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Applying Nondiscrimination Requirements to Fully Insured Health Plans: When, and How?

One of the most common questions we receive from employers sponsoring group health plans is, “Can we offer different health benefits to different employees?” Related questions include, “Can we make our hourly employees pay a greater percentage of the cost of the plan than our higher-paid salaried employees?” or “Can we limit health benefits solely to managers and executive level employees?” And for the last 20 years, the answer has been, “Yes, so long as your plan is fully-insured.” This answer reflects the fact that, prior to Health Care Reform, Section 105(h) of the Internal Revenue Code (which prohibits discrimination in favor of certain “highly compensated individuals”) applied solely to “self-funded” or “self-insured” group health plans. Under Code Section 105(h), highly compensated individuals (“HCIs”) are taxed on some or all of the benefits they receive under a self-funded health plan if that plan discriminates (in favor of such HCIs) in terms of either (i) their eligibility to participate in the plan, or (ii) the benefits they receive under the plan.

The Affordable Care Act extends these nondiscrimination principles to fully-insured group health plans through a combination of (i) a new provision (Section 2716) of the Public Health Service Act (“PHSA”) (which generally applies to governmental employers), and (ii) new sections of the Internal Revenue Code and ERISA that make Section 2716 and several other provisions of the PHSA applicable to non-governmental group health plans. Section 2716 of the PHSA provides that “rules similar to” the nondiscrimination provisions set forth in Code Section 105(h) shall apply to group health plans other than self-insured plans (i.e., to insured plans). These rules are effective for plan years beginning on or after September 23, 2010, but they do not apply to “grandfathered” plans. The non-discrimination requirements of Section 105(h) continue to apply to self-insured plans.

There are two key differences between these two sets of nondiscrimination rules. The most significant difference is the consequence of violating the rules. As noted above, if a self-funded plan is determined to be discriminatory, the HCIs in whose favor the plan discriminates are taxed (under Code Section 105(h)) on some or all of the “discriminatory” benefits they receive. For example, if a group health plan provides coverage for refractive eye surgery, but limits such coverage solely to executives, then an executive who receives $5,000 of reimbursements (or payments) for refractive eye surgery will have an additional $5,000 of taxable income for that year.

By contrast, if a fully-insured plan violates the requirements of PHSA Section 2716, there are no adverse tax consequences to the HCIs. Instead, the employer is subject to an excise tax (or, in the case of certain governmental employers, a civil penalty) of $100 per day per non-HCI discriminated against. The employer may also be subject to a civil action (filed by affected participants or the Department of Labor) to compel it to provide nondiscriminatory benefits (or to stop providing “discriminatory” benefits).

The other key difference is that PHSA Section 2716 applies solely to “non-grandfathered” plans (generally, plans that either were not in existence on March 23, 2010, or have made significant changes in costs or benefits since that date). By contrast, Section 105(h) applies to all self-insured/self-funded plans, regardless of whether they are considered “grandfathered” plans for purposes of Health Care Reform.

As noted above, Section 2716 of the PHSA was scheduled to apply to non-grandfathered insured health plans as of the first plan year beginning on or after September 23, 2010 (i.e., January 1, 2011 for calendar year plans, but earlier for certain fiscal year plans). In September of 2010, the IRS issued Notice 2010-63, requesting public comments on these new discrimination requirements for insured plans. Comments were due by November 4, 2010. However, the aspect of Notice 2010-63 that caught the public’s eye was the explanation of the penalty for non-compliance: $100 per day per non-highly compensated individual discriminated against, plus a possible civil action to enjoin the discriminatory practice. Because “HCIs” are (by definition) limited to 10% owners, the five most highly-paid officers and the top 25% most highly paid employees of the employer, this means that providing a “discriminatory benefit” to even one HCI could trigger a penalty of $100 per day times 75% of the total number of employees in the employer’s workforce. For an employer with 1000 employees, this means a penalty of up to $75,000 per day!

The benefits community’s reaction to Notice 2010-63 was intense. In response to the comments it received, the IRS recently issued Notice 2011-1, which addresses the timing (i.e., the effective date) of the new nondiscrimination requirements for insured group health plans (other than grandfathered plans). Notice 2011-1 provides that:

    1.     Compliance with the nondiscrimination requirements of PHSA Section 2716 will not be required until after regulations (or other guidance of general applicability) have been issued with respect to that new statutory requirement; and 

    2.     Compliance with the nondiscrimination requirements for insured plans will not be required until plan years beginning a specific period after such guidance is issued.

Therefore, sponsors of fully-insured plans that are not “grandfathered” from the provisions of Health Care Reform (as well as fully-insured plans that lose their grandfathered status) now have a temporary reprieve from the nondiscrimination requirements and the onerous penalties associated with noncompliance. However, absent a statutory repeal of Section 2716, non-grandfathered insured plans will eventually be subject to nondiscrimination requirements that are similar to the “nondiscriminatory eligibility” and the “nondiscriminatory benefits” tests currently applicable to self-funded plans under Code Section 105(h).

Planning for the eventual application of the discrimination rules to fully insured plans is difficult, because at this point, no one knows how “similar” the new rules will be to the existing rules under Section 105(h). To complicate matters, there are many open questions regarding how to apply the current Section 105(h) rules to self-funded plans. The regulations under that Code Section are now over 30 years old. Health plans and health reimbursement arrangements have changed significantly since that time. Therefore, it is possible, if not even likely, that the IRS may issue guidance that addresses both the application of Code Section 105(h) to self-funded plans and the application of PHSA Section 2716 to non-grandfathered insured plans.

In addition to providing for a temporary delay in the effective date of Section 2716, Notice 2011-1 also requests additional comments from the public regarding some of the issues that have already been identified (either by the IRS or by comments in response to Notice 2010-63) in applying the nondiscrimination rules of Section 105(h) to fully-insured plans. Specifically, the IRS is requesting comments on:

  • What is a “discriminatory” benefit (i.e., is a higher percentage of cost paid by the employer, or a shorter waiting period, a “benefit”)? 
  • Can the “eligibility” test be based on the percentage of “highly compensated employees” (those making more than $110,000 per year) that are eligible to benefit (rather than on the definition of HCI in Section 105(h), which is generally the top-paid 25% of employees of the employer)? 
  • Can/should the eligibility test be applied separately to employees in geographically separate locations? 
  • Should the IRS set forth any “safe harbor” plan designs (rather than mathematical eligibility tests)? 
  • Should the IRS allow employers to aggregate plans with different, but “substantially similar,” benefits? 
  • How should the rules apply to “expatriate” or “inpatriate” coverage? 
  • How should the rules apply to multiemployer (i.e., union) plans? 
  • Can plans avoid penalties if HCIs pay for coverage with after-tax dollars (a common practice to avoid taxation under 105(h))? 
  • Will there be “transition rules” for corporate mergers/acquisitions (like the current transition rule for qualified retirement plans)? 
  • How will the rules apply in 2014 when other aspects of Health Care Reform (such as the individual mandate and additional employer requirements) become effective?

The IRS will also need to address issues such as (i) how the rules apply to retirees, (ii) how the rules apply to former employees electing (or receiving employer-paid) COBRA benefits, and (iii) which employees may be excluded from the tests. Other issues include how to apply the rules when one benefit option under an insured plan is “grandfathered” but another benefit option is not, or how to apply the rules when one plan is insured and another is self-funded. Until such guidance is issued, employers sponsoring “grandfathered” plans may want to preserve that status as long as possible. Insured plans that are not grandfathered (or that cannot economically remain grandfathered) will need to plan for the eventual application of the nondiscrimination requirements. For example, insured plans that currently provide benefits solely to executives, or that provide better benefits (or lower cost structures) for their more highly paid employees, will likely require significant redesign once the nondiscrimination requirements become effective.