The Affordable Care Act imposes, for the first time, nondiscrimination rules on non-grandfathered, insured group health plans similar to those that apply to self-insured plans under Section 105(h) of the Internal Revenue Code (the Code). While overlooked at first, this new provision has gained increasing attention as employers have begun to realize the significant impact that it could have on their health care benefit structures.

The Affordable Care Act provides that the new rules are effective on the first day of the first plan year beginning on or after September 23, 2010 (or January 1, 2011 for calendar year plans). However, no guidance has yet been issued with respect to these new rules. Therefore, employers were faced with complying with the new nondiscrimination rules, without knowing how to comply. Fortunately, the Internal Revenue Service arrived with a last-minute holiday gift in the form of IRS Notice 2011-1. This notice provides that because regulatory guidance is essential to the operation of the nondiscrimination rules, the agencies have determined that compliance should not be required until after guidance has been issued. Further, the notice provides that any future guidance will not apply until plan years beginning a specified period after issuance of the guidance. Effectively, this means that compliance with the nondiscrimination rules is delayed at least until January 1, 2012 for calendar year plans, and potentially later depending on when the agencies issue guidance.

Notice 2011-5 also solicits public comments regarding the operation of the nondiscrimination rules for insured plans. Comments are requested by March 11, 2011. Future guidance to be issued by the agencies will form the basis of the nondiscrimination rules for insured plans (and potentially self-insured plans as well if the Code Section 105(h) rules are revised). This article reviews the current state of the Code Section 105(h) rules and potential implications of the nondiscrimination rules for insured plans.

The Code Section 105(h) Nondiscrimination Rules for Self-Insured Health Plans

The starting point for understanding the nondiscrimination rules that apply to insured group health plans is to examine the nondiscrimination rules that apply to self-insured health plans (referred to as the “Code Section 105(h) Rules”).

Overview of the Code Section 105(h) Rules

Code Sections 105(a) and 105(b) operate together to allow an employee to exclude from gross income reimbursements for medical care received through an employer-sponsored health plan, whether insured or self-insured, to the extent the coverage is attributable to employer contributions (including employee pre-tax salary reductions). This gross income exclusion does not apply to amounts that are paid to a highly compensated individual (HCI) under a self-insured medical plan unless the plan satisfies the nondiscrimination requirements of Code Section 105(h)(2).

Under Code Section 105(h)(2), a self-insured health plan is not permitted to discriminate in favor of HCIs as to eligibility to participate or as to benefits provided under the plan (either in general or in operation). These rules are applied on a controlled group basis and apply to all self-insured group health plans, including medical, dental, vision and health flexible spending account plans.

The Code Section 105(h) regulations provide that in order to pass the “eligibility” test, a self-insured health plan must meet one of the following three requirements: (1) at least 70 percent of all nonexcludable employees must actually participate in the plan; (2) at least 70 percent of all nonexcludable employees must be eligible to participate in the plan and at least 80 percent of all employees who are eligible to participate in the plan must actually do so; or (3) the plan must be offered to a nondiscriminatory classification of employees. Treas. Reg. § 1.105-11(c)(2). Certain employees may be excluded for purposes of determining whether the eligibility test is satisfied, including (i) employees with less than 3 years of service; (ii) employees who are under age 25; (iii) part-time employees (generally defined as one who normally works less than 35 hours per week); (iv) seasonal employees (generally defined as one who works less than 9 months per year); (v) collectively bargained employees if health coverage has been the subject of good faith bargaining; and (vi) non-resident aliens. Treas. Reg. § 1.105-11(c)(2)(iii).

In order to pass the “benefits” test, all benefits provided to highly compensated employees must be provided to all other participants (and the plan may not discriminate in favor of HCIs in actual operation). Treas. Reg. § 1.105-11(c)(3). An HCI is anyone who is (a) one of the 5 highest paid officers, (b) a shareholder who owns more than 10 percent of stock of the employer, or (c) among the highest paid 25 percent of all employees. The 25 percent rule means that an employer will always have some HCIs that are receiving coverage under its self-insured health plan, even if the employer has no “highly compensated employees” under the rules of Code Section 414(q).

Effect of Discriminatory Arrangement Under Code Section 105(h)

If a self-insured health plan is discriminatory under Section 105(h), some or all of the benefits that are provided to the current or former HCIs (i.e., the medical claims that are paid) are treated as taxable income to these HCIs. Code § 105(h)(7); Treas. Reg. § 1.105-11(e)(2) and (3). This income is not subject to income tax withholding even though the amount is includible in the gross income of the employee. See Treas. Reg. § 31.3401(a)(19)-1. Notwithstanding the withholding exception, the resulting income is still reportable as taxable wages on an employee’s W-2 Form. See Treas. Reg. § 1.6041-2(a)(1) (provides reporting of wages and other payments of taxable compensation). Historically, the risk of a discriminatory arrangement under Section 105(h) has fallen primarily upon the employee although the passage of Code Section 409A created circumstances where the employer may also have liability as a result of discriminatory arrangement.

The Affordable Care Act Nondiscrimination Rules for Insured Health Plans

The Affordable Care Act adds Section 2716 to the Public Health Service Act (PHSA). Section 2716 generally provides that a group health plan (other than a self-insured plan) must satisfy the requirements of Code Section 105(h)(2) and directs that this provision be interpreted applying rules “similar to the rules” contained in Code Sections 105(h)(3) (nondiscriminatory eligibility classification), 105(h)(4) (nondiscriminatory benefits) and 105(h)(8) (controlled group rules). Section 2716 also provides that a “highly compensated individual” has the meaning given by Section 105(h)(5).

Exemptions from the New Nondiscrimination Rules

The health plan exemptions that generally apply under the Affordable Care Act also apply to PHSA Section 2716. This means that certain insured health plans are exempt from the new nondiscrimination rules, as follows:

  • Grandfathered Health Plans. Under the Affordable Care Act, “grandfathered” health plans are exempt from many of the new requirements, including the new nondiscrimination provisions set forth in Section 2716. Accordingly, an insured grandfathered health plan will not have to worry about complying with these new rules until it loses its grandfathered plan status.
  • HIPAA-Excepted Benefits. Unlike the Code Section 105(h) Rules, the insured nondiscrimination rules do not apply to health plans which are also exempt from the provisions set forth in Part 7 of ERISA and Chapter 100 of the Code. As a result, the new nondiscrimination rules do not apply to most stand-alone insured dental and vision plans, or insured stand-alone retiree-only plans provided the requirements for the exemption are met.

Penalty for Violating the Insured Nondiscrimination Rules

An insured group health plan that fails to comply with the applicable nondiscrimination requirements is subject to the taxes, remedies and penalties that generally apply for a plan failing to comply with the requirements of Part 7 of ERISA and Chapter 100 of the Code. Code Section 4980D allows the IRS to assess an excise tax of $100 per day for each day of noncompliance with respect to each affected participant (i.e., each individual discriminated against under the plan). In certain situations, the excise tax is capped at a maximum amount per year. Insured health plans sponsored by small employers, generally defined as one who employs an average of 2 to 50 employees during the preceding calendar year, appear to be exempt from the penalty.

The amount of the excise tax is capped if noncompliance is due to reasonable cause and not willful neglect, and the IRS may waive the excise tax in certain situations. Employers are required to self-report any violations of Code Section 4980D and pay the associated excise tax to the IRS using Form 8928. In addition to the IRS penalties, the plan sponsor or insurer could be subject to a civil action under ERISA to enjoin the non-compliance or for other equitable remedies. The fact that the penalties are imposed on the employer, coupled with the requirement to self-report, makes it all the more important that employers have guidance as to how to comply with the insured nondiscrimination rules.

Application of the Code Section 105(h) Nondiscrimination Rules to Insured Health Plans

There are a number of insured health plan arrangements that could potentially violate the new nondiscrimination rules. In the self-insured health plan context, employers have been fairly aggressive in implementing arrangements that arguably could be viewed as discriminatory because of the perception that the risk of liability is primarily an employee concern (provided there are no Code Section 409A issues). This is not likely to be true in the insured plan context. Because the penalties on an employer for a discriminatory insured arrangement are so much steeper than those imposed with respect to a self-insured arrangement, employers may have less tolerance for insured arrangements that operate at the margin. Furthermore, because insurers are subject to these rules as well, they may be more vigilant in identifying and prohibiting employers from implementing insured discriminatory arrangements.

Executive Medical Coverage

Some employers provide special health coverage (e.g., supplemental top-hat coverage) to executives and/or directors that is not available to other employees. To avoid a violation of the Code Section 105(h) nondiscrimination rules, this type of coverage has traditionally been offered through an insured arrangement. This type of an arrangement is likely to be discriminatory under the new insured nondiscrimination rules (unless, of course, it is exempt as a HIPAA-excepted benefit, or it is a grandfathered plan).

Post-Termination Insured Health Coverage

Granting a period of post-employment health coverage under an insured plan in connection with a severance program to a group of employees who are exclusively or disproportionately comprised of HCIs is likely to be discriminatory under the new rules. Employers who have already promised this type of health plan coverage in an existing employment agreement or severance agreement may have to renegotiate the terms of the agreement to avoid a violation of the new nondiscrimination rules. This may prove to be particularly challenging with respect to terminated executives who are already receiving severance and have no motivation to renegotiate the terms of their severance package.

To avoid the Code Section 105(h) nondiscrimination rules, employers who sponsor self-insured health plans often require the HCI to pay the entire premium for health coverage on an after-tax basis, and then make a taxable cash payment to the HCI equal to the cost of coverage (which may be grossed up for taxes). In that situation, the medical benefits paid under the plan would be excluded from the employee’s gross income by application of Code Section 104(a)(3), and thus, the rules of Code Sections 105(b) and 105(h) would not apply because there are no employer contributions. This approach for avoiding a violation of the nondiscrimination rules may not work for insured health plans because the insured nondiscrimination rules appear to apply regardless of whether the employee or the employer pays for the coverage. This means that employers who sponsor insured health plans may not be able to avoid a discriminatory arrangement by simply requiring the executive to pay for the coverage on an after-tax basis.

On the other hand, unlike the Code Section 105(h) rules, it does not appear that failure of the insured nondiscrimination rules will cause a problem under Code Section 409A because the benefits themselves are still nontaxable under Code Section 105(b).

Exclusion of Part-Time Employees

Many employers exclude part-time employees who work below a certain number of hours from their health plans. The Code Section 105(h) rules allow employers to exclude part-time employees who work less than 35 hours per week (with some exceptions). If this exclusion is applied with respect to the insured nondiscrimination rules, then employers will have some flexibility to exclude part-time employees without causing the arrangement to be discriminatory.

Two-Tiered Health Plan Structure

Some employers provide a two-tiered health plan structure. One option provides a more comprehensive set of benefits while another option is less comprehensive but also less expensive. In some cases, the less comprehensive option is only available to hourly employees. In the self-insured context, the question of whether the plan can satisfy the applicable nondiscrimination tests depends on the proportion of HCIs to non-HCIs participating in the more comprehensive option. It is unclear whether the agencies will adopt a similar approach with respect to insured plans. If not, this could have significant implications for employers in certain industries where such arrangements are common. In addition, if one option is self-insured and another option is insured, significant complications arise as to how the self-insured and insured nondiscrimination rules apply.

Geographic Locations

Multistate employers often find it necessary to have different insured plans for different groups of employees because of variations in provider networks. It is unclear how to apply this type of an arrangement under the insured nondiscrimination rules.

Post-Acquisition Benefit Structures

Employers who are involved in a mid-year merger or acquisition often do not integrate their health benefits until the end of the plan year. In some cases, this is done to ensure that employees do not lose the amounts credited towards their deductibles or out-of-pocket maximums. In other cases, it is done to avoid an early termination penalty in an insured contract or administrative services agreement. There is nothing in the Code Section 105(h) rules which permits this practice. It is hoped that the guidance will address this issue for insured plans.

Retiree Insured Health Coverage

Granting retiree insured health coverage to one or a few HCIs, when such coverage is not otherwise part of the employer’s personnel policies, or allowing an HCI to qualify for the employer’s retiree insured health coverage on terms that are preferential, may violate the new nondiscrimination rules unless the retiree coverage is provided under a retiree-only health plan that qualifies as an excepted benefit.


Over the years, many employers have adopted insured health plans as a way of providing health benefits that would not be permitted if the self-insured health plan nondiscrimination rules applied, including special health plan coverage for executives and limited retirees. Notice 2011-1 provides employers a pass for 2011, but it is unclear whether the arrangements set forth above will survive the future guidance. Employers who are concerned about the nondiscrimination rules for their insured plans should submit comments to the IRS.