Health Benefits by Class

Question: How can employers design their health plan with different strategies for certain classes of employees?

Short Answer: Employers taking a class-based health plan design approach should ensure the class distinctions are a) clearly communicated to employees in any plan materials addressing eligibility, b) approved by the insurance carriers and/or stop-loss providers, and c) designed to comply with any applicable nondiscrimination rules.

Class-Based Health Plan Terms

Employers often will seek to offer different plan benefits or design different contribution strategies for certain classes of employees based on a variety of factors. 

Common classes for whom employers may consider having different health benefit strategies include:

  • Geographic region

  • Hourly vs. salaried

  • Exempt vs. non-exempt

  • Type of work performed

  • Job classification

  • Contingent workforce

  • Temps and interns

  • Full time vs. part-time

Common health plan distinctions for such classes include:

  • Different eligibility conditions

  • Different waiting period

  • Limiting health plan options to specific classes

  • Excluding certain benefits for classes

  • Dependent eligibility differences by class

  • Contribution strategies by class

Employers seeking any of these class-based health plan design approaches should address three main issues:

  1. Clearly Communicate Class Distinctions in Plan Materials;

  2. Confirm Class Distinctions with Insurance Carriers/Stop-Loss; and

  3. Structure the Approach to Comply with Applicable Nondiscrimination Rules.

Issue #1: Clearly Communicate Class Distinctions in Plan Materials

ERISA requires that employers administer and maintain the plan pursuant to its written terms, including its eligibility requirements.  Any class-based approach to the plan’s eligibility terms would need to be clearly communicated to employees in any plan materials addressing eligibility (e.g., SPD, EOC, COC policy, certificate, open enrollment materials, new hire materials, handbook).

Clear written terms addressing these class distinctions will minimize the possibility of a potential claim for ERISA breach of fiduciary duty or claim for benefits by an employee who purports to have access to the benefits offered to another class of employees.

Issue #2: Confirm Class Distinctions in With Insurance Carriers/Stop-Loss

Insurance carriers (and stop-loss providers for self-insured plans) generally reserve the right to approve any class-based benefit distinctions.  These carrier restrictions are designed to avoid potential adverse selection issues in the employer’s class-based plan design.

If an insurance carrier or stop-loss provider were to discover that an employer structured plan benefits by class in an unapproved manner, the carrier could be within its right to deny paying (or reverse payment for) claims. That could ultimately likely make the employer responsible for self-funding claims incurred—which is a worst-case scenario of potentially unlimited liability that employers must avoid.

Accordingly, it is crucial that the insurance carrier (or stop-loss provider) agree to the employer’s class-based plan design.

Issue #3: Structure the Approach to Comply with Applicable Nondiscrimination Rules

Health plan nondiscrimination rules are designed to prevent employers from offering tax-advantaged benefits (such as health coverage) in a manner that discriminates in favor of employees who are highly compensated.  While that basic intent is straightforward enough, the actual application of nondiscrimination limitations can in some situations be quite complex.

The primary nondiscrimination issues for employers seeking to distinguish health plan benefits by class will differ based on whether the health plan is self-insured (including level-funded) or fully insured.  All employers will generally face the same set of nondiscrimination considerations when considering whether to have different plan contribution strategies by class.

All Plans: Class-Based Contribution Strategies—Section 125 Nondiscrimination Rules

Employers often do not have the ability to devise a separate contribution structure for specific classes (e.g., as a cost-cutting strategy) because of the Section 125 nondiscrimination rules.

The Section 125 cafeteria plan rules govern employee pre-tax contributions to the health plan.  Those rules are designed to (among other things) ensure that contributions and benefits are available on a nondiscriminatory basis for highly compensated participants (HCPs) and non-HCPs. 

For purposes of Section 125, an HCP is:

  • An officer;

  • A more-than-5% owner of the employer in the current or preceding year; or

  • For 2023, an employee who earned in excess of $135,000 in the prior year.

The key component of these rules for this purpose is the “uniform election” requirement.  That provision requires that employers provide a “uniform election with respect to employer contributions.”

A contribution structure that charges more to certain non-HCPs for the same benefit generally does not provide a “uniform election with respect to employer contributions”.  This means full-time non-HCP employees eligible for the same plan option as an HCP generally must be offered at least the same employer contribution amount that is available to HCPs for that same plan option.

Furthermore, in almost all cases the same Section 125 nondiscrimination rules apply to employer HSA contributions.  This means that employers will generally have to make the same employer HSA contribution amount available to full-time non-HCPs enrolled in the HDHP plan option as made available to any HCPs. 

Geographic Location-Based Contribution Classes Permitted:

The general rule described above applies to “similarly situated participants.”  In other words, the employer cannot provide a greater contribution for any HCP than any non-HCPs who are “similarly situated participants” eligible for the same plan option.  This means that the employer is permitted to provide a greater contribution to certain employees (even if some of them are HCPs) as long as any non-HCPs participating in the same plan option and receiving the lower employer contribution rate are not “similarly situated.”

The definition of “similarly situated” permits the employer to categorize employee groups based on reasonable differences in plan benefits.  The primary example of a reasonable difference in the rules is employees in different geographical locations.  Employers may therefore have different contribution structures for different employee classes by region. 

For more details:

Self-Insured Plans: Class-Based Plan Design—Section 105(h) Nondiscrimination Rules

The §105(h) nondiscrimination rules are designed to prevent discrimination in favor of highly compensated individuals (HCIs) under a self-funded health plan. The §105(h) rules define HCIs differently from the §125 cafeteria plan HCP definition.

For purposes of §105(h), an HCI is:

  • One of the top five highest-paid officers;

  • A shareholder who owns more than 10% of the value of stock; or

  • Among the highest-paid 25% of all employees.

There are three main components of the §105(h) non-discrimination rules:

  1. Eligibility Test

  2. Benefits Test

  3. Operational Discrimination Test

1. 105(h) Nondiscrimination: Eligibility Test

The §105 rules provide that a plan will satisfy the eligibility components of the test only if the plan does not discriminate in favor of HCIs as to eligibility to participate.  Accordingly, for purposes of eligibility, a self-insured health plan can exclude or provide different eligibility terms for classes of employees only if the classification is “reasonable and nondiscriminatory”. 

Hourly vs. Salaried and Geographic Location-Based Eligibility Classes Permitted:

The definition of “reasonable and nondiscriminatory” in the rules specifically refers to distinctions based on the nature of compensation, such as hourly vs. salaried, and geographic location.  Therefore, it will generally not be an issue for the employer to provide different self-insured health plan eligibility terms to employees based on these classes.

2. 105(h) Nondiscrimination: Benefits Test

The benefits test component of §105(h) requires that all benefits provided to eligible HCIs under the plan also be available to all eligible non-HCIs.  Under a single plan testing approach, creating different classes of benefits for eligible employees would be a problem because it would result in non-HCIs in the lower tier benefit class not receiving the richer benefits available to HCIs in the higher class.

For example, take an employer that designs a richer health plan option for Class A, and a lower tier plan option for Class B.  This would be problematic under a single plan testing approach because the plan would not provide non-HCIs in Class B the same benefits as those available to HCIs in Class A.

Disaggregation Through Plan Design Permitted:

The §105(h) rules allow employers to disaggregate the self-insured health plan into two or more separate plans for nondiscrimination testing purposes. Therefore, employers can specify in the plan document that the different benefit arrangements are to be considered separate plans—even if they are included in a single plan document. That will permit each group to separately pass the Benefits Test.

The following is a template self-insured plan document provision for this purpose:

Section 105(h): Separate Plans

“Pursuant to the ‘Multiple plans’ provisions set forth in Treas. Reg. §1.105-11(c)(4), each coverage level, each group of Employees covered by the Plan, and each class of benefits provided under the Plan constitute a separate ‘plan’ for purposes of the Internal Revenue Code Section 105(h) nondiscrimination requirements and any other applicable law.”

3. 105(h) Nondiscrimination: Operational Discrimination

Finally, the §105(h) rules include an umbrella provision preventing self-insured health plans from discriminating against non-HCIs in operation.  Whether a plan is operationally discriminatory is a facts and circumstances test based on each plan’s specific arrangement.

The limited guidance available for this component of the rule suggests it would rarely become an issue in class-based self-insured health plan design.  For example, a plan is not considered discriminatory merely because HCIs participating in the plan utilize plan benefits to a greater extent than non-HCIs.

Avoid Plan Amendments Targeted to Benefit HCIs:

The IRS’s main concern with this requirement appears to be that the employer does not selectively establish, amend, or terminate the plan in a manner designed to benefit HCIs.  For example, an employer would act in a manner that is operationally discriminatory if it amended the plan’s benefits to cover an HCI’s specific condition, then removed that benefit enhancement upon the HCI no longer needing it or a non-HCI expressing interest in the same benefits.

Failing the Section 105(h) Nondiscrimination Requirements

If the IRS were to audit a self-insured health plan and find its arrangement to be discriminatory under §105(h), HCIs would be taxed on all or a portion of the benefits they received under the plan, referred to as the “excess reimbursement.” This could be a significant tax liability depending on the amount and cost of services actually received by the HCIs.

Fully Insured Plans: Class-Based Plan Design—No Nondiscrimination Rules in Effect

At this point, the only significant remaining ACA item yet to take effect is the fully insured plan nondiscrimination rules.  The ACA added Public Health Service Act §2716, which provides that insured group health plans will be subject to rules “similar to” the nondiscrimination requirements that have long applied to self-insured plans under Internal Revenue Code §105(h) (as described above).  The §2716 insured plan rules technically were to apply at the same time as the first wave of the ACA market reforms, which was the first plan year beginning on or after September 23, 2010.

However, the IRS issued Notice 2011-1 at the end of 2010 providing that** employers are not required to comply with the new §2716 nondiscrimination rules for insured plans until the Departments issue regulations or other administrative guidance. ** The DOL and HHS indicated their agreement with the IRS to delay enforcement.  The Notice further states that any such guidance will not apply until plan years beginning a specified period after issuance (e.g., it may not apply until the first plan year beginning on or after six months following the regulatory issuance date).

Fully Insured Plan Sponsor Perspective:

Employers enjoy much greater flexibility with respect to class-based plan design where the health plan is fully insured.  However, employers should keep in mind that a) the Section 125 cafeteria plan rules will still govern any contribution-based class design approach (even for fully insured plans), and b) any class-based plan design may need to be reviewed again at a future date if the ACA fully insured plan nondiscrimination rules take effect.

Class-Based Health Plan Design Summary

Employers seeking to establish a class-based health plan design approach need to confirm the approach with the plan’s insurance carriers and/or stop-loss providers. 

Any such class-based designed will also need to comply with the core nondiscrimination limitations:

  • _Class-Based Contribution Strategies for All Plans: _The Section 125 cafeteria plan rules generally prohibit providing any HCEs ($135k+ in 2023) a larger employer contribution for the same plan option for which a non-HCE is eligible.  In other words, if both HCEs and non-HCEs are eligible for the same plan option, the employer contribution (including employer HSA contributions) generally must be at least as generous as for non-HCEs.  Regional differences are permitted.

  • _Class-Based Plan Design for Self-Insured Plans: _Self-insured plans need to also comply with the §105(h) nondiscrimination rules.  Those rules impose restrictions on plan design based on eligibility, benefits, and operational nondiscrimination.  Different eligibility terms for employee classes are permitted if the classification is reasonable and nondiscriminatory, which includes hourly vs. salaried and regional classes.

  • Class-Based Plan Design for Fully Insured Plans: No additional nondiscrimination rules are currently in effect for fully insured plan designs.  However, employers should be aware that the ACA added new §2716 nondiscrimination rules for fully insured plans that that could take effect pending future IRS guidance—and if so, those rules will be “similar to” the §105(h) nondiscrimination rules.

 Upon confirming any such class-based health plan design approach does not present any insurance carrier, stop-loss provider, or nondiscrimination concerns, employers should implement the class-based design by clearly communicating the approach to employees in any plan materials addressing eligibility (e.g., SPD, EOC, COC, policy, certificate, open enrollment materials, new hire materials, handbook).

Relevant Cites:

Prop. Treas. Reg. §1.125-7(c)(2):

(2) Benefit availability and benefit election. A cafeteria plan does not discriminate with respect to contributions and benefits if either qualified benefits and total benefits, or employer contributions allocable to statutory nontaxable benefits and employer contributions allocable to total benefits, do not discriminate in favor of highly compensated participants. A cafeteria plan must satisfy this paragraph (c) with respect to both benefit availability and benefit utilization. Thus, a plan must give each similarly situated participant a uniform opportunity to elect qualified benefits, and the actual election of qualified benefits through the plan must not be disproportionate by highly compensated participants (while other participants elect permitted taxable benefits)…A plan must also give each similarly situated participant a uniform election with respect to employer contributions, and the actual election with respect to employer contributions for qualified benefits through the plan must not be disproportionate by highly compensated participants (while other participants elect to receive employer contributions as permitted taxable benefits).

Prop. Treas. Reg. §1.125-7(e)(2):

(2) Similarly situated. In determining which participants are similarly situated, reasonable differences in plan benefits may be taken into account (for example, variations in plan benefits offered to employees working in different geographical locations or to employees with family coverage versus employee-only coverage).

Treas. Reg. §1.105-11(c)(2)(iii):

(ii) Classification test. A plan satisfies the requirements of this subparagraph if it benefits such employees as qualify under a classification of employees set up by the employer which is found by the Internal Revenue Service not to be discriminatory in favor of highly compensated individuals. In general, this determination will be made based upon the facts and circumstances of each case, applying the same standards as are applied under section 410(b)(1)(B) (relating to qualified pension, profit-sharing and stock bonus plans), without regard to the special rules in section 401(a)(5) concerning eligibility to participate.

Treas. Reg. §1.410(b)-4(b):

(b) Reasonable classification established by the employer. A classification is established by the employer in accordance with this paragraph (b) if and only if, based on all the facts and circumstances, the classification is reasonable and is established under objective business criteria that identify the category of employees who benefit under the plan. Reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location, and similar bona fide business criteria. An enumeration of employees by name or other specific criteria having substantially the same effect as an enumeration by name is not considered a reasonable classification.

 Treas. Reg. §1.105-11(c)(3)(i):

(3) Nondiscriminatory benefits.

(i) In general. In general, benefits subject to reimbursement under a plan must not discriminate in favor of highly compensated individuals. Plan benefits will not satisfy the requirements of this subparagraph unless all the benefits provided for participants who are highly compensated individuals are provided for all other participants…

 Treas. Reg. §1.105-11(c)(4)(i):

(4) Multiple plans, etc.

(i) General rule. An employer may designate two or more plans as constituting a single plan that is intended to satisfy the requirements of section 105(h)(2) and paragraph (c) of this section, in which case all plans so designated shall be considered as a single plan in determining whether the requirements of such section are satisfied by each of the separate plans. A determination that the combination of plans so designated does not satisfy such requirements does not preclude a determination that one or more of such plans, considered separately, satisfies such requirements. A single plan document may be utilized by an employer for two or more separate plans provided that the employer designates the plans that are to be considered separately and the applicable provisions of each separate plan.

IRS Chief Counsel Memorandum FREV-113006-01:

Section 1.105-11(c)(4) of the regulations provides that, “A single plan document may be utilized by an employer for two or more separate plans provided that the employer designates the plans that are to be considered separately and the applicable provisions of each plan.” Thus, if each of the plans is tested as two separate plans (one for the surviving spouse and dependents of physicians and another plan for everyone else), each plan will pass the benefits test.

Treas. Reg. §1.105-11(c)(3)(ii):

(ii) Discriminatory operation. Not only must a plan not discriminate on its face in providing benefits in favor of highly compensated individuals, the plan also must not discriminate in favor of such employees in actual operation. The determination of whether plan benefits discriminate in operation in favor of highly compensated individuals is made on the basis of the facts and circumstances of each case. A plan is not considered discriminatory merely because highly compensated individuals participating in the plan utilize a broad range of plan benefits to a greater extent than do other employees participating in the plan. In addition, if a plan (or a particular benefit provided by a plan) is terminated, the termination would cause the plan benefits to be discriminatory if the duration of the plan (or benefit) has the effect of discriminating in favor of highly compensated individuals. Accordingly, the prohibited discrimination may occur where the duration of a particular benefit coincides with the period during which a highly compensated individual utilizes the benefit.

Treas. Reg. §1.105-11(e)(1):

(e) Excess reimbursement of highly compensated individual.

(1) In general. For purposes of section 105(h) and this section, a reimbursement paid to a highly compensated individual is an excess reimbursement if it is paid pursuant to a plan that fails to satisfy the requirements of paragraph (c)(2) or (c)(3) for the plan year. The amount reimbursed to a highly compensated individual which constitutes an excess reimbursement is not excludable from such individual's gross income under section 105(b).

 IRS Notice 2011-1:

Because regulatory guidance is essential to the operation of the statutory provisions, the Treasury Department and the IRS, as well as the Departments of Labor and Health and Human Services (collectively, the Departments), have determined that compliance with § 2716 should not be required (and thus, any sanctions for failure to comply do not apply) until after regulations or other administrative guidance of general applicability has been issued under § 2716. In order to provide insured group health plan sponsors time to implement any changes required as a result of the regulations or other guidance, the Departments anticipate that the guidance will not apply until plan years beginning a specified period after issuance.

Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship.  Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).

Brian Gilmore
The Author
Brian Gilmore

Lead Benefits Counsel, VP, Newfront

Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans. Brian also presents regularly at trade events and in webinars on current hot topics in employee benefits law.

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