Compliance Corner: Nondiscrimination Rules for Health and Welfare Plans

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By: Colin Clark | Staff Attorney

Employers that sponsor health and welfare benefits for their employees must consider whether their cost structures and benefit designs meet the various nondiscrimination requirements that apply to health and welfare plans under federal law, particularly in situations where benefits and/or cost structures vary for different groups of employees. Unlike the nondiscrimination rules that apply to retirement plans, the nondiscrimination rules for group health and welfare plans can, at times, be ambiguous and subject to disparate interpretations. In this Compliance Corner article, we will provide a high-level overview of the various nondiscrimination rules that can apply to health and welfare plans, and we will discuss some of the unsettled ambiguities in the nondiscrimination rules under Sections 125 and 105(h) of the Internal Revenue Code (“Code”).

Employment-Based Discrimination Rules (Title VII, GINA, ADA, ADEA)

Under Title VII of the Civil Rights Act of 1964 (“Title VII”), employers are prohibited from failing or refusing to hire or discharge an individual, or otherwise engaging in any kind of employment-based discrimination against an individual on the basis of race, color, religion, sex, or national origin. As amended by the Pregnancy Discrimination Act of 1978 (PDA), Title VII also generally prohibits discrimination “because of or on the basis of pregnancy, childbirth, or related medical conditions.” EEOC guidance states that, as a basic principle, benefits under an employer-sponsored group health plan “must be provided without regard to the race, color, sex [including pregnancy], national origin, or religion of the insured.”

In addition to Title VII, other employment-based discrimination rules potentially applicable to employer-sponsored group health plans include the Genetic Information Nondiscrimination Act of 2008 (“GINA”), Americans with Disabilities Act of 1990 (“ADA”), and Age Discrimination in Employment Act of 1967 (“ADEA”). GINA prohibits group health plans, insurers, and employers from discriminating on the basis of genetic information. Under Title I of GINA, group health plans and insurers generally are prohibited from (i) adjusting premiums or contribution rates based on genetic information; (ii) requesting or requiring an individual to undergo genetic testing; or (iii) requesting, requiring, or purchasing genetic information for underwriting purposes.

The ADA prohibits employers from discriminating against qualified individuals on the basis of disability, including with respect to numerous items affecting group health plans. An individual generally is considered to have a disability under the ADA if the individual has a physical or mental impairment that substantially limits one or more major life activities. Many medical conditions and disorders have been found to be disabilities for ADA purposes, including, for example, cancer, cerebral palsy, diabetes, epilepsy, HIV infection, multiple sclerosis, muscular dystrophy, and many mental health conditions (e.g., depression, bipolar disorder, PTSD, etc.). The fact that individuals with particular disabilities have not received equal benefits does not necessarily mean that a plan violates the ADA. Even with a difference in benefits, there will be no ADA violation if the difference is not a result of a “disability-based distinction” in the plan or if the employer can show that the plan design is bona fide and is not a subterfuge to evade ADA rules.

The ADEA prohibits employers from failing or refusing to hire or discharge an individual, or otherwise engaging in any kind of employment-based discrimination against an individual on the basis of his or her age, including with respect to the benefits provided to employees. Discrimination claims under the ADEA can arise either from the direct “disparate treatment” of employees based on age or, more often, because of the indirect “disparate impact” that a benefit design or practice has on older vs. younger employees.

HIPAA Nondiscrimination Rules

Part 2 (aka, the “Portability” rules) under the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) includes rules that prohibit group health plans and insurers from discriminating against individuals with regard to eligibility, premiums, or contributions on the basis of specified health status-related factors. The following items are considered to be health status-related factors for this purpose: health status, medical condition (including both physical and mental illnesses), claims experience, receipt of health care, medical history, genetic information, evidence of insurability, or disability.

A plan may not require an individual to pay more in premiums or contributions than a similarly situated individual if the difference is based on a health factor; however, HIPAA’s nondiscrimination rules do not prohibit insurers from applying underwriting principles to establish group insurance premiums, nor do they prohibit group health plans from imposing contribution differences or benefit restrictions that apply to all similarly situated individuals. For example, a plan may limit or exclude coverage for specific conditions or diseases, for certain types of treatments or drugs, or based on a determination that the benefits are experimental or not medically necessary; however, any such limits or exclusions may not be intended to target the coverage of individual participants, directly or indirectly, based on a health factor.

Generally, when determining whether individuals are similarly situated for HIPAA nondiscrimination purposes, distinctions among groups must be based on a bona fide employment-based classification that is consistent with the employer’s usual business practices. Examples include distinctions based on whether employees are full-time vs. part-time, geographic location, membership in a collective bargaining unit, date of hire, length of service, current vs. former employee status, and different occupations.

