New Rules for Highly Paid Workers

A little-noticed provision in the law subjects new insured plans to the same non-discrimination rules as self-insured plans (section 105(h) of the Internal Revenue Code). Under the section, health benefits that discriminate in favor of highly compensated employees with respect to eligibility to participate or benefits received are not excluded from income.

Highly compensated individuals are generally defined to include the five highest-paid officers, more-than-10% shareholders and the top 25% of all employees who participate in the plan.

Under section 105(h), plans that discriminate in favor of highly compensated individuals must include in those individuals’ income the value of the “excess reimbursements” received. These excess reimbursements are determined under the regulations and may vary depending on the type of discrimination involved. In some cases, however, the value of the amounts included in income is the value of the actual benefits received, not merely the coverage, and this can be very high in the case of a highly compensated person who has significant medical costs.

It remains to be seen if these types of penalties would apply to insured plans or if only the value of the insurance coverage would be taxed; the legislation requires that rules “similar” to those that apply under 105(h) as currently written would apply to insured plans.  

Going forward, employers that want to purchase new insurance to provide special benefits for their officers during employment (or want to enroll new individuals in such plans) and employers that have made contractual agreements with employees to provide insured benefits for agreed-upon periods after retirement will have to re-evaluate, and perhaps amend, such arrangements.

Self-funded plans that provide such discriminatory arrangements have tried to design them to avoid adverse tax consequences (e.g., by treating and reporting the cost of such benefit coverage as a taxable benefit), but employers with insured plans have not had to adopt such measures. Since the insured plans were not subject to non-discrimination rules, the benefits were always tax-free.

Enacted in 1978, section 105(h) was originally seen as applying primarily to small businesses that might be tempted to provide special benefits to their owners, but it has applied to self-insured plans with large benefit programs, including retiree medical.  However, the regulations are old and do not reflect modern medical plans. Self-insured plans have struggled to apply section 105(h) to plans that allow a choice of benefits and to plans that base benefits on location, length of service and other factors.

Due in part to a strong reaction to Congress’s attempt to impose objective non-discrimination rules in 1986 for all health plans (so-called “section 89,” which was repealed), the IRS has not attempted to update these standards. The IRS apparently has not tried to enforce or apply these standards in a dogmatic manner to large self-funded, non-insured plans that provide benefits to the rank and file. However, by expanding the scope of employers subject to section 105(h), this legislation may provide an impetus to the IRS to create more objective rules and to enforce them more vigorously.