Sponsors of qualified retirement plans must ensure that the contributions or benefits provided do not discriminate in favor of highly compensated employees (HCEs). The Internal Revenue Code (IRC) outlines the basis for establishing who the HCEs and key employees are. These determinations are then used to test plans for compliance with nondiscrimination testing requirements.

HCE determination

Most nondiscrimination testing is based on how HCEs are defined. Employees are generally considered to be HCEs if they meet one of the following requirements:

• 5% owners (own more than 5%)
• Earned more than $80,000, as indexed, in the prior year ($150,000 for 2023, $155,000 for 2024)

The term “5% owner” refers to a person owning more than 5% of the outstanding stock of the corporation (or owning stock that possesses more than 5% of the total voting power of all the corporation’s stock) or, for employers that are not corporations, any person who owns more than 5% of the capital or profits of the employer.

In order to determine the ownership percentage, the constructive ownership rules of IRC §318 apply. An employee is considered as owning the stock (directly or indirectly) owned by or for their spouse, parents, children, or grandchildren. These rules apply to both HCE and key employee determinations.

The dollar limit is the limit applicable for the look-back year. For example, to determine HCEs in 2024, compensation for 2023 is considered. Employees with 2023 compensation that exceeds the 2023 limit of $150,000 are considered HCEs. An employee who does not meet the HCE definition is considered to be a non-highly compensated employee (NHCE).

Alternate HCE determination: Top paid group election

In some companies, more than 20% of the employees may meet the HCE definition. In these cases, the employer may elect to apply the “top paid group” election (also known as the “top 20%” rule) to determine HCEs in the controlled group. Applying this election can reduce the number of HCEs in the controlled group, which may help one or more plans to meet the nondiscrimination testing requirements.

Under this definition of HCE, the top 20% of all non-excludable employees in the controlled group (ranked by compensation in the look-back year) will be considered HCEs. All other employees will then be considered NHCEs.

In order to apply the top 20% rule, the non-excludable employees will first need to be determined. For this purpose, the following employees may be excluded from the total pool of employees in the controlled group:

• Employees with less than six months of service
• Employees under age 21
• Employees who generally work less than 17½ hours per week
• Employees who generally work no more than six months of the year
• Employees subject to a collective bargaining agreement (if this represents at least 90% of all employees and the collectively bargained employees are also excluded from the plan being tested)
• Nonresident aliens with no U.S. earned income

The exclusion of employees must be based on the above requirements and not the eligibility requirements of the plan. The age and service requirements above can be modified to a shorter period of time or a younger age, if desired.

Once the population of non-excludable employees (for purposes of HCE determination) has been established, the employees will then be ranked by compensation earned in the prior year. The top 20% of these employees may be considered HCEs.

For purposes of the top 20% rule, the HCE dollar limit ($80,000, as indexed) still applies. An employee in the top 20% whose compensation does not exceed the HCE dollar limit will be considered an NHCE. For this reason, some controlled groups that apply the 20% rule may have fewer than 20% of their employees in the HCE category.

The following points should also be considered:

• An employee who does not work at least one hour of service in the current year will be considered an NHCE.
• Any new employees that earn compensation in the current year, but who have no prior year compensation, are also considered NHCEs.
• The number of HCEs may not exactly equal 20% of the total non-excludable employees for nondiscrimination testing purposes due to terminations and new hires.
• When the total non-excludable population is multiplied by 20% to determine the number of HCEs, this result may be rounded using any reasonable method (round up, round down, to the nearest) as long as it is nondiscriminatory and consistent.

Key employee determination

While the majority of nondiscrimination tests take HCEs into consideration, the top-heavy test is based on key employees. Key employees are defined as the following:

• 5% owners (own more than 5%)
• 1% owners (own more than 1%) with salary in excess of $150,000
• Officers with annual salary in excess of $130,000, as indexed ($220,000 for 2024)

For the last bullet point above, no more than 50 employees (or, if fewer, the greater of three or 10% of the employees) shall be treated as officers.

The definition of key employees is more restrictive than the definition of HCEs. As a result, all key employees are HCEs, but not all HCEs are key employees.

Common pitfalls

Plan sponsors should be aware of the following issues with respect to their HCE and key employee determinations:

• Consistent definition of HCE. Regardless of whether or not certain plans are aggregated or disaggregated for testing purposes, all defined benefit (DB) and defined contribution (DC) plans sponsored within the controlled group must have the same HCE definition. The plan documents of all plans in the controlled group should be reviewed to ensure compliance.
• Employees with little or no compensation in the prior year. There may be new high-earning participants in the controlled group that earned partial or zero income in the prior year. If their prior year earnings are under the dollar limit, they will be considered NHCEs regardless of the compensation earned in the current year.
• Former HCEs. Some tests may require the determination of former HCEs. A former employee would be considered a former HCE if they were an HCE when they separated from service or if they were an HCE any time after reaching age 55.
• Look-back year. In general, the compensation that is considered when determining HCEs is the prior year’s compensation. Off-calendar year plans may elect to establish the look-back year as the calendar year that begins within the 12-month period immediately preceding the determination year for purposes of the compensation limit. This election does not apply for the ownership test.
• Compensation. Compensation used for determining HCEs is total compensation and should be defined in the plan. This may be different from the compensation used for testing purposes or the plan’s definition of compensation for benefit determination purposes.

For additional information on this topic, please contact your Milliman consultant.