Highly Compensated Employee: Everything You Need to Know
What Is a Highly Compensated Employee?
A highly compensated employee, as it relates to an employer-sponsored retirement plan that offers tax advantages, would include any employee who meets either of the following conditions:
- The employee owns more than 5 percent of an organization; or
- The employee has received greater than $115,000 in annual compensation (2014 compensation limit). The limit for annual compensation is generally adjusted on an annual basis.
Note: To pass either of these two tests, an employee must have met the criteria in the previous plan year or the current plan. If the employee was hired during the calendar year, he or she will not be eligible for highly compensated employee status until the following calendar year.
Any employer does have a choice under the Internal Revenue Service's regulation to expand the definition of highly compensated employee to include those employees who have annual compensation within the top 20 percent of compensation totals for all employees at the organization. IRS regulations allow a company to realize tax deductions if it offers retirement plans to its employees. As such, many companies will contribute to either a defined contribution plan or a defined benefit plan on behalf of its employees. If an employer bases its contributions to either of these plan accounts on the employee’s annual compensation, the IRS requires the company to offer as close to equal retirement benefits to both lower compensated employees and highly compensated employees. If a company is unable to offer similar retirement benefits, the company is at risk of losing that highly favored tax benefit offer by the IRS to employers.
The first prong of the highly compensated employee definition test is ownership. As previously mentioned, a highly compensated employee will meet the first prong if they own greater than 5 percent of the organization that is the sponsor of the retirement plan at any point in time during the previous or current calendar years. The ownership prong does not require the employees to meet an annual compensation threshold. Thus, if the employee is merely paid nominal annual compensation, the ownership prong would still apply if they own greater than 5 percent of the organization. Furthermore, if an employee who meets the ownership standard of greater than 5 percent reduces the ownership percentage below 5 percent or ceases to be an owner of the organization, he or she will continue to be defined as a highly compensated employee for the rest of the calendar year as well as through the following year if the employee remains employed with the organization.
To determine whether an employee would be considered an owner in the corporation context, one must examine the value of the stock owned by the employee as a percentage of the value of stock outstanding. In addition, an examination of the voting power of the employee’s stock ownership as it relates to the percentage of stock voting rights could be undertaken to determine if the employee meets the ownership prong. Also, if an employee has the ability to exercise an option that would allow them to acquire stock, that employee is deemed to be an owner of that stock for the purposes of being defined as an owner and a highly compensated employee.
In the context of a partnership, the ownership test hinges upon the employee’s percentage of profit or capital interest. When someone is employed by an LLC or LLP, they would meet the ownership test based on their membership interest in comparison to the total membership percentage.
The discussion of ownership as it relates to retirement plans cannot be concluded without a review of ownership attribution. Ownership attribution dictates that under certain circumstances, an employee’s or an organization’s direct ownership must be attributed to an employee of another organization. Attribution among family members happens to be a more common attribution form than others. In this context, if an employee is an owner of 25 percent of an organization through ownership attribution, their spouse, children, parents, and grandkids will all be attributed a 25 percent ownership stake in the same organization. This attribution scenario will generally arise if an owner’s relative becomes an employee at the same organization.
Along these lines, the most common scenario involves the owner’s children working at the organization during breaks in the school calendar or after graduation. Given the ownership attribution rules, the owner’s child would be treated in the same position as the owner and thus defined as a highly compensated employee.
The second prong of the test to determine if an employee must be defined as a highly compensated employee is based on an employee’s annual compensation. An employee will be defined as highly compensated if they receive annual compensation in excess of the IRS established threshold during the previous year. The threshold in 2014 was $115,000 and is generally indexed according to inflation annually with threshold increases being implemented in $5,000 increments. When considering the annual compensation amounts, the IRS refers to the compensation amount reported on the Form W-2 for those employees who work for corporations. Those who are self-employed are judged based on the amount of earned income. For these calculations, compensation from S corporation shareholder distributions or other passive income from rents or royalties is not included.
In a manner similar to the treatment in the ownership test, any compensation amounts received from related entities of the organization must be included in the compensation calculation to determine if the compensation is over the IRS threshold. Additionally, an organization that sponsors retirement plans may include a provision that restricts the number of employees classified as highly compensated employees to a number lower than 20 percent of the organization’s workforce. For example, if an organization currently employees 40 employees and 10 of those employees have earned compensation that would define them as highly compensated employees, the organization may rely on the top-paid group election, which would allow only the top 20 percent (eight of those 10 employees) to be treated as highly compensated employees.
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