Self-funded group health plans are subject to nondiscrimination rules under Section 105(h) of the Internal Revenue Code.  Fully insured health plans are not subject to these rules.   Because VEBAs and HRAs are self-funded group health plans, they must meet the nondiscrimination rules even if they are offered alongside fully insured group health plans. 

In this context, “nondiscrimination” means that the plans may not discriminate in favor of “highly compensated individuals.”  If we’re going to give you a tax break, said Congress, you better spread it around.  Nondiscrimination testing for group health plans, including VEBAs and HRAs, involves some of the most complex and arcane rules that the IRS ever dreamed up.  We’re going to de-mystify them here.

If you cannot meet the Percentage Test, you can still meet the Eligibility Rule using the Reasonable Classification Test.  So many tests! 

A plan satisfies the Reasonable Classification Test if qualifies under a classification of employees which the IRS determines does not discriminate in favor of highly compensated individuals.  The IRS makes this determination using the same standards it applies to retirement plans under Section 410(b)(1)(B) of the Internal Revenue Code. 

Let’s pause for a moment.  Regulations[1] implementing nondiscrimination rules for health plans were issued in 1979 and have never been updated.  Back then, this writer was living a version of “That 70s Show.” The reference to 410(b)(1)(B) is no longer valid, because it was changed and moved to another part of the Code.  Accordingly, the IRS has stated that it is reasonable to apply either the “old” standard (the “Fair Cross Section Test” described in the original text) or the “new” standard (the “Nondiscriminatory Classification Test.” )[2]  More tests! 

F-1.     The Fair Cross Section Test.  The Fair Cross Section Test requires that a plan provide the same benefits to highly compensated individuals and to “more than nominal” numbers of representatives from middle and lower wage brackets.  That’s it.  The IRS doesn’t say what they mean by more than nominal, but the Meriam Webster online dictionary describes “nominal” as “trifling, insignificant.”[3]  Put another way, the plan must cover more than trifling or insignificant numbers of middle and lower wage groups to pass this test.  It’s not a model of clarity, and it appears to be a low bar.  Most public employers offer these benefits to all employees enrolled in group health plan coverage, and under the ACA, they must offer coverage to anyone who works an average of 30 hours per week.  More than a trifling or insignificant number of middle and low wage workers will benefit, and you should be able to stop here. 

If an employer offers this benefit only to highly compensated individuals and a handful of individuals identified by name from lower or middle wage categories just to meet the fair cross section test, however, the IRS will not likely treat arrangement as covering a “reasonable classification” of employees.  And since “nominal” may mean something different to the IRS than it does to the Meriam Webster dictionary, you might want to consider whether it meets the Nondiscriminatory Classification Test to be certain.

F-2.     The Nondiscriminatory Classification Test.  The Nondiscriminatory Classification Test is a numerical test.  It’s a complex, multi-step, and in some respects, arbitrary rule.  What was the IRS smoking in 1979?  

The Nondiscriminatory Classification Test is described in Treasury regulations that were originally designed for retirement plans.[4]  Let’s break it down by steps.

Step 1:  Determine the plan’s “Ratio Percentage.” 

You do this by comparing the percentage of non-HCIs who benefit under the plan with the percentage of HCIs who benefit. 

Example:  Blizzard City contributes $100 per month to a VEBA for employees that enroll in its health plan.  It has 250 employees.  Of this amount, the top paid 25%, or 62.5, are highly compensated individuals (HCIs).  The rule says to round up, which means there are 63 HCIs.  The balance, or 187, are non-highly compensated employees, or non-HCIs. 

Of the 63 HCIs, 13 are members of a union that has bargained for other benefits.  Those 13 HCIs are excludable.  That leaves 50 nonexcludable HCIs. Of the 50 nonexcludable HCIs, 40 enroll in the health plan and receive VEBA contributions.

Of the 187 non-HCIs, 75 are members of the same union and are excludable.  Another 15 are excludable because they have not completed 3 years of service, they have not attained age 25, or they are part-time or seasonal employees as described in the nondiscrimination rule (not the ACA).  That leaves 97 nonexcludable non-HCIs.  Of the 97 nonexcludable non-HCIs, 50 enroll in the health plan and receive VEBA contributions. 

Let’s do the math: 

1. Non-HCIs who benefit under the plan: 50

                        divided by

            All nonexcludable non-HCIs:                         97

                        equals                                                  51.55%

1. HCIs who benefit under the plan: 40

                        divided by

            All nonexcludable HCIs:                                50

                        equals                                                  80.00%

64. Divide a by b for the Ratio Percentage: 64.43%

Step 2: Determine the Non-HCI Concentration Percentage.  This is the percent of all nonexcludable employees who are nonexcludable non-HCIs.  Thus,

1. Nonexcludable non-HCIs: 97

            divided by

1. The sum of nonexcludable non-HCIs (97)

            and nonexcludable HCIs (50):                       147

65. equals: 65.99% 

Step 3:  Pull up the table published in IRS regulations at 1.410(b)-4 (available here).   A portion of the table is printed below. 

The non-HCI concentration percentage for the City of Blizzard was determined under Step 2 to be 65.99%.  Round up to 66% and find it in the left column below.  Go to the middle column and find the associated safe harbor percentage.  In this case it is 45.50%.  Go to the third column and find the unsafe harbor percentage.  In this case it is 35.50%.  We bolded this line in the table below.

If the plan’s Ratio Percentage (determined under Step 1) is higher than the safe harbor percentage from the table, you pass the nondiscrimination test.  If it is between the safe harbor percentage and the unsafe harbor percentage, the IRS will consider “facts and circumstances” in determining whether the plan passes.  If the Ratio Percentage falls below the unsafe harbor percentage, the plan fails the nondiscrimination test. 

In our example, the Ratio Percentage determined under Step 1 is 64.43%.  The City of Blizzard passes easily.  Filled with exuberance, the Mayor announces a new holiday:  “Nondiscrimination Testing Day.”  The Governor is pleased to hear about it and sends a note encouraging the Mayor to run for the state legislature. 

Non-highly compensated
employee concentration
percentage                              Safe harbor percentage           Unsafe harbor percentage

0–60                                                    50.00                                       40.00

61                                                        49.25                                       39.25

62                                                        48.50                                       38.50

63                                                        47.75                                       37.75

64                                                        47.00                                       37.00

65                                                        46.25                                       36.25

66                                                        45.50                                       35.50

67                                                        44.75                                       34.75

Etc.                                                      Etc.                                          Etc.

(there are 99 rows)

[1] 1.105-11.

[2] “Taxpayers may use either the standards set forth in the current 410(b) regulations or those applied under pre-86 TRA section 410(b)(1)(B).”  Field Service Advice (FSA) 2903, Vaughn # 2903 (1994). 

[3] Available here.

[4] Treas. Reg. Sec. 1.410(b)-4

The Fair Cross Section Test requires that a plan provide the same benefits to highly compensated individuals and to “more than nominal” numbers of representatives from middle and lower wage brackets.  That’s it.  The IRS doesn’t say what they mean by more than nominal, but the Meriam Webster online dictionary describes “nominal” as “trifling, insignificant.”[1]  Put another way, the plan must cover more than trifling or insignificant numbers of middle and lower wage groups to pass this test.  It’s not a model of clarity, and it appears to be a low bar.  Most public employers offer these benefits to all employees enrolled in group health plan coverage, and under the ACA, they must offer coverage to anyone who works an average of 30 hours per week.  More than a trifling or insignificant number of middle and low wage workers will benefit, and you should be able to stop here. 

If an employer offers this benefit only to highly compensated individuals and a handful of individuals identified by name from lower or middle wage categories just to meet the fair cross section test, however, the IRS will not likely treat arrangement as covering a “reasonable classification” of employees.  And since “nominal” may mean something different to the IRS than it does to the Meriam Webster dictionary, you might want to consider whether it meets the Nondiscriminatory Classification Test to be certain.

[1] Available here.

The Nondiscriminatory Classification Test is a numerical test.  It’s a complex, multi-step, and in some respects, arbitrary rule.  What was the IRS smoking in 1979?  

The Nondiscriminatory Classification Test is described in Treasury regulations that were originally designed for retirement plans.[1]  Let’s break it down by steps.

Step 1:  Determine the plan’s “Ratio Percentage.” 

You do this by comparing the percentage of non-HCIs who benefit under the plan with the percentage of HCIs who benefit. 

Example:  Blizzard City contributes $100 per month to a VEBA for employees that enroll in its health plan.  It has 250 employees.  Of this amount, the top paid 25%, or 62.5, are highly compensated individuals (HCIs).  The rule says to round up, which means there are 63 HCIs.  The balance, or 187, are non-highly compensated employees, or non-HCIs. 

Of the 63 HCIs, 13 are members of a union that has bargained for other benefits.  Those 13 HCIs are excludable.  That leaves 50 nonexcludable HCIs. Of the 50 nonexcludable HCIs, 40 enroll in the health plan and receive VEBA contributions.

Of the 187 non-HCIs, 75 are members of the same union and are excludable.  Another 15 are excludable because they have not completed 3 years of service, they have not attained age 25, or they are part-time or seasonal employees as described in the nondiscrimination rule (not the ACA).  That leaves 97 nonexcludable non-HCIs.  Of the 97 nonexcludable non-HCIs, 50 enroll in the health plan and receive VEBA contributions. 

Let’s do the math: 

1. Non-HCIs who benefit under the plan: 50

                        divided by

            All nonexcludable non-HCIs:                         97

                        equals                                                  51.55%

1. HCIs who benefit under the plan: 40

                        divided by

            All nonexcludable HCIs:                                50

                        equals                                                  80.00%

64. Divide a by b for the Ratio Percentage: 64.43%

Step 2: Determine the Non-HCI Concentration Percentage.  This is the percent of all nonexcludable employees who are nonexcludable non-HCIs.  Thus,

1. Nonexcludable non-HCIs: 97

            divided by

1. The sum of nonexcludable non-HCIs (97)

            and nonexcludable HCIs (50):                       147

65. equals: 65.99% 

Step 3:  Pull up the table published in IRS regulations at 1.410(b)-4 (available here).   A portion of the table is printed below. 

The non-HCI concentration percentage for the City of Blizzard was determined under Step 2 to be 65.99%.  Round up to 66% and find it in the left column below.  Go to the middle column and find the associated safe harbor percentage.  In this case it is 45.50%.  Go to the third column and find the unsafe harbor percentage.  In this case it is 35.50%.  We bolded this line in the table below.

If the plan’s Ratio Percentage (determined under Step 1) is higher than the safe harbor percentage from the table, you pass the nondiscrimination test.  If it is between the safe harbor percentage and the unsafe harbor percentage, the IRS will consider “facts and circumstances” in determining whether the plan passes.  If the Ratio Percentage falls below the unsafe harbor percentage, the plan fails the nondiscrimination test. 

In our example, the Ratio Percentage determined under Step 1 is 64.43%.  The City of Blizzard passes easily.  Filled with exuberance, the Mayor announces a new holiday:  “Nondiscrimination Testing Day.”  The Governor is pleased to hear about it and sends a note encouraging the Mayor to run for the state legislature. 

Non-highly compensated
employee concentration
percentage                              Safe harbor percentage           Unsafe harbor percentage

0–60                                                    50.00                                       40.00

61                                                        49.25                                       39.25

62                                                        48.50                                       38.50

63                                                        47.75                                       37.75

64                                                        47.00                                       37.00

65                                                        46.25                                       36.25

66                                                        45.50                                       35.50

67                                                        44.75                                       34.75

Etc.                                                      Etc.                                          Etc.

(there are 99 rows)

[1] Treas. Reg. Sec. 1.410(b)-4

The nondiscrimination rules include a Benefits Rule and an Eligibility Rule.  Under the Benefits Rule, all employees in the plan must be eligible for the same benefits.  If you offer VEBA or HRA with different levels of contributions to different classes of employees, then you must “disaggregate” your plan into two or more plans with identical benefits and test each disaggregated plan separately.  This may be the case, for example, if you offer different VEBA contributions to salaried and hourly employees.  You may use the Fair Cross Section test or the Nondiscriminatory Classification Test. 

Imagine if, in our example above, the city manager (a highly compensated individual) negotiates a monthly VEBA contribution of $500, while everyone else receives $100 per month.  That violates the Benefits Rule.  The city could disaggregate the plan into two plans, one for the city manager and one for everyone else.  But since the city manager is an HCI, and no non-HCIs receive the same contribution, the plan for the city manager would fail both the Benefits Rule and the Eligibility Rule.  All of the VEBA contributions to the city manager would be treated as taxable income.

For purposes of applying the nondiscrimination rules under section 105(h), all employees must be treated as employed by a single employer under certain “controlled group” rules described in sections 414 (b) and (c) of the Code.  The controlled group rules it refers to apply to corporations, partnerships, and “trades or businesses.”  They do not apply to public employers for nondiscrimination testing purposes. 

Under the ACA’s Employer Shared Responsibility rule, however, public employers must apply a reasonable, good faith interpretation of the controlled group rules when determining their status as applicable large employers.  We describe these rules in depth in our ACA module here.  It’s possible that the plan being tested under the nondiscrimination rules includes employees from related entities of the employer because of the ACA.  If that’s the case, and benefits vary based on employers, we think employers may follow the 1979 nondiscrimination rules and ignore employees of other entities that are part of a controlled group due to the application of Sections 414(b) and (c).  There’s no similar requirement for public employers to apply a reasonable, good faith interpretation of the controlled group rules for nondiscrimination testing.