What Is the Section 105(h) Test?

The Section 105(h) Test is a set of nondiscrimination rules found in the Internal Revenue Code (IRC) that apply to self-insured health plans. These rules are designed to ensure that highly compensated employees (HCEs) do not receive disproportionately favorable benefits compared to non-highly compensated employees (non-HCEs). The test is named after Section 105(h) of the IRC and primarily applies to employers who choose to self-fund their health coverage instead of purchasing insurance through a third-party carrier.

Self-insured health plans are those where the employer assumes the financial risk of providing health benefits to employees, as opposed to paying premiums to an insurance company. These plans are subject to different regulatory requirements than fully insured plans, and Section 105(h) is one of the key compliance provisions.

Purpose and Background

Congress introduced Section 105(h) as part of broader efforts to promote fairness in employer-provided health coverage. The underlying principle is that tax-advantaged benefits, like employer-sponsored health plans, should not be used to give preferential treatment to executives or highly paid employees at the expense of the rest of the workforce. To maintain the tax-exempt status of benefits under a self-insured plan, employers must comply with Section 105(h).

Failing to pass the Section 105(h) Test does not invalidate the health plan itself, but it does result in adverse tax consequences for highly compensated individuals who receive discriminatory benefits. Specifically, the excess reimbursements provided to those individuals may become taxable income.

Who Is Subject to the Test

Section 105(h) applies only to self-insured group health plans. This includes medical, dental, and vision plans that are not fully insured by a commercial insurance carrier. Employers of any size who choose to self-fund their health coverage are subject to the rules, including private companies, nonprofit organizations, and government entities.

Fully insured health plans are generally exempt from Section 105(h), although other nondiscrimination rules under the Affordable Care Act (ACA) or other statutes may apply in those cases.

Highly Compensated Individuals and Key Employees Defined

For the purposes of Section 105(h), a “highly compensated individual” includes:

• One of the five highest-paid officers
• A shareholder who owns more than 10% of the employer’s stock
• An individual who is among the highest-paid 25% of all employees

The test uses the definition of “highly compensated” based on facts during the plan year. It’s important to note that this definition is distinct from other IRS definitions of HCEs under retirement plan rules (like Section 414(q)).

Section 105(h) also refers to “key employees” in some contexts. While these terms may overlap, the primary concern is whether certain individuals are receiving favored treatment under the plan.

Key Components of the Section 105(h) Test

The Section 105(h) nondiscrimination rules include two primary tests: the Eligibility Test and the Benefits Test. A self-insured plan must satisfy both to avoid discriminatory outcomes.

Eligibility Test

The Eligibility Test examines whether a sufficient number of non-HCEs are eligible to participate in the plan. It looks at the proportion of non-highly compensated employees who can benefit compared to the total workforce. In general, the plan must benefit a group of employees that does not disproportionately exclude non-HCEs.

Three different methods can be used to pass the Eligibility Test:

1. 70% Test – At least 70% of all employees must be eligible under the plan.
2. 70%/80% Test – At least 70% of all employees are eligible, and at least 80% of those eligible are participating.
3. Nondiscriminatory Classification Test – The group of employees covered must not discriminate in favor of HCEs based on job classification or other criteria.

Benefits Test

Even if the plan meets the Eligibility Test, it must also pass the Benefits Test. This test examines whether the actual benefits provided under the plan are available on the same terms to all participants. If HCEs are offered richer benefits, faster reimbursement, or fewer restrictions than non-HCEs, the plan may fail this test.

Common causes of failure include offering executives a separate health reimbursement arrangement (HRA) with higher limits or customizing deductible levels for officers while maintaining stricter provisions for lower-level employees.

Consequences of Failing the Section 105(h) Test

A plan that fails either the Eligibility Test or the Benefits Test does not lose its overall tax-favored status for the employer or non-HCEs. However, the highly compensated individuals who benefit from discriminatory features may be taxed on the value of the excess benefits they received.

For example, if a self-funded health plan offers top executives a fully paid, concierge-style health benefit while other employees receive only a basic plan with co-pays and deductibles, the excess value of the executive plan may be included in their taxable income.

Employers are also required to report these amounts appropriately and withhold the necessary taxes, which may lead to administrative complications and employee dissatisfaction if not handled carefully.

Best Practices for Compliance

Employers can take several steps to maintain compliance with Section 105(h):

• Design self-insured plans with uniform eligibility and benefit terms
• Avoid providing separate benefit tiers that favor executives
• Conduct annual nondiscrimination testing with support from benefits consultants or legal counsel
• Maintain clear documentation of plan design and eligibility criteria

Because the rules can be complex and penalties may affect individuals rather than the plan sponsor, careful planning and review are essential.

The Bottom Line

The Section 105(h) Test is a critical compliance requirement for employers that sponsor self-insured health plans. It exists to ensure that all employees—regardless of compensation level—have equitable access to tax-favored health benefits. While the rules do not prohibit tailored benefits altogether, they limit how much more favorably highly compensated individuals can be treated. Failure to comply may result in unexpected tax liability for executives and additional administrative burdens for employers. Businesses that offer self-insured plans should regularly evaluate their benefit structure and testing procedures to avoid these outcomes.