The determination of who is considered a Highly Compensated Employee (“HCE”) is one of the most important factors in maintaining 401(k) plan compliance. The nondiscrimination tests applicable to 401(k) plans rely on a correct HCE determination. Mistakes made in HCE status can have adverse consequences and may jeopardize the tax qualified status of the plan.

One of the key definitions in the Internal Revenue Code is found in IRC Section 414(q) – Highly Compensated Employees. The statutory definition is fairly short (9 succent subsections) and appears at first blush to be relatively straightforward; however, the more nuanced regulations and practical applications of this seemingly innocuous definition can stump even the most experienced practitioners and HR professionals.

The primary area of difficulty in practice is generally not the definition itself, but rather obtaining the correct employee compensation and ownership information required to accurately determine the HCEs. In this post, we will review the basics of the HCE definition, discuss the Top Paid Group Election, and highlight common errors that plague the HCE determination.

Highly Compensated Employee Definition

Employees may be HCEs by either ownership or compensation. This includes:

• Any employee in the look-back year or the determination year (generally the plan year) who owns or owned more than 5% of the employer, or

• Any employee who had compensation in excess of the annual dollar threshold in the look-back year ($135,000 in 2022 for 2023 testing, $150,000 in 2023 for 2024 testing).

Note that an employee only needs to satisfy one of the requirements (either the ownership test or the compensation test) to be considered an HCE, the employee does not need to satisfy both.

The look-back year is the immediately preceding 12 months. For example, a 401(k) plan that runs on a calendar year basis would use compensation paid in calendar year 2023 to determine the HCEs in the plan for the 2024 plan year.

The more than 5% ownership test is satisfied if at any time during either the look-back year or the current year, the employee owned more than 5% of the employer. The employer includes any member of a related employer group by virtue of either a Controlled Group or an Affiliated Service Group.

• For more details: Newfront 401(k)ology—Controlled Groups and Related Employers

Ownership by Attribution

The ownership test also extends to employees who are certain family members of individuals who directly own more than 5% of the employer. This includes any lineal ascendants and descendants of the more than 5% owner and includes the owner’s spouse.

Lineal ascendants includes both parents and grandparents, and descendants includes both children related by blood and by legal adoption. There is no attribution to siblings, nieces/nephews or daughter/son in laws.

Ownership may also filter through estates and trusts, where the beneficiary may be considered the indirect owner of the employer. For example, if an entity is owned by a trust, the beneficiaries of that trust would be considered owners of the employer.

Best Practices: The attribution rules can be extremely complicated, depending on the ownership structure of the employer. If there are estates, trusts or stock ownership restrictions in the corporate structure, plan sponsors should carefully review the direct and indirect ownership attribution rules with legal counsel to determine each year (or when there is a change in ownership) who is considered a more than 5% owner. It is the employer’s responsibility to share the ownership results with those who are responsible for overseeing the operational compliance of the retirement plan, including the plan’s service providers.

Top Paid Group Election – Limits HCEs based Solely on Compensation

The Top Paid Group Election (aka Top 20% Election) is a testing option that must be identified in the plan’s legal document. If elected, the Top Paid Group Election will change the plan’s approach to determining the number of employees that are considered highly compensated under the compensation prong of the HCE determination. The election can be changed each year¹, but the discretionary amendment to elect/remove the top paid group election must be signed before the last day of the plan year for which it is applicable (effective retroactively to the first day of that plan year). Once made, the election applies for all subsequent years unless subsequently changed by plan amendment.

¹Check with the plan’s service provider to confirm that the change would not violate any protected benefits before changing the election.

The Top 20% election only impacts the number of employees that are considered HCEs by virtue of the compensation test. Any employee who is a 5% or more owner (direct or indirect) is considered an HCE, regardless of the amount of their compensation. In effect, the election allows the employer to rank the employees from highest paid to lowest paid, then only considers those in the top 20% as HCEs. Employees who have not worked for the employer for six (6) months, who normally work less than 17.5 hours per week or less than six (6) months, who have not attained age 21 or who are union members (only if the plan excludes all union members) are excluded in total employee count.

Practical Note: The Top Paid Group Election applies to all the employer’s qualified plans and employee benefit plans that rely on the same HCE determination, including the employer’s dependent care FSA.

In some employer demographics, particularly when the employer has a significant number of employees with gross compensation over the applicable limit for that year in comparison to the total number of employees of the employer, the Top 20% will move some otherwise HCEs into the Non-Highly Compensated (NHCE) group for purposes of the annual nondiscrimination testing, thereby improving the chance of passing (or at least mitigating the adverse effects of a failure).

Let’s consider the below fact pattern:

• Employer had 10 employees in 2022 (plan runs on a calendar year basis)

• Top Paid Group is elected for the 2023 plan year

• Number in top 20% = 2

• 5 of the employees had gross compensation in excess of $135,000 in 2022.

• 100% owner had the greatest compensation in 2022

Because the Top Paid Group election was made for 2023, the employer will have 2 HCEs rather than 5 HCEs included in the 2023 nondiscrimination tests. The HCEs would include the owner and the next highest paid employee. The other three employees who had compensation in excess of $135,000 will be considered NHCEs in the 2023 annual nondiscrimination testing.

What if the 100% owner is not one of the 2 highest paid?

If the 100% owner is not one of the two highest paid employees in 2022, then there will be 3 HCEs in the 2023 plan year because a more than 5% owner is always an HCE.

What if the 100% owner’s child is one of the employees at the company but only earns $50,000?

If the 100% owner is not one of the two highest paid employees and the owner’s child is one of the employees earning less than $135,000 in 2022, then there will be 4 HCEs in the 2023 plan year because a more than 5% owner (including by attribution to a lineal descendant) is always an HCE.

Whoa! Do you mean that even though the Top Paid Group is elected there could be 4 HCEs instead of only 2? That is correct, because the Top 20% election only applies to those ranked by compensation and has no impact on those that are considered more than 5% owners.

Nondiscrimination Tests Based on HCEs

The correct determination of who is considered a Highly Compensated Employee has numerous applications in plan operation and compliance. To maintain a retirement plan that remains exempt from taxation, qualified retirement plans must demonstrate compliance with the applicable regulations on an annual basis. Below is a summary of the most common nondiscrimination tests that rely on the correct HCE determination:

• ADP and ACP testing (Code §§401(k)(3) and 401(m))

• General non-discrimination (Code §§401(a)(4) and (5))

• Coverage (§410(b))

If the HCE determination is incorrect, all the above nondiscrimination tests will be inaccurate. The implications of each failed test can be quite costly to correct and may jeopardize the tax qualified status of the retirement plan.

For more detailed information on nondiscrimination testing, please refer to the IRS’ Guide to Common Qualified Plan Requirements.

Impact on Nondiscrimination Testing

The Top 20% election can be greatly beneficial in the Average Deferral Percentage Test because the higher paid employees will have lower deferral averages than the lower paid employees with gross compensation in excess of $135,000 (2023 testing based on 2022 compensation).

Consider an HCE who defers $20,500 in 2022 and has gross compensation limited to $305,000 (deferral average of 6.72%) versus an employee who would be an HCE without the top paid group election who defers $20,500 and has gross compensation of $150,000 (deferral average of 13.67%). If the Top Paid Group Election is made for 2022, the 13.67% deferral average is counted in the non-highly compensated employee group. That can make a huge difference in passing the Average Deferral Percentage Test!

Most Common Errors in Determining HCEs

1. Failure in applying attribution rules. A daughter who works at the same employer as one of the parents may no longer have the same last name, so it is not apparent to someone reviewing the census data that she is related to a more than 5% owner. The same is true of spouses who do not share the same last name.

2. Failure in identifying owners. The internal payroll resource of the employer may not have all the information to know who the more than 5% owners are, especially when there are trusts or estates involved. The operation of the plan is dependent on the correct ownership information being supplied to the service provider tasked with completing the annual nondiscrimination testing. As we all know, bad data in equals bad data out.

3. Failure to use §415(c) compensation to determine the HCEs. Employers may elect to define eligible plan compensation by excluding certain items of compensation. The compensation elected in the plan document and used for allocation purposes is not the same definition of compensation that must be used to determine HCEs. Compensation for purposes of determining HCEs must use the §415(c) compensation definition.

4. Failure to aggregate compensation between related employers. Related employers may operate separate plans and/or separate payrolls but one thing they must do is aggregate compensation paid to individuals that work for both entities when making the HCE determination. If Company A pays shared Employee X compensation of $125,000 and related Company B pays that same employee compensation of $125,000, then Employee X’s compensation for HCE determination is $250,000.

Fiduciary note: Employers have a fiduciary responsibility to oversee plan management and operation. The importance of the HCE determination in operating a compliant retirement program cannot be emphasized enough. Consult with the plan’s service providers and ERISA legal counsel if there are any questions about the HCE determination. This can be especially complicated if the entity has been involved in a business transaction (merger or acquisition).

Conclusion

There are so many rules, limits and definitions that apply to 401(k) plans and most plan sponsors are not experts in the retirement plan field. Most plan sponsors rely upon their service providers to accurately determine the HCEs, but as noted previously – garbage in equals garbage out. The service providers must be given the correct information and it is the plan sponsor’s responsibility to provide accurate and complete ownership and compensation. If there is one key term that every plan sponsor should know, it is Highly Compensated Employee. Likewise, if there is one determination that can derail the operational compliance of your 401(k) Plan, it is that of the Highly Compensated Employee.

Newfront’s Retirement Services team is available to assist you with questions regarding plan operation, compliance or other retirement plan questions that may arise.

Email us at 401kHelp@newfront.com.

Helpful Quick Links

• Identifying HCEs in an Initial or Short Plan Year

• Cost of Living Adjustments

• Tax Consequences of Plan Disqualification

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