What is a 'Highly Compensated Employee'

A highly compensated employee (HCE) is -- according to the Internal Revenue Service -- anyone who:

  • Owned more than 5% of the interest in a business at any time during the year or the preceding year, regardless of how much compensation that person earned or received; or,
  • For the preceding year, received compensation from the business of more than $115,000 (if the preceding year is 2014; $120,000 if the preceding year is 2015, 2016, 2017 or 2018), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

BREAKING DOWN 'Highly Compensated Employee'

Tax-deferred retirement plans, such as 401(k) plans, were implemented by the Internal Revenue Service (IRS) to offer equal benefits to all workers. Initially, all employees could contribute as much as they want, with total contribution matched by the employer up to $16,500 annually. High earners could contribute much more than other employees, and thus, were likely to benefit more from the tax-free plan which allowed them to lower their tax liabilities considerably. Seeing that not all employees were receiving equal benefits from retirement plans, the IRS set rules against high earners contributing over a certain limit based on the average contribution of the other employees.

The Internal Revenue Service (IRS) requires that all 401(k) plans take a non-discrimination test every year. The test separates employees into two groups – nonhighly compensated and highly compensated employees (HCE). By examining the contributions made by HCEs, the compliance test determines whether all employees are treated equally through the company’s 401(k) plan.

The non-discrimination stipulations are set in place so that employee retirement plans do not discriminate in favor of highly compensated employees. Defining highly compensated employees provided a way for the IRS to regulate deferred plans and ensure that companies were not just setting up retirement plans to benefit their executives.

The 5% threshold is based on voting power or the value of company shares. The interest owned by an individual also includes the interest attributed to his or her relatives such as spouse, parents, children, grandchildren, but not grandparents or siblings. An employee with exactly 5% ownership in the company is not considered a highly compensated employee, whereas one with a 5.01% interest in the company has the HCE status. For example, an employee with 3% holdings in the company will be considered an HCE if his spouse owns 2.2% interest in the same company (total interest is 5.2%).

Failing the Test

If the average contributions of HCEs to the plan are more than 2% higher than the average contributions of non-HCEs, the plan would fail the non-discrimination test. In addition, contributions by HCEs as a group cannot be more than two times the percentage of other employees’ contributions. Clearly, how much an HCE can contribute to their own retirement plans depends on the level of non-HCEs participation in the plan.

In simpler terms, when a company contributes to a defined-benefit or defined-contribution plan for its employees and those contributions are based on the employee's compensation, the IRS requires that the company minimize the discrepancy between the retirement benefits received by highly compensated and lower compensated employees. If the employer fails to correct the discrimination, the plan could lose its tax-qualified status and all contributions will have to be re-distributed to the plan’s participants. The employer could also face severe financial and tax consequences as a result of distributing the contributions and earnings.

A company can correct any imbalance in its retirement plans by making additional contributions for the non-highly compensated group of employees. Alternatively, the firm could make distributions to the HCE group which will have to make withdrawals from the plan and pay taxes on the withdrawals.

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