Section 105(h) Nondiscrimination Testing: What Changes When You Move to a Level-Funded Health Plan

2026-09-21 • 11 min read

Level-funded health plans are legally self-funded, which means Section 105(h) nondiscrimination testing applies even though it never applied under your old fully insured plan. Here is what changes and how to stay compliant.

Quick Answer (as of 2026): Section 105(h) nondiscrimination testing applies to self-funded health plans, and a level-funded plan counts as self-funded under federal law even though it looks and feels like traditional insurance. A plan that discriminates in favor of highly compensated employees loses tax-free treatment for their reimbursements, a rule that never applied under most employers' prior fully insured coverage.

Section 105(h) nondiscrimination testing is the rule that decides whether a self-funded health plan can favor executives and owners without a tax penalty. Employers who move from a fully insured group health plan to a level-funded plan to control 2026 premium increases often do not realize they have crossed into a completely different compliance regime. This guide explains what the test requires, who counts as highly compensated, and what happens if a level-funded plan gets the eligibility rules wrong.

What Is Section 105(h) Nondiscrimination Testing?

Section 105(h) of the Internal Revenue Code prevents a self-insured medical reimbursement plan from favoring highly compensated individuals in either eligibility or benefits. The rule comes from IRS regulation 26 CFR 1.105-11, which lays out two separate tests a self-funded plan must pass every plan year: an eligibility test and a benefits test. A plan that fails either test does not become illegal, but the highly compensated employees who benefited from the discrimination lose the tax-free treatment on the reimbursed amount.

Does Section 105(h) Apply to a Fully Insured Group Health Plan?

No, not currently. The Affordable Care Act's Section 2716 was written to extend a 105(h)-style nondiscrimination rule to fully insured group health plans, but the IRS delayed enforcement in Notice 2011-1 and has never issued the regulations needed to activate it. That non-enforcement period, according to employee benefits compliance publishers tracking the issue, remains in effect. In practice, a fully insured small group plan can offer richer benefits or a shorter waiting period to owners and executives without triggering a federal nondiscrimination penalty. A self-funded plan, including a level-funded plan, does not get that pass.

Why Does Moving to a Level-Funded Plan Trigger This Testing?

A level-funded plan is legally a self-funded arrangement, even though the employer pays a fixed monthly amount that behaves like a traditional premium. Under ERISA and the Internal Revenue Code, the employer is the plan sponsor and carries the claims risk above the stop-loss attachment point, which is exactly the structure Section 105(h) was written to police. According to KFF, the share of small firms offering level-funded plans grew from 7% in 2019 to 37% in 2025, and Mercer's National Survey found employer-sponsored coverage costs reached $17,496 per employee in 2025, pushing more small employers toward level funding to control the increase. Every one of those employers inherited Section 105(h) testing obligations the moment their plan switched from fully insured to level-funded, whether or not their broker mentioned it.

Summit Health Benefits reviews your plan design before you move to level funding. We check eligibility rules, waiting periods, and benefit tiers against Section 105(h) so a premium-saving move does not create a new tax exposure for your leadership team. Get a compliance review.

Who Counts as a Highly Compensated Individual Under Section 105(h)?

A highly compensated individual under Section 105(h) is defined three ways under the regulation: one of the 5 highest-paid officers of the company, a shareholder who owns more than 10% of the company's stock, or an employee among the highest-paid 25% of all employees. This is a completely different test from the $160,000 compensation threshold used to define a highly compensated employee for Section 125 cafeteria plan nondiscrimination testing in 2026. A company can have an employee who clears the Section 125 dollar threshold but falls outside the Section 105(h) 25% group, or the reverse, so the two tests must be run separately rather than assumed to produce the same list of names.

Which employees can be excluded from the Section 105(h) eligibility count?

The regulation allows a plan to exclude several categories of employees when calculating the eligibility test: employees who have not completed 3 years of service, employees under age 25, part-time employees working fewer than 35 customary weekly hours, seasonal employees working fewer than 9 customary months, employees covered by a collective bargaining agreement where health benefits were subject to good-faith bargaining, and nonresident aliens with no U.S.-source earned income. A plan may always treat anyone working fewer than 25 hours a week, or fewer than 7 months a year, as part-time or seasonal for this purpose, regardless of what other employees in similar roles work.

What Is the Section 105(h) Eligibility Test?

The eligibility test checks whether enough of the non-excludable workforce actually participates in the plan, using one of two methods. A plan passes the percentage test if it benefits 70% or more of all employees, or 80% or more of eligible employees if at least 70% of all employees are eligible. Alternatively, a plan can pass a classification test if its eligibility rules use a nondiscriminatory classification, evaluated under the same facts-and-circumstances standard the IRS applies to qualified retirement plans under Section 410(b)(1)(B). A level-funded plan that limits eligibility to full-time salaried staff while excluding a large hourly workforce can fail this test even without any intent to discriminate, simply because the excluded group happens to skew lower-paid.

What Is the Section 105(h) Benefits Test?

The benefits test requires that every benefit available to a highly compensated individual be available to all other plan participants on the same terms, and the same rule applies to dependent coverage. A plan fails this test if executives get a richer benefit tier, a separate deductible, or dental coverage that hourly employees do not receive, and it also fails if any employer-funded reimbursement cap varies by an employee's age, years of service, or compensation level. The regulation's own example is direct: a plan offering a $5,000 reimbursement cap to officers and a $1,000 cap to everyone else fails the benefits test outright, and the officer's reimbursement above $1,000 is taxable.

What Happens If a Level-Funded Plan Fails Section 105(h) Testing?

A highly compensated individual in a plan that fails either test must include the excess reimbursement in gross income for the year the plan year ends. If the plan discriminates in the benefit itself, such as an executive-only dental rider, the entire amount reimbursed for that benefit becomes taxable to the highly compensated individual. If the plan discriminates in eligibility instead, the taxable amount is calculated by a proportional formula comparing what all highly compensated individuals received to what the entire plan paid out, applied to each highly compensated individual's own reimbursements. The employer does not pay a penalty on a failed test; the tax cost lands on the highly compensated employees themselves, through their own W-2 income for that year.

How Does Section 105(h) Interact With a Section 125 Cafeteria Plan?

When a self-funded medical reimbursement plan is offered as a benefit option inside a <a href="/blog/section-125-cafeteria-plan-2026-guide">Section 125 cafeteria plan</a>, the IRS regulation is explicit about which rule controls which question. Section 105(h) determines whether a given reimbursement is taxable or tax-free in the first place. Section 125's own rules then determine whether an employee is treated as having elected all available taxable benefits, including a benefit that Section 105(h) has already made taxable because the plan discriminated. In other words, a level-funded plan that fails Section 105(h) testing can create a taxable benefit that then flows through the cafeteria plan's own election rules, layering two separate compliance questions on top of one plan design decision.

Frequently Asked Questions

What is Section 105(h) nondiscrimination testing?

Section 105(h) nondiscrimination testing is an IRS requirement, found at 26 CFR 1.105-11, that a self-funded medical reimbursement plan cannot favor highly compensated individuals in eligibility or benefits. A plan that fails either the eligibility test or the benefits test does not become illegal, but the highly compensated employees who received the discriminatory advantage lose the tax-free treatment on that portion of their reimbursements.

Does a fully insured group health plan need Section 105(h) testing?

No, not under current enforcement. The Affordable Care Act's Section 2716 was intended to apply a similar nondiscrimination rule to fully insured plans, but the IRS delayed enforcement in Notice 2011-1 and has never issued final regulations to activate it. A fully insured small group plan can currently offer richer terms to executives without a federal nondiscrimination penalty, which is why the rule often surprises employers moving to a self-funded structure.

Why does a level-funded health plan trigger Section 105(h) testing?

A level-funded plan is legally a self-funded arrangement under ERISA and the Internal Revenue Code, even though the fixed monthly payment feels like a traditional insurance premium. The employer is the plan sponsor carrying claims risk above the stop-loss attachment point, which is the exact structure Section 105(h) was written to regulate. Employers moving to level funding to control 2026 premium increases inherit this testing obligation the moment the plan switches from fully insured to self-funded.

Who is a highly compensated individual under Section 105(h)?

Under 26 CFR 1.105-11, a highly compensated individual is one of the 5 highest-paid officers of the company, a shareholder owning more than 10% of the company's stock, or an employee among the highest-paid 25% of all employees. This definition is separate from the $160,000 compensation threshold used for Section 125 cafeteria plan nondiscrimination testing in 2026, so employers must run both tests independently rather than assume the two produce the same list of employees.

What is the difference between the Section 105(h) eligibility test and the benefits test?

The eligibility test checks whether enough non-excludable employees participate in the plan, passed either by covering 70% of all employees or by using a nondiscriminatory classification of employees. The benefits test checks that every benefit and reimbursement cap available to highly compensated individuals is also available to all other participants on the same terms, with no variation by age, years of service, or compensation level.

What happens if a level-funded plan fails Section 105(h) testing?

The highly compensated individuals who benefited from the discrimination must include the excess reimbursement in their gross income for the year the plan year ends, taxed through their own W-2 income. The employer does not pay a separate penalty; the tax cost falls on the highly compensated employees themselves, calculated either as the full discriminatory benefit amount or through a proportional formula, depending on whether the plan discriminated in benefits or in eligibility.

How does Section 105(h) interact with a Section 125 cafeteria plan?

When a self-funded medical plan sits inside a Section 125 cafeteria plan, Section 105(h) determines whether a specific reimbursement is taxable or tax-free, and Section 125's own rules then determine how that taxability flows through the employee's benefit elections. A level-funded plan that fails Section 105(h) testing can create a taxable benefit that then interacts with the cafeteria plan's election rules, layering two compliance questions on top of one plan design choice.

Sources

This article cites 26 CFR 1.105-11 (Internal Revenue Service regulation on self-insured medical reimbursement plans), IRS Notice 2011-1 on the delayed enforcement of Affordable Care Act Section 2716, the Kaiser Family Foundation's data on level-funded plan adoption among small firms, and the Mercer National Survey of Employer-Sponsored Health Plans for 2025 cost data. This article is for informational purposes only and does not constitute legal or tax advice. Consult a benefits compliance attorney or tax professional before making plan design decisions.

Related reading: <a href="/blog/level-funded-health-plan-small-business-2026">how level-funded health plans work</a>, <a href="/blog/highly-compensated-employee-definition">how a highly compensated employee is defined for other benefit tests</a>, <a href="/blog/wrap-plan-document-spd-requirements">ERISA plan document and SPD requirements for self-funded plans</a>, and <a href="/blog/health-insurance-premium-increase-2026-by-state">2026 premium increase data by state</a>.

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