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Identifying Highly Compensated Employees in an Initial or Short Plan Year

Identifying a plan’s highly compensated employees (HCEs) is critical to the operation of a qualified retirement plan. The definition of an HCE is set forth in IRC Section 414(q). This Snapshot discusses how to identify HCEs in a plan’s initial plan year or in a short plan year.

IRC Sections and Treas. Regulations

Resources

Analysis

Highly Compensated Employees – In General

Section 414(q) sets forth two tests for determining if an employee is an HCE – an ownership test and a compensation test. An employee is an HCE if he or she satisfies either of the two tests.

Generally, an employee is an HCE under the ownership test if he or she is a 5% owner at any time during the current plan year (also known as the determination year) or the 12 month period immediately preceding the determination year (also known as the lookback year).

An employee is an HCE under the compensation test (as determined under IRC Section 415(c)(3)) if he or she received compensation from the employer in excess of $80,000 (as adjusted under IRC Section 415(d) - $120,000 for 2016) during the lookback year and, if elected by the employer, is in the top 20% of employees ranked by compensation (also known as the top-paid group election) for the lookback year. The employer may make the election for any year. Once made, the election applies for all subsequent years until it is revoked. There is no filing or reporting requirement with the Service. However, the plan document must be consistent with the election. Therefore, a plan amendment may be required to reflect the election, depending upon the terms of the plan. See Sections IV, V and VII of Notice 97-45.

An employer with a non-calendar year plan can elect to have the lookback year for purposes of the compensation test be the calendar year that begins with or within the 12 month period immediately preceding the determination year. Such an election may not be made for the ownership test. The requirements for making a calendar year election are set forth in Section V of Notice 97-45.

Ownership Test – General Rule

Initial plan year:

An employee is an HCE if he or she is an employee during the initial plan year (determination year) and is a 5% owner at any time during the plan year or the 12 month period immediately preceding the plan year (lookback year).

Example 1: A retirement plan is established effective as of January 1, 2016. Susan was a 10% owner of the plan sponsor during calendar years 2015 and 2016. Susan is an HCE for the 2016 plan year under the ownership test because she was a 5% owner anytime during the determination year – 2016. She is also an HCE because she was a 5% owner anytime during the lookback year - 2015.

Example 2: Same facts as Example 1, however Susan owned 5% of the plan sponsor during 2016 but owned 1% of the plan sponsor in 2015. Susan is an HCE for the 2016 plan year under the ownership test because she was a 5% owner anytime during the determination year – 2016, even though she was a 1% owner during the lookback year - 2015.

Short plan year:

An employee is an HCE if he or she is an employee during the short plan year and is a 5% owner at any time during the plan year (determination year) or the 12 month period immediately preceding the plan year (lookback year).

Example 3: A retirement plan is established effective October 1, 2016. The plan year is the calendar year, so the first plan year is a short plan year that begins on October 1, 2016, and ends on December 31, 2016. The determination year is the short plan year that begins on October 1, 2016, and ends on December 31, 2016. The lookback year is the 12 month period that begins on October 1, 2015, and ends on September 30, 2016. An employee who was a 5% owner anytime during the 3 month determination year or the 12 month lookback year is an HCE for the determination year.

Example 4: A retirement plan has an October 1 to September 30 plan year. Effective October 1, 2016, the plan is amended to change to the calendar year effective January 1, 2017. There is a short plan year that begins on October 1, 2016, and ends on December 31, 2016. For the short plan year that begins on October 1, 2016, and ends on December 31, 2016, the HCEs under the ownership test are the employees who own at least 5% of the plan sponsor any time during the determination year - October 1, 2016, to December 31, 2016, or the lookback year – October 1, 2015, to September 30, 2016.

Compensation Test – General Rule

Initial plan year:

An employee is an HCE if he or she is an employee during the initial plan year and his or her compensation during the 12 month period immediately preceding the plan year (lookback year) exceeded the dollar limitation under IRC Section 414(q)(1) for the lookback year.

Example 5: Corporation X establishes a retirement plan effective as of January 1, 2017. John’s compensation from Corporation X during 2016 was $200,000. Corporation X does not make the top-paid group election. John is an HCE in the 2017 plan year because his compensation exceeded $120,000 in 2016, the lookback year.

Example 6: Corporation X was incorporated on July 1, 2016. There is no predecessor employer. Corporation X establishes a retirement plan effective as of January 1, 2017. Corporation X does not make the top-paid group election. The first employees were hired on July 1, 2016. Jack’s compensation from Corporation X during the 6 month period in which it was in business (July 1, 2016 to December 31, 2016) was $150,000. The lookback year is still the 12 month period immediately preceding the first plan year (January 1 to December 31, 2016). However, the compensation that is taken into account for the lookback year is the compensation that