Section 105(H)(2) Nondiscrimination Rules

January 1, 2017

Determine If Your Plan is Discriminatory

The Affordable Care Act¹ applies the Section 105(h)(2) nondiscrimination rules to non-grandfathered, fully-insured health plans. However, the IRS has delayed enforcement of the rules against fully-insured plans until it has issued further guidance. Over three years later, we’re still waiting for that guidance. The 105(h) nondiscrimination rules are still in effect, however, for self-funded plans, and prohibit employers from offering health benefits in a manner that discriminates in favor of highly compensated employees.

Section 105(h)(2) nondiscrimination rules are complex; however, a quick review of the employer’s benefit, contribution and eligibility strategies will help most employers determine whether or not they need to perform the detailed nondiscrimination tests.

It is also important to remember that employers are able to provide highly compensated employees with additional taxable income which could be used to pay for benefits. The Section 105(h)(2) testing exists to ensure that benefits provided to employees on a tax-free basis are limited to plans that are nondiscriminatory.

Highly Compensated Employees
Employers must determine which employees are considered highly compensated employees (HCE). Section 105(h)(2) defines an HCE as:

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

Certain individuals can be excluded from the group of the highest 25 percent of paid employees and disregarded from the testing as long as they do not participate in the plan. Excluded individuals include:

  • Employees who have not completed three years of service
  • Employees who have not attained age 25
  • Part-time (defined as less than 35 hours per week) or seasonal employees
  • Collectively bargained employees
  • Non-resident aliens who receive no U.S. source earned income

Perform a Quick Check
Before analyzing the Section 105(h)(2) requirements in detail, an employer can consider these criteria to more quickly determine if the employer passes or fails.

Quick Check #1 - Employer Passes
Barring special circumstances, such as a plan being part of a controlled group according to the IRS 414 rules, an employer who offers benefits in the following ways would not violate the Section 105(h)(2) nondiscrimination rules.

  • An employer offers the identical health benefits to all full-time employees, with the same contribution requirements regardless of age, years of service, or compensation.
  • Employees covered by a collective bargain agreement, and not covered by the plan, can be ignored for testing purposes. These employees can be offered a separate plan with different benefits and different contribution requirements.

It is possible for an employer to offer health benefits in a manner that varies in terms of eligibility, coverage or contribution for different employees, but then it must consider and pass the Section 105(h)(2) tests.

Quick Check #2 - Employer Fails
If an employer offers health benefits that clearly favor individuals in the highly compensated group (defined above) in terms of benefits, eligibility or contribution, the plan will likely fail the Section 105(h) rules based on the “benefits test” described below. Failure to comply with Section 105(h) will mean that the benefit plan must alter its terms or be subject to penalties.

Perform the Section 105(H)(2) Tests
This summary will provide enough detail for most employers to perform an analysis of how the rules apply to their plan. However, there are additional strategies (i.e. combining multiple plans into one plan or creating complex classifications of employees) that have been used by some employers wishing to offer dissimilar benefits to separate groups of employees. Any employer considering one of these more complex approaches should seek the advice of a qualified advisor or legal counsel.

To pass the Section 105(h)(2) nondiscrimination rules an employer must meet two separate tests:

  1. The Benefits Test
  2. The Eligibility Test

The names of the tests have long been the source of confusion, and subject to some criticism, since the “benefits test” considers a number of factors including eligibility, and the “eligibility test” principally measures who actually benefits under the plan.

The Benefits Test 
The benefits test has two components, which we will discuss below:

  • Is the plan offered in a manner that is discriminatory on its face?
  • Is the plan operated in a discriminatory manner?

The statute requires that “all benefits provided for [HCEs] are provided for all other participants” and that “all the benefits available for the dependents of HCEs must also be available on the same basis for dependents of all non-HCE participants.”

Discriminatory On Its Face
A plan must meet the following four requirements to be considered nondiscriminatory on its face.

