Identifying an employer’s highly compensated employees is crucial to the administration of qualified retirement plans, as well as 403(b) plans that provide employer contributions. This post provides an overview of the rules for determining who is a highly compensated employee.
The dollar amount used in this post is the 2018 inflation adjusted dollar amount because that is the amount that is used to determine whether an individual is a highly compensated employee for the 2019 plan year. For other plan years, other dollar amounts may apply.
The definition of “highly compensated employee” appears simple: for a plan year, an employee is a highly compensated employee if either:
(1) The employee is a 5 percent owner at any time during the plan year or the preceding plan year; or
(2) The employee’s compensation was more than $120,000 for the preceding plan year.
A plan’s definition of highly compensated employee can stop here. But for employers with more than 20 percent of their employees making than $120,000 per year, an additional requirement is available to limit the number of employees who qualify as highly compensated employees. These employers may elect to add the following requirement to the income threshold:
(3) The employee must also be in the “top-paid group of employees” for the preceding plan year.
Each of these three requirements is explained in more detail below.
5 percent owner
If an employee is a 5 percent owner, the employee is a highly compensated employee regardless of what the employee’s compensation is or whether the employee is in the top-paid group of employees.
An employee qualifies as a 5 percent owner if the employee owns more than 5 percent of the employer at any time during the current or preceding plan year. If the employer is a corporation, ownership is determined based on stock ownership. If the employer is not a corporation (e.g., a partnership), ownership is determined based on share of capital or profit interests.
In determining an employee’s ownership, certain attribution rules apply. For example, an individual is treated as owning the interest owned by the individual’s spouse, parents, children, and grandchildren; shareholders and partners are deemed to own proportionate shares of interests owned by their corporations and partnerships; and an individual with an option to acquire stock is considered to own the stock subject to the option. Stock owned by a qualified retirement plan, such as an ESOP, is not treated as owned by the participants in the plan.
Note that although the 5 percent owner rule applies to 403(b) plans, no employee at a tax-exempt entity that does not issue stock or have capital or profit interests will qualify as a 5 percent owner for purposes of the definition of highly compensation employee.
Compensation over $120,000
For purposes of determining which employees had over $120,000 in compensation for the preceding plan year, a definition of compensation within the meaning of Internal Revenue Code Section 415(c)(3) must be used. The employer should first look to the plan document to see whether it provides a definition of “highly compensated employee” that includes a specific definition of “compensation.” If it does, that specific definition must be used (assuming, of course, it complies with Code Section 415(c)(3)).
If the plan does not provide a definition of “highly compensation employee,” or if the plan’s definition of “highly compensated employee” does not provide a specific definition of “compensation,” any definition of compensation that complies with Section 415(c)(3) may be used (e.g. the amount reported in Box 1 of an employee’s Form W-2, plus the employee’s pre-tax deferrals to the employer’s 401(k) plan, pre-tax employee contributions under the employer’s cafeteria plan, and pre-tax employee contributions related to qualified transportation fringe benefits).
Top-paid group of employees
An employee is in the top-paid group of employees for a plan year if the employee is in the top 20 percent of employees when ranked according to compensation for the year.
To determine who is in the top 20 percent of employees, first the employer must determine its total number of employees for the plan year (taking into account all employees of all members of a controlled group of corporations that includes the employer).
When determining the total number of employees, the employer starts with all common law employees, leased employees that are treated as employees under the employer’s qualified retirement plan, and self-employed individuals that are treated as employees. Then, the following categories of employees are excluded from the total number of employees:
(1) Employees who perform no services for the employer during the plan year
(2) Employees who have not had their 21st birthday by the end of the plan year
(3) Employees who have not completed 6 months of service by the end of the plan year
(4) Employees who normally work less than 17 ½ hours per week
(a) Weeks when the employee does not work at all are not taken into consideration when determining whether an employee normally works less than 17 ½ hours per week
(b) This exclusion may be applied to groups of employees if 80 percent of the employees in the group normally work less than 17 ½ hours per week
(c) Alternatively, the 17 ½ hour per week exclusion may be applied to job categories if the median number of hours worked by employees in that job category was 500 hours or less during the preceding plan year
(5) Employees who normally work during not more than 6 months during the year
(a) An employee that works one day in a given month is deemed to have worked during that month
(6) Nonresident aliens who receive no compensation that qualifies as income from a source within the U.S.
An employer may choose to use a shorter period of service, smaller number of hours, or lower age for any of these exclusions, or may choose not to impose any age, service, or hours requirements.
Employees covered by a collective bargaining agreement are included in the total number of employees. However, if more than 90 percent of the employer’s employees are covered by collective bargaining agreements and the plan being tested covers only employees not covered by a collective bargaining agreement, then the employees covered by collective bargaining agreements are not included in the total number of employees unless the employer elects to include them.
Once the employer has determined the total number of employees for the plan year, the employer then calculates 20 percent of that of number.
Next, the employer must rank all of its employees by compensation for the plan year, including employees in the excluded categories discussed above (except employees excluded based on the exclusion related to collective bargaining agreements). The employees with the most compensation, up to the 20 percent number, are the top-paid group of employees.
An employee is not precluded from qualifying as a highly compensated employee simply because the employee is not included in the total number of employees for purposes of the 20 percent calculation. For example, even if an employee who has not completed 6 months of service by the end of 2018 is excluded from the total number of employees for purposes of calculating how many employees are included in the top-paid group of employees, the employee may be a member of the top-paid group of employees for 2018, and a highly compensated employee for the 2019 plan year, if the employee’s compensation for 2018 exceeded $120,000 and the employee was among the highest compensated employees for 2018 when ranked on the basis of compensation.
Other Items to Note
Additional election for plans with a non-calendar year plan year. For plans that have a plan year other than the calendar year, an employer may elect to use calendar year data to determine an employee’s compensation and the top-paid group, if applicable. Under the calendar year data election, the “preceding plan year” is the calendar year that begins during the preceding plan year.
For example, if the calendar year data election is in place for a plan with a plan year that runs from July 1 to June 30, to determine whether an employee is a highly compensated employee for the plan year beginning July 1, 2019, the employer would use data for calendar year 2019. But remember, the calendar year data election only affects the compensation and top-paid group determinations; an employee who is a 5 percent owner at any time during the plan year beginning July 1, 2019, or the plan year beginning July 1, 2018, is a highly compensated employee for the plan year beginning July 1, 2019.
Implementation of elections. No notification or filing with the IRS is required for either a top-paid group or calendar year data election. However, if the plan document includes a definition of “highly compensated employee,” the plan document must reflect the election(s), and if the employer changes either election, the plan document must be amended to reflect the change. A plan is not required to add a definition of “highly compensated employee” merely to reflect a top-paid group or calendar year data election.
Elections must be applied consistently. If an employer makes a top-paid group election or calendar year data election, the election must apply consistently for all of its plans. Employers should take particular care to ensure that elections are consistent between their existing plans and any plans acquired as part of a corporate merger or acquisition.