Section 125 (Cafeteria Plan) Nondiscrimination Rules

The Treasury Regulations under Code Section 451 include a key tax rule commonly known as the “constructive receipt” doctrine, which essentially provides that a taxpayer who has the unrestricted right to receive taxable income in a given year must recognize the income in that year, even if the taxpayer gives up the right to receive it. Code Section 125 provides an important exception to the constructive receipt doctrine. It allows employees to voluntarily forego receipt of otherwise taxable income in order to pay for qualified benefits on a pre-tax basis. However, for prohibited group members (i.e., highly compensated individuals or key employees, depending on the test being run), the tax advantages of the cafeteria plan will only apply if the cafeteria plan satisfies certain nondiscrimination testing requirements under Code Section 125.

For prohibited group members to receive the tax advantages under Code Section 125, cafeteria plans must pass three nondiscrimination tests: (1) the Eligibility Test; (2) the Contributions & Benefits Test; and (3) the Key Employee Concentration Test:

Eligibility Test:  The Eligibility Test generally requires that the plan not discriminate in favor of highly compensated individuals (“HCIs”) with respect to eligibility to participate. For this purpose (and for purposes of the Contributions & Benefits “Utilization” test discussed below), HCIs include the following individuals: (i) more than 5% owners of the employer; (ii) officers during the preceding plan year (or the current plan year if it is his/her first year of employment); (iii) employees with compensation above the specified threshold under Code Section 414(q) in the preceding plan year (e.g., $150,000 for 2023, $155,000 for 2024); or (iv) spouses or dependents of any of the aforementioned individuals.

While the Eligibility Test includes employment (i.e., waiting period) and entry date requirements, those requirements are ill-defined and, due to more restrictive rules subsequently issued under the Affordable Care Act, are considered by many to be effectively irrelevant. The more important requirement under the Eligibility Test is what is commonly known as the “nondiscriminatory classification” test; although, as discussed below, the nondiscriminatory classification test has its own ambiguities as well.

The nondiscriminatory classification test states that a cafeteria plan must benefit a group of employees who qualify under a reasonable classification (based on objective business criteria) established by the employer, and the group of employees included in the classification must satisfy either the safe harbor percentage test or the unsafe harbor percentage component of the facts and circumstances test set out in the Treasury Regulations under Code Section 410(b). The safe harbor and unsafe harbor percentage tests are mathematical tests that compare the percentage of non-HCIs who are eligible to participate (i.e., the number of eligible non-HCIs over the total number of nonexcludable non-HCIs) with the percentage of HCIs who are eligible to participate (i.e., the number of eligible HCIs over the total number of nonexcludable HCIs).

Problem with the Nondiscriminatory Classification Test:  Examples in the proposed regulations suggest that the nondiscriminatory classification test looks beyond who can participate in the cafeteria plan and also considers who is eligible for individual benefits and payment levels offered under the plan, suggesting that a cafeteria plan may fail the Eligibility Test if different benefits are made available to HCIs and non-HCIs under the plan. However, no corresponding language in the text of the proposed regulations states such a rule, nor does the preamble to the regulations or any later guidance provide an explanation. In the absence of further guidance, it would seem reasonable to conclude that the nondiscriminatory classification test may be applied to the cafeteria plan as a whole, rather than to the benefit and design components thereunder.

Contributions & Benefits Test:  The Contributions & Benefits Test includes both a benefit availability test and a benefit utilization test. The “Availability Test” requires that a plan must give each “similarly situated participant” a uniform opportunity to elect qualified benefits or employer contributions. When determining whether participants are “similarly situated,” the proposed regulations state that reasonable differences in plan benefits may be taken into account (e.g., variations in plan benefits offered to employees working in different geographical locations or enrolled in different coverage tiers).

The “Utilization Test” requires that the actual election of qualified benefits, or the utilization of employer contributions for qualified benefits, must not be disproportionate by HCIs vs. non-HCIs. Qualified benefits are disproportionately elected by HCIs if the aggregate qualified benefits they elect, calculated as a percentage of their compensation, exceed the aggregate qualified benefits elected by non-HCIs, calculated as a percentage of their compensation. Whether employer contributions are disproportionately utilized by HCIs is determined in a similar manner, substituting “aggregate employer contributions” for “aggregate qualified benefits.” Because the Utilization Test compares benefit elections or utilization of employer contributions by HCI vs. non-HCI based on a percentage of compensation, it often is not difficult to pass the Utilization Test (unless there is an unusually high proportion of non-HCIs who either elect very few available pre-tax benefits or who do not participate at all).