  1. Required employee contributions must be the same for HCEs and non-HCEs for each benefit level.
  2. The same type of benefits that are available to HCEs must be available to non-HCEs.
  3. The maximum benefit level cannot vary based on age, years of service, or compensation.
  4. HCEs and non-HCEs must have the same waiting periods.

Differences can exists in these areas between different classes of employees as long as the requirements of the eligibility test are met (discussed below). For example, an employer could have different contribution requirements for salaried employees vs. hourly employees, but not for “executives” vs. other employees. If the plan is determined to be discriminatory on its face, it does not comply with Section 105(h)(2) rules and may be subject to penalties.

Discriminatory in Operation
A less common reason for a plan to be deemed discriminatory is in its actual operation. For example, if a plan added a benefit for a particular treatment for one plan year during which an HCE received coverage for that treatment, then terminated the benefits as soon as the HCE no longer needed the treatment, the plan would be considered discriminatory, and fail to comply with Section 105(h)(2) rules.

The Eligibility Test 
An employer passes the eligibility test if it passes any one of three different tests.

  • The 70% Test – At least 70 percent of employees must benefit from the plan.
  • The 70%/80% Test – If at least 70 percent of all non-excludable employees are eligible, the plan benefits at least 80 percent of the eligible employees.
  • The Nondiscriminatory Classification Test – The plan benefits a nondiscriminatory classification of employees. This test requires (1) eligibility based on a bona fide business classification, and (2) a sufficient ratio of benefiting non-HCEs to benefiting HCEs.

The first two tests provide a method to pass the eligibility test using a clear measure of participation rates. If the employer does not meet either of these tests, it may still pass based on the more subjective classification test. There is some debate whether employees need to actually enroll in, or simply be eligible for, the plan to be counted in the eligibility test. The more conservative approach, and the approach we recommend, is to count only the employees who actually enroll in a benefit.

Example: The 70% Test

XYZ Company has 100 employees. All employees are eligible for the health benefits.

  • 30 employees are considered highly compensated individuals.
  • 10 employees have less than three years of service and excluded from testing.
  • 65 non-excludable employees (counting both HCEs and non-HCEs) actually participate in the plan.

The employer passes the 70 percent test. Participation equals 72 percent (65 ÷ 90).

Example: The 70%/80% Test

XYZ Company has 100 employees.

  • 70 employees are eligible for the health benefits.
  • 30 employees are considered highly compensated individuals.
  • 56 non-excludable employees (counting both HCES and non-HCEs) actually participate in the plan.

The employer passes the 70%/80% test: 70 percent are eligible (70 of 100) and 80 percent of those eligible participate (56 ÷ 70).

The Nondiscriminatory Classification Test
Employers need to consider this test if it offers different benefits to different groups of employees and cannot meet either of the first two eligibility tests. There are a number of strategies employers can consider when attempting to pass the classification test. This summary describes a common approach most employers can use to determine if they offer benefits in a nondiscriminatory manner. If an employer fails to meet the requirements described below, it may still be possible to pass the test using a more complex strategy such as combining multiple plans into a single plan. If an employer wants to consider other alternatives, they should retain a qualified advisor or legal counsel.

To meet the classification test, the employer must show two things:

  1. Benefits are offered based on reasonable classifications.
  2. The classifications are not discriminatory in favor of highly compensated employees.

Benefits Must be Offered to Employees Based on Reasonable Classifications
The rules allow an employer to offer different benefits to different “reasonable” classifications of employees. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria.

Classifications Are Not Discriminatory
The IRS will consider the “facts and circumstances” of the classifications to determine if classifications are discriminatory. If the employer is not confident that their classifications will be deemed non-discriminatory, the employer may be able to meet the safe harbor test described below.

The subjective criteria include:

  • The underlying business reason for the classification. The greater the business reason for the classification, the more likely the classification is to be non-discriminatory.
  • The percentage of employees benefiting under the plan. The higher the percentage, the more likely the classification is to be non-discriminatory.
  • Representative number of employees. Measures whether the number of employees benefiting under the plan in each salary range is representative of the number of employees in each salary range of the employer’s workforce.

As stated above, the classifications are also not discriminatory if the employer can meet an objective “safe-harbor” test. The test compares the ratio of the percentage of non-HCEs to HCEs who participate in the plan.

The safe-harbor test involves comparison of participation rate to a table included in the regulations. The results of a simple formula may answer the question for most employers.

  • Compare the percentage of non-HCEs who participate in the plan to the percentage of HCEs who participate.
  • If the non-HCEs participant rate is at least 50 percent of the rate HCEs participate, the plan passes.

This is a fairly low bar to meet. An employer would have to have very low non-HCE participation to fail this test.


Employer XYZ has 150 non-excludable employees: 100 non-HCEs, 50 HCEs

  • All 50 of the 50 HCEs participate (100 percent)
  • Only 50 of the 100 non-HCEs participate (50 percent)
  • The ratio equals 50 percent (50 percent ÷ 100 percent) and the employer meets the safe harbor.

It is possible to pass the safe harbor with even lower participation of non-HCEs. For the sake of simplicity, this more complex calculation is described in the appendix at the end of this paper.

Many employers will satisfy the Section 105(h)(2) nondiscrimination rules simply because they offer the same benefits, contributions and eligibility to all employees. Employers who vary their benefit plan provisions for different groups of employees need to carefully consider the Section 105(h)(2) nondiscrimination rules to avoid paying what could be a significant penalty.

If an employer has a more complicated situation or wishes to maintain a benefits strategy that may be discriminatory, a more detailed analysis must be conducted, and expert or legal advice should be sought.

Appendix 1 - Safe Harbor Test 

STEP 1: Determine the plan’s Ratio Percentage. A plan’s Ratio Percentage is the
percentage determined by dividing the percentage of the non-HCEs who benefit under the plan by the percentage of - Employer XYZ has 150 non-excludable employees - 100 non-HCEs, 50 HCEs.

  • All 50 of the 50 HCEs participate (100 percent).
  • Only 50 of the 100 non-HCEs participate (50 percent).
  • The ratio equals 50 [percent (50 percent ÷ 100 percent).

STEP 2: Determine the plan’s Non-HCE Concentration Percentage. A plan’s Non-HCE Concentration Percentage is the percentage of all employees who are non-HCEs. Employees who can be excluded are not taken into account.

STEP 3: Determine the Safe Harbor Percentage from the Nondiscriminatory Classification Table. Next, the employer must determine the applicable Safe Harbor Percentage for the plan by consulting the Code §410(b) Nondiscriminatory Classification Table published by the IRS. The Non-HCE Concentration Percentage determined in step 1 dictates the applicable Safe Harbor Percentage. The test is easier to pass as the percentage of non-highly compensated employees increases.

In the Nondiscriminatory Classification Table, find the applicable Non-HCE Concentration Percentage in left column, and match that with the corresponding Safe Harbor Percentage. For example, if the Non-HCE Concentration Percentage is 75 percent, the applicable Safe Harbor Percentage is 38.75 percent.

STEP 4: Compare the plan’s Ratio Percentage With the Safe Harbor Percentage. Compare the Ratio Percentage from step 1 with the Safe Harbor Percentage from step 3. If the plan’s Ratio Percentage is equal to or greater than the Safe Harbor Percentage, then the plan’s employee classification meets the safe harbor and is deemed nondiscriminatory.

Nondiscrimination Classification Table


Safe Harbor


61 49.25
62 48.50
63 47.75
64 47.00
65 46.25
66 45.50
67 44.75
68 44.00
69 43.25
70 42.50
71 41.75
72 41.00
73 40.25
74 39.50
75 38.75
76 38.00
77 37.25
78 36.50
79 35.75
80 35.00
81 34.25
82 33.50
83 32.75
84 32.00
85 31.25
86 30.50
87 29.75
88 29.00
89 28.25
90 27.50
91 26.75
92 26.00
93 25.25
94 24.50
95 23.75
96 23.00
97 22.25
98 21.50
99 20.75