We talk a lot about Highly Compensated Employees (HCEs) in our business. What is a “Highly Compensated Employee?” Does it just mean someone we think makes a lot of money? No. There is a specific definition.

There are two ways an employee can be an HCE:

If the employee’s compensation exceeded the applicable threshold in the prior year. In 2015, this threshold is $120,000. Someone earning more than $120,000 in 2015 will be an HCE for 2016. By using prior year compensation, we know who the HCEs are for a given year as soon as the year starts, rather than having to wait until the year is over to know who the HCEs are.

If the person owned more than 5% of the employer in the current year or the prior year, regardless of compensation earned. This can produce some interesting results: an owner taking $30,000 of salary is an HCE, while a non-owner paid $100,000 is not. It is important to note that 5% ownership exactly does not make one an HCE. It has to be more than 5%.

HCE status is not necessarily a permanent thing. If an employee’s compensation fluctuates, he may move in and out of HCE status from year to year. Because of the one-year lookback rule, such a person might be an HCE in a year his compensation is lower but not be an HCE in a year the compensation is higher.

There are family attribution rules under which an individual is considered as owning the stock owned by his spouse, children, grandchildren, and parents. If Michelle owns 100% of a business and employs husband Tom and children Bethany and Arthur, then Tom, Bethany, and Arthur are all deemed to own 100% of the business and are therefore HCEs, regardless of how much they are paid.

An employer may make the “top-paid group” election. This means that to be an HCE based on compensation, an employee must be in the group consisting of the top 20 percent of the employees when ranked on the basis of compensation paid. Crazy as it seems, it is possible that under this election an employee making $500,000 would not be an HCE. A more-than-5% owner will still be an HCE whether he is in the top-paid group or not. The top-paid group election is fairly rare. It is used in certain situations when it produces favorable testing results.

Why is it important to know who the HCEs are? It all stems from Internal Revenue Code Section 401(a)(4), which says that to be tax-qualified, a plan may not discriminate in favor of HCEs. HCE status comes into play in the following areas, among others:

• ADP and ACP testing in 401(k) plans. These tests relate to salary deferrals and matching contributions, respectively.
• Coverage testing. Ensures that enough non-HCEs benefit under a plan compared to the proportion of HCEs that benefit.
• Cross-testing. Shows whether the contribution amounts given to HCEs by the employer are out of line with those given to non-HCEs.
• Compensation testing. When a plan does not include all of an employee’s compensation in determining benefits (e.g., excluding overtime or bonuses), it must make sure that the exclusion does not give HCEs too significant an advantage.

The term seems so simple, but there really is a lot to the concept of Highly Compensated Employees and determining who they are. It is one of the first things we need to know when designing a plan or testing an existing plan.

Reach out to us if you'd like to learn more about how we can help you with your 401(k) plan. If you liked this article, you may want to check out our free checklist for plan fiduciaries below.