine months (or less than seven months under industry rules). |
| Collective Bargaining | IRC § 105(h)(3)(B)(v) | Union employees covered by a collective bargaining agreement where accident and health benefits were bargained in good faith. |
| Nonresident Aliens | IRC § 105(h)(3)(B)(vi) | Nonresident aliens who receive no earned income from sources within the United States. |
The Two Statutory Testing Prongs
To maintain full tax exclusion for HCIs, the self-insured plan must satisfy both the Eligibility Test and the Benefits Test.
1. The Eligibility Test (IRC § 105(h)(3))
The plan must satisfy at least one of the following three alternative tests:
- The 70% Test: The plan benefits 70% or more of all non-excludable employees.
- The 70% / 80% Test: The plan benefits at least 70% of all non-excludable employees who are eligible to benefit, and at least 80% of those eligible actually enroll (benefit).
- Nondiscriminatory Classification Test: The plan benefits an objective classification of employees (e.g., salaried vs. hourly) that does not discriminate in favor of HCIs, evaluated using the IRC § 410(b) Safe Harbor ratio percentage benchmarks.
2. The Benefits Test (IRC § 105(h)(4))
All benefits provided for participants who are HCIs must be provided for all other participants on a uniform, non-discriminatory basis:
- Uniform Limits: Maximum reimbursement caps, deductibles, and copayments must be identical across all classes.
- Uniform Waiting Periods: HCIs cannot have immediate eligibility (e.g., day 1) if non-HCIs are subject to a 30-, 60-, or 90-day waiting period.
- No Compensation Proportionality: Benefit levels or employer contribution amounts cannot be proportional to compensation or age.
- No Executive Carve-Outs: Plans offering supplemental executive physicals, concierge doctor retainers, or executive health reimbursements fail § 105(h)(4) unless extended equally to all participants.
Excess Reimbursement Calculation & W-2 Tax Treatment
If a plan violates Section 105(h), the taxable excess reimbursement is calculated according to Treas. Reg. § 1.105-11(e):
- Discriminatory Benefit: If a benefit is available only to HCIs (or not uniformly provided to non-HCIs), 100% of the reimbursement received by the HCI under that benefit is taxable gross income.
- Discriminatory Coverage (Eligibility Failure):If the plan fails the Eligibility Test, a proportion of the general reimbursements received by each HCI is taxable, determined by multiplying the HCI's total claims by the statutory fraction:Taxable Amount = (Total Claims Paid to HCI) × (Total Claims Paid to ALL HCIs ÷ Total Claims Paid to ALL Participants)
Excess reimbursements must be reported as taxable wages on IRS Form W-2 (Boxes 1, 3, and 5) for the calendar year in which the plan year ends. Employers failing to report these amounts face failure-to-withhold penalties under IRC § 6656, information return penalties under IRC § 6721 and § 6722, and exposure to employee dispute liabilities.