Historically, self-funded/self-insured group health plans have been subject to the Code Section 105(h) nondiscrimination rules, while fully-insured group health plans have not.  If a self-insured plan violated these provisions, affected highly-compensated individuals then needed to include some or all of the value of the benefit received in their taxable income.  Under  the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act ("PPACA"),  insured plans (other than "grandfathered" insured plans) now will also be subject to Code Section 105(h) non-discrimination testing effective with the first plan year starting on or after September 23, 2010 (for most plans this means January 1, 2011), but with a "twist."

What does this mean for insured group health plans?

There are different, and potentially harsher, penalties and remedies (than in the self-insured context) if an insured plan is found to be discriminatory (discriminates in favor of highly compensated individuals) in eligibility or benefits under Code Section 105(h).

Under IRS Notice 2010-63, if an insured group medical plan provides better benefits for highly compensated individuals then the plan would be subject to a civil action to compel it to provide nondiscriminatory benefits and there would be a daily excise tax or civil penalty charged to the employer plan sponsor equal to the number of non-highly compensated individuals covered under the plan multiplied by $100 (for example, a group of 100 non-highly compensated covered individuals would generate a penalty to the employer of $10,000 per day during the period of noncompliance).  In contrast, if a self-insured plan provides better benefits for highly compensated individuals and has 100 non-highly compensated covered individuals, then the highly compensated individuals lose a tax benefit, and the non-highly compensated individuals are not affected. 

Prior to PPACA, employers that wished to provide "discriminatory" benefits to highly-compensated employees or former employees either did so through fully-insured programs or required the highly-compensated individual to pay the fair market value of the cost of the coverage on an after-tax basis (or, if the employer paid the cost, the individual's income included the cost of the premiums paid by the employer).   This method avoided the application of Code Section 105(h).  It is unclear whether under the PPACA extension to insured plans the same exception would apply.

Action Items:  What should insured group health plans do?

1. Determine if the insured group health plan will be subject to the Code Section 105(h) nondiscrimination provisions by analyzing the plan's grandfathered status under PPACA;
   
   
2. If the insured plan is not grandfathered under PPACA, then examine the plan's features to identify provisions which may be discriminatory.  Because employers control eligibility more than the insurers, some practices that can create problems for insured plans include:

a.       Waiver of waiting periods for entry for highly compensated new hires; or

b.      Continuing coverage during a severance period only for executives (or other highly compensated individuals) per a severance agreement or an executive employment agreement; or

c.       "Executive" medical plans which are limited to senior management or provide a higher level of reimbursement and benefits than those provided to non-highly compensated employees.

The IRS last issued regulations under Code Section 105(h) in 1981 and is now asking for comments whether guidance is needed to cover the extension of Code Section 105(h) to insured plans.  Stay tuned for more guidance on the applicability of Code Section 105(h) to insured plans.