Defined Contribution and Highly Compensated Individuals (HCIs)

May 19, 2014

This article reviews the special rules for "Pure" Defined Contribution Health Plans and Highly Compensated Individuals (HCIs).DC_and_HCI

Background on Defined Contribution Health Plans

Most employers setting up a "Pure" Defined Contribution Health Plan use a limited Section 105 Medical Reimbursement Plan, called a Healthcare Reimbursement Plan (HRP), to establish allowances that are tax-deductible to the company and tax-free to employees.

Using an HRP, a company can set up different employee classesAll employees in the same class should be treated equally. An HRP does not have to benefit all employees so long as benefits offered to one or more classes of employees do not discriminate in favor of Highly Compensated Individuals.

Defined Contribution and Highly Compensated Individuals (HCIs)

Each class within an HRP must comply with certain rules for HCIs within the class in order to enjoy all tax savings.

HCIs include the highest paid five company officers, shareholders with more than 10 percent of the employer’s stock, and/or the highest paid 25 percent of employees. However, they exclude self-employed individuals (e.g. sole proprietors), partners, and S-Corp shareholders who hold more than two percent of their company’s stock. 

The Section 105 rules each HRP class must meet are as follows:

  1. Eligibility. An HRP class must not be set up in a way that disproportionately benefits, or “discriminates” in favor of, HCIs.

  2. Discrimination. Benefits offered within an HRP class must not discriminate in favor of “highly-compensated individuals” (HCIs) within that class.

The IRS considers “all facts and circumstances” in determining whether an HRP or class within an HRP complies with these rules. Employers are responsible to make sure classes meet these requirements. To the extent employers adhere to the following three guidelines, they are more likely to meet these tests and ensure tax-free reimbursement for all employees in the HRP:

  1. Create classes based on objective business criteria.  These may include job categories, geographic location, part-time or full-time status, etc.

  2. Ensure classes do not consist primarily of HCIs. An HRP class with only a nominal number of employees who are not HCIs may be considered discriminatory.

  3. Explicitly specify the basis on which discrimination testing will occur in the plan document.

The consequences for violating Section 105 eligibility and discrimination rules are not significant. If, upon audit, an HRP class is found to violate these rules, the HCIs who received HRP reimbursements must pay income taxes on the “excess” portion of the reimbursements they actually received. HCIs do not pay income taxes on the allowances they do not use or on their entire reimbursement. Moreover, their HRP reimbursements are still exempt from FICA and FUTA taxes and are fully deductible by the employer.

Violating the eligibility and discrimination tests described above does not mean other employees are entitled to the higher level of benefits received by HCIs or other classes.  Similarly, a violation does not cancel or otherwise invalidate the HRP or jeopardize the company's ability to deduct all HRP reimbursements.

Bottom Line on Defined Contribution and HCIs

To meet the Section 105 eligibility and discrimination rule testing, use the guidelines above to set up HRP classes based on bona-fide job criteria -- and be sure to document the criteria in the Plan Documents.

What questions do you have about the requirements for Defined Contribution and Highly Compensated Individuals? Leave a comment.

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