Key Takeaways
- Key employees meet IRS tests on ownership or pay.
- Top officers, 5% owners, or 1% owners earning $150K+ qualify.
- Key status affects retirement plan nondiscrimination rules.
- Family ownership counts toward key employee status.
What is Key Employee?
A key employee is defined under IRS rules as an individual who holds significant ownership or compensation status within a business, primarily for retirement plan compliance purposes. This classification helps determine if a company's qualified plans are "top-heavy," meaning benefits favor highly compensated individuals disproportionately.
The term differs from a highly compensated employee (HCE) but overlaps in many cases, affecting nondiscrimination testing and plan contribution requirements. Understanding key employee status is essential for companies managing C-suite roles and ownership structures.
Key Characteristics
Key employees meet specific IRS criteria based on ownership and compensation, including:
- Officer Test: Officers earning above an IRS-adjusted threshold (e.g., $220,000 in 2024) limited to top 10% or 50 officers, considering titles and authority.
- 5% Owner Test: Any individual owning more than 5% of the company, either directly or through family attribution, regardless of pay.
- 1% Owner Test: Owners with at least 1% interest earning over $150,000 annually.
- Family Attribution: Ownership stakes held by relatives such as spouses or children count toward key employee status.
- Impact on Plans: Determines if retirement plans are top-heavy and trigger minimum contribution rules.
How It Works
Employers assess key employee status annually based on data from the prior plan year to ensure compliance with IRS guidelines. This involves reviewing compensation, ownership percentages, and officer roles in line with set thresholds.
If key employees hold more than 60% of plan assets at the determination date, the plan is considered top-heavy, requiring minimum contributions to non-key employees. This process helps maintain fairness in benefits distribution and avoid discrimination against lower-paid staff.
Examples and Use Cases
Key employee status applies across industries and can influence company retirement plans and reporting obligations:
- Airlines: Delta and American Airlines may classify senior executives as key employees based on compensation and ownership, affecting their 401(k) plan designs.
- Technology Firms: Executive officers in tech companies often exceed thresholds, requiring careful plan monitoring to comply with IRS top-heavy rules.
- Investment Selection: Companies may align employee benefits with broader financial goals, including investing in large-cap stocks or growth stocks to diversify retirement plans.
Important Considerations
Annual review of key employee status is crucial, as compensation thresholds and ownership interests can change with inflation and business developments. Employers should consult plan documents and financial professionals to maintain compliance.
Understanding the distinction between key employees and highly compensated employees helps optimize plan design and nondiscrimination testing. Additionally, evaluating D&B reports may assist in verifying ownership and financial status for accurate classification.
Final Words
Key employee status directly impacts retirement plan compliance and benefits allocation, so accurately identifying these individuals is essential. Review your workforce against the IRS criteria annually to ensure your plan meets nondiscrimination rules and avoid costly penalties.
Frequently Asked Questions
A Key Employee is defined under IRS Section 416 as an officer earning above a set compensation threshold, an owner with more than 5% interest, or an owner with at least 1% interest earning over $150,000. This classification helps determine if retirement plans are top-heavy.
The IRS uses three main tests: the Officer Test for top compensated officers, the 5% Owner Test for owners with more than 5% interest regardless of pay, and the 1% Owner Test for owners with at least 1% interest earning over $150,000 annually.
While all Key Employees are considered HCEs, the terms have different criteria. Key Employee status is based on ownership and officer roles with specific thresholds, whereas HCE status includes broader compensation-based nondiscrimination rules.
Identifying Key Employees is crucial because if a retirement plan is top-heavy—meaning more than 60% of benefits belong to Key Employees—the plan must provide minimum contributions to non-key employees to ensure fairness.
Yes. The IRS applies family attribution rules, meaning ownership interests held by relatives like spouses, children, or parents are credited to the employee when assessing Key Employee status.
No. Former Key Employees who no longer meet ownership or compensation tests, such as after selling their shares, are excluded from top-heavy calculations.
The Officer Test applies to the highest compensated officers but is limited to the greater of 10 employees or 10% of all employees, with a maximum of 50 officers considered as Key Employees.
For exempt organizations, Key Employees are those managing at least 10% of assets, income, or expenses and earning over $150,000. These organizations must report up to the top 20 Key Employees on Form 990.
