Section 505 Nondiscrimination Requirements

Certain tax-exempt employee benefit plans are governed by specific Internal Revenue Code (IRC) rules designed to ensure they do not disproportionately benefit an organization’s highest-paid employees. These regulations, known as nondiscrimination rules, promote fairness in the distribution of employee benefits. By establishing standards for both eligibility and the value of benefits provided, the tax code aims to prevent the concentration of tax-favored advantages among a select group. For a benefit plan to receive preferential tax treatment, it must demonstrate that it serves a wide cross-section of the workforce, not just those in the highest compensation brackets.

Organizations Subject to Nondiscrimination Rules

The nondiscrimination requirements in Section 505 of the Internal Revenue Code apply to a specific set of tax-exempt organizations that provide welfare benefits to employees. These rules primarily concern trusts established to pre-fund benefits, ensuring these funds are not used in a manner that favors the most compensated individuals.

The most common type of organization subject to these rules is the Voluntary Employees’ Beneficiary Association (VEBA), described in IRC Section 501(c)(9). A VEBA is a tax-exempt trust created by an employer or through collective bargaining, which funds life, sick, accident, or similar benefits for its members or their dependents. The tax-exempt status allows investment earnings within the trust to grow without being taxed, but this advantage is conditioned on adherence to nondiscrimination standards.

Another entity covered is the supplemental unemployment benefit (SUB) trust, as defined in IRC Section 501(c)(17). These trusts provide payments to employees who are involuntarily separated from employment, whether the separation is temporary or permanent. Like VEBAs, these trusts must ensure their benefit structure does not discriminate to maintain their tax-exempt status.

Core Nondiscrimination Requirements

Section 505 compliance rests on a two-part test that examines both who is eligible for benefits and the value of the benefits provided. These tests are designed to prevent plans from being structured to favor highly compensated individuals (HCIs).

Eligibility (Classification Test)

The first requirement is the eligibility test, often called the classification test. This test scrutinizes the group of employees eligible to participate in the plan to ensure the classification is not skewed toward HCIs. A plan can satisfy this test by meeting a numerical safe harbor, such as benefiting at least 70% of all non-excludable employees.

Another safe harbor is met if 80% or more of all eligible employees benefit, provided that at least 70% of all non-excludable employees were eligible in the first place. If a plan cannot meet a safe harbor, it can still pass by satisfying a “facts and circumstances” analysis. Under this standard, the employer must demonstrate that the employee classification is reasonable and based on objective business criteria.

Benefits Test

The second requirement is the benefits test, which focuses on the actual benefits provided under the plan. This test mandates that all benefits available to HCIs must also be available on the same terms to all other participating employees. It also prohibits providing any benefit in a manner that disproportionately favors the highly compensated.

However, a plan will not be considered discriminatory simply because the benefits are provided as a uniform percentage of compensation. For instance, a life insurance benefit structured as two times an employee’s annual salary is permissible, provided the same formula applies to all participants. A limitation is that the amount of annual compensation that can be considered for calculating benefits is capped; for 2025, this inflation-adjusted limit is $350,000.

Key Definitions

Central to both tests is the definition of a “highly compensated individual.” Under rules similar to those in IRC Section 414(q), an HCI is an employee who was a 5% owner of the business at any time during the current or preceding year. It also includes employees who received compensation from the business of more than $160,000 during the preceding year, though employers can elect to limit this second group to only the top 20% of employees by pay.

When performing these tests, employers are permitted to exclude certain categories of employees from consideration. These excludable employees include:

• Employees who have not completed three years of service
• Employees under the age of 21
• Seasonal or less-than-half-time employees
• Employees covered by a collective bargaining agreement if the benefits were a subject of good-faith bargaining

Annual Compliance Testing

To ensure adherence to the nondiscrimination rules, organizations must conduct formal compliance testing each year. This annual review is a necessary function for maintaining the plan’s tax-favored treatment. The process requires a systematic approach to gathering information, applying the specific tests, and maintaining records to substantiate the plan’s compliant status.

Data Gathering

The first step in the testing process is the collection of comprehensive employee data. This involves compiling a detailed census of all employees for the plan year being tested. The necessary information includes each employee’s date of hire to determine years of service, date of birth to verify age, and hours worked to identify part-time or seasonal status. This data is used to determine which employees can be excluded from testing.

Beyond basic demographic information, the organization must gather precise compensation figures for every employee. This includes salary, wages, and bonuses to identify the highly compensated individuals for the testing period. Finally, the plan administrator must collect data on the specific benefits provided or paid to each participant, such as tracking the dollar amount of claims paid in a medical reimbursement plan.

Applying the Tests

Once the data is gathered and the employee groups are identified, the administrator can proceed with the actual tests. For the eligibility test, the administrator calculates the percentages required by the safe harbors. This involves comparing the ratio of non-highly compensated employees benefiting from the plan to the total number of non-excludable, non-highly compensated employees against the corresponding ratio for highly compensated employees.

For the benefits test, the analysis focuses on the type and amount of benefits received. If benefits are tied to salary, the administrator must verify that the formula is applied uniformly and that compensation is capped at the legal limit. For other benefits, the test confirms that the features and availability of benefits do not differ between the highly compensated and non-highly compensated groups.

Documentation

Documentation of the entire testing process is a final step. The organization should maintain permanent records of the data census, the identification of highly compensated and excludable employees, and the detailed calculations for both the eligibility and benefits tests. These records should clearly demonstrate how the plan satisfied the nondiscrimination requirements for that specific year.

This documentation serves as proof of compliance in the event of an IRS audit. The annual testing results, including the raw data and the step-by-step application of the tests, should be formally compiled into a report and stored with other important plan documents.

Consequences of Noncompliance

When a benefit plan fails to meet the nondiscrimination requirements of Section 505, the consequences are targeted and primarily financial. A Section 505 failure does not cause the VEBA or other trust to lose its exemption. Instead, the penalty is directed specifically at the highly compensated individuals who received the discriminatory benefits, ensuring that non-highly compensated employees are not harmed.

The direct result of a failed test is a tax liability for the HCIs. The value of the discriminatory portion of the benefit they received, referred to as the “excess benefit,” is included in their gross income for the taxable year. This means the HCIs lose the tax-free nature of the benefit and must pay income taxes on the amount deemed to be discriminatory.

The calculation of the excess benefit depends on which test was failed. If the plan failed the benefits test because a particular benefit was not available to all participants, the entire amount of that benefit paid to the HCI is considered excess and becomes taxable income. If the failure was due to the eligibility test, a portion of the total benefit received by the HCI is taxed, determined by a formula that factors in the extent to which the plan’s coverage was discriminatory. The plan sponsor is responsible for calculating this amount and reporting it correctly.

This income inclusion must be properly handled for payroll tax purposes. The excess benefit amount is subject to income tax withholding as well as other applicable payroll taxes. The employer must report this additional taxable income on the HCI’s Form W-2 for the year, placing the financial burden of noncompliance on the individuals the rules were designed to prevent from being favored.