Key Employee Concentration Test:  To satisfy the Key Employee Concentration Test, key employees must not receive more than 25% of the total qualified benefits provided for all employees under the cafeteria plan during the plan year. For this purpose, key employees include: (i) officers with compensation above a specified threshold for the given year (e.g.; $215,000 for 2023; $220,000 for 2024); (ii) more than 5% owners of the employer; or (iii) more than 1% owners of the employer with annual compensation in excess of $150,000. Although the regulations do not address how to value qualified benefits for purposes of the Key Employee Concentration Test, there is support in the legislative history for looking to the contributions required to obtain those benefits, rather than calculating the actual expense reimbursements provided under the plan.

Section 105(h) Nondiscrimination Rules (for Self-Funded Plans)

Self-funded group health plans are subject to additional nondiscrimination rules under Code Section 105(h), which include an “Eligibility Test” and a “Benefits Test.” The prohibited group for 105(h) nondiscrimination testing purposes are also referred to as highly compensated individuals (“105(h) HCIs”), but their status as highly compensated is determined based on different criteria than the criteria used for determining HCI status under Code Section 125. A 105(h) HCI generally is any individual who falls under one or more of the following categories: (1) one of the five highest-paid officers; (2) a more than 10% owner; or (3) among the highest-paid 25% of all employees (other than excludable employees who are not participants).

If a plan fails one of the 105(h) tests, HCIs lose the benefit of the applicable tax exclusion under Code Section 105(b) for medical expense reimbursements, and they have the value of any “excess reimbursements” included in their taxable income. The amount of the excess reimbursements depend on which test is failed. If a plan fails the Eligibility Test, the taxable amount is determined by multiplying the benefits received by the HCI during the year by a fraction, the numerator of which is the amount of total benefits received by all HCIs and the denominator of which is the total amount of benefits received by all participants for the plan year. If the plan fails the Benefits Test, the entire amount of the discriminatory benefit received by the HCI will be considered an excess reimbursement and included in taxable income.

Eligibility Test:  A plan will pass the 105(h) Eligibility Test if it passes any of the following three alternative tests: (1) the plan benefits 70% or more of all non-excludable employees (70% Test); (2) the plan benefits 80% or more of all non-excludable employees who are eligible to benefit, if 70% or more of all non-excludable employees are eligible to benefit under the plan (70%/80% Test); or (3) the plan benefits a classification of employees established by the employer that is found by the Internal Revenue Service (“IRS”) not to be discriminatory in favor of 105(h) HCIs (Nondiscriminatory Classification Test). The nondiscriminatory classification test determination is made based on the facts and circumstances of each case, generally applying the same standards as are applied for purposes of Code section 410(b) minimum coverage testing for qualified retirement plans.

Problem with the 105(h) Eligibility Test:  A threshold issue for the Eligibility Test is what exactly is being tested: the employees who are eligible, or those who actually benefit under the plan? Under the Code provision creating the test, self-insured plans must “not discriminate in favor of HCIs as to eligibility to participate.” However, each of the three alternative eligibility tests is phrased in terms of who “benefits” under the plan. This raises the question of what it means to benefit—does an employee only have to be eligible to elect health coverage, or must the employee actually be participating in such coverage?

The more cautious answer, based on the literal wording of Code Section 105(h), is that in order to benefit, an employee must have elected coverage or have been provided with free coverage by plan design. However, the problem with this approach is that plans may offer equal benefits and contribution rates for all employees and still fail the 105(h) Eligibility Test if there is a low participation rate among non-HCIs. A more liberal interpretation is that “to benefit” means to be eligible to elect health coverage. One argument in support of this interpretation is that the incorporation of Code Section 410(b) concepts requires that we define “to benefit” for 105(h) purposes the same way it is defined for 401(k) plan eligibility testing purposes.

Benefits Test:  In order for a plan to pass the 105(h) Benefits Test, all benefits provided to HCIs who are participating in the plan must be provided to all other participants. The regulations require that benefits be nondiscriminatory, and they do not explicitly address whether required employee contributions must be uniform. Nevertheless, they strongly imply that participant contributions will be considered under the Benefits Test, and the IRS has issued private letter rulings indicating that a plan may become discriminatory if required contributions cause a coverage difference between HCIs and non-HCIs. The regulations further state that the maximum benefit level attributable to employer contributions cannot vary based on age or years of service, and that the type and amount of benefits subject to reimbursement must not be in proportion to employee compensation.

Other Nondiscrimination Rules

As a final note, although not discussed in this Compliance Corner article, employers should be aware that there are other fact-based and mathematical nondiscrimination testing requirements that apply to dependent care assistance programs (aka, dependent care flexible spending accounts), health savings accounts (when offered outside of a cafeteria plan), and group term life insurance benefits.