Employers often wonder whether all employees must be provided with the same health benefits, or even whether employers can offer health benefits to some employees but not to others. Can an employer single out a group of employees to receive better health benefits than other employees? Can an employer cover more of the cost of health benefits for some employees than for others? Can some employees be denied health benefits altogether? The answer to each of these questions is, "Perhaps."
There are several keys to unlocking the answers to these questions. First and foremost, an employer's flexibility on these questions depends on whether the health benefits are insured or self-insured, and whether the health benefits are offered through a Section 125 (cafeteria) plan. Fully-insured health benefits offered outside of a Section 125 plan can be made available in a "discriminatory" fashion, so long as the basis for distinguishing among employees is not prohibited. In other words, a fully-insured health plan not associated with a Section 125 plan can provide health benefits to some employees but not others, or charge some employees more for coverage than others, unless the basis for distinguishing among employees is a prohibited form of discrimination, such race, gender, or health condition. Thus, an employer may, for instance, offer generous, fully-insured health benefits to its executives, but offer no health benefits to anyone else in the company, as long as the benefits are independent of a Section 125 plan.
This brings up an important point: what does it mean to offer benefits through a Section 125 plan? Section 125 plans are commonly known as cafeteria plans, and many employers believe a cafeteria plan exists only when a variety of benefits, such as dependent care assistance programs, flexible spending accounts, health insurance, disability insurance, etc., are made available for the employees to choose. In truth, a variety of benefits does not need to be offered; rather, a cafeteria plan is created any time employees are offered a choice between cash compensation and one or more nontaxable benefits. Thus, if an employer allows its employees to pay their portion of premiums for health insurance through pre-tax payroll deductions, the employer has created a cafeteria plan, even if no other benefits are offered through the plan. It is easy to see why many employers maintain cafeteria plans without even realizing it.
So, we know fully-insured health benefits offered outside of a Section 125 plan can be made available to some employees but not others. What about self-insured health benefits or health benefits offered through a Section 125 plan? Both of these types of health benefits are subject to similar but different nondiscrimination rules designed to prevent an employer from offering more favorable benefits to "highly compensated employees" or "key employees." These nondiscrimination rules are complicated and can have undesirable effects on executives and other highly compensated employees. The following discussion does not fully describe all nondiscrimination tests, but does summarize the most significant tests.
Self-Insured Health Plan Nondiscrimination Tests.
The self-insured health plan nondiscrimination rules, set forth in Internal Revenue Code Section 105 and the regulations which follow that section, state that a self-insured health plan may not discriminate in favor of "highly compensated employees" (HCEs) either as to eligibility or as to benefits. For purposes of these rules, a "highly compensated employee" means an individual who is among the employer's five highest paid officers, a shareholder who owns more than 10% of the value of the employer's stock, or one of the highest-paid 25% of employees.
Generally, to avoid eligibility discrimination problems, a self-insured plan must "benefit" 70% or more of all employees, or 80% or more of all eligible employees if at least 70% of all employees are eligible to benefit under the plan. A self-insured plan will satisfy the nondiscriminatory benefits requirement if all benefits provided for highly compensated participants are also provided for all other participants. This test is applied to the benefits subject to reimbursement under the plan rather than to actual claim payments made under the plan.
The question of what it means to "benefit" under a plan cannot be decisively answered. One interpretation is that to "benefit" means merely to be eligible to participate in the plan. (This is the interpretation used with 401(k) plan eligibility testing.) The other interpretation is that to "benefit" means to actually elect health coverage under the plan. This latter interpretation is more conservative and makes more sense in light of the 70%/80% test described above. Therefore, to "benefit" probably should mean that the employee has actually enrolled in the health plan.
What happens if a self-insured health plan fails the nondiscrimination tests? If a self-insured plan is discriminatory, HCEs are taxed on the "excess reimbursements" they receive under the plan. An "excess reimbursement" under a plan which discriminates in the employees it covers (eligibility) is a percentage of the benefits paid to HCEs under the plan. Thus, when a plan discriminates in coverage, HCEs are taxed on that percentage of the benefits they receive which is equal to the percentage of benefits paid to all HCEs under the plan. When a plan is discriminatory in the specific benefits it provides, HCEs are taxed on the benefit they receive which other participants did not receive.
Section 125 Plan Nondiscrimination Rules.
In order to get tax savings, Section 125 plans and the component benefit plans in them must not discriminate in favor of HCEs or "key employees" (Keys). To make sure this does not happen, Congress devised tests that Section 125 plans must pass. If a Section 125 plan does not pass these tests (that is, if the plan is discriminatory), then HCEs and Keys will have adverse tax consequences. For example, HCEs may have to pay taxes on the amount of their salary reductions.
The nondiscrimination tests are complicated but they can be boiled down to two basic themes. First, one nondiscrimination test examines eligibility. If not enough non-highly compensated employees (non-HCEs) can get into the plan, then the plan will fail as being discriminatory. A second test states that a plan must not be discriminatory as to contributions and benefits. A plan will be considered discriminatory if the HCEs/Keys can get more benefits than non-HCEs.
The Section 125 plan nondiscrimination rules are set forth in Internal Revenue Code §125 and the regulations which follow that section. Where companies are related through common ownership, the companies are treated as a single employer, and the nondiscrimination tests are applied to the employee group as a whole.
Section 125 Eligibility Test.
First, a Section 125 plan may not discriminate in favor of HCEs as to eligibility to participate. For Section 125 purposes, an HCE includes someone who is an officer, a more-than-5% shareholder, "highly compensated" (over $100,000/year for 2007), or a spouse or dependent of the first three individuals. A Section 125 plan will pass the eligibility test if it satisfies these requirements: (1) it benefits a nondiscriminatory classification of employees; (2) the same employment requirement applies to all employees, with no more than three years of employment needed to participate; and (3) entry into the plan is not delayed beyond the first day of the plan year after the employment requirement is met.
In order for a classification to be nondiscriminatory it must be reasonable, such as based on an objective business criteria like job categories, nature of compensation (salaried or hourly), and geographic location. Also, the group of employees in the classification benefiting under the plan must not discriminate in favor of HCEs. In general, a plan will pass this test if the percentage of non-HCEs eligible under the plan is at least 50% of the percentage of eligible HCEs. If the percentage of eligible non-HCEs is less than 50% of the percentage of eligible HCEs, then the plan may still pass under certain conditions.
Some plan designs raise red flags in this area. These include separate Section 125 plans for different groups (e.g., having one plan for hourly employees and another plan for salaried employees), plans excluding part-timers, and plans with different entry dates for different employee groups.
Contributions and Benefits Test.
A Section 125 plan also must not discriminate in favor of HCEs as to the availability and utilization of benefits (the "contributions and benefits" test). That is, participants must be given an equal opportunity to select benefits, contributions must be available on a nondiscriminatory basis, and benefits must not be disproportionately received by HCEs. Also, a Section 125 plan must not discriminate in favor of HCEs in actual operation.
While there is little guidance on how to apply this test (the regulations governing the contributions and benefits test state only that it is a "facts and circumstances" test), any plan which provides contributions and benefits on a nondiscriminatory basis is unlikely to discriminate in actual operation. However, a plan will fail this test if non-taxable benefits are disproportionately selected by HCEs, even if benefits are available to everyone on a nondiscriminatory basis. This test would be failed, for example, if a non-taxable benefit is offered to all participants but only HCEs elect that benefit. A Section 125 plan must also not discriminate in favor of HCEs in actual operation. An example of discriminatory operation would be a plan's duration (or offered benefit) that coincides with the period during which HCEs utilize the plan or benefit.
One way to circumvent the contributions and benefits test is by using the Section 125 "safe harbor." The "safe harbor" provides that a Section 125 plan which offers health benefits will satisfy the contributions and benefits test if it contributes for each participant 100% of the cost of individual health coverage for the majority of similarly-situated HCEs, or 75% of the cost of health coverage for the participant having the highest cost health benefit coverage. Any contributions above those amounts must bear a uniform relationship to compensation.
Key Employee Concentration Test.
Section 125 plans are also subject to a "key employee concentration test." If the qualified benefits under a Section 125 plan provided to Keys exceed 25% of the total of all benefits provided for employees under the plan, it will fail the key employee concentration test. A "key employee" is an officer whose compensation exceeds $140,000, a more-than-5% owner of the employer, or a more-than-1% owner of the employer with compensation greater than $150,000.
If your Section 125 plan does not pass all of its nondiscrimination tests, then HCEs/Keys, depending upon which tests are failed, may be taxed on the combination of the taxable benefits with the greatest aggregate value that they could have selected for the plan year. That is, HCEs/Keys who make salary reductions may be taxed on the amount of those salary reductions. If a plan has a cash-out option or an option to apply employer contributions to taxable benefits, then the HCEs/Keys who elect non-taxable benefits will be taxed on the greater of (a) the cash-out amount or other taxable benefits that they could have elected instead, or (b) their salary reductions. Other plan participants will not be affected.
Correcting Test Failures
Nondiscrimination testing can be performed prior to the start of the year or any time during the year, but corrections cannot be made after the end of the plan year. Assuming there are not significant changes in the plan design, in the plan participants, or in the law, a plan which passes the nondiscrimination tests when first set up generally should continue to pass the tests in future years. Nevertheless, if an employer determines that it may fail a health plan nondiscrimination test, what can it do? If the test is conducted prior to the start of the plan year, the employer can modify the plan or regulate the elections of HCEs and Keys to ensure the tests are passed. For instance, HCEs and Keys can be offered an insured health plan outside of a Section 125 plan, or the employer can pay the premiums for HCEs and Keys outside of the Section 125 plan. If the tests are conducted during the plan year, legislative history suggests that employers are allowed to alter the elections of HCEs and Keys in order to pass nondiscrimination tests. Ideally, then, the plan will have reserved the employer's right to change the elections of HCEs and Keys in this situation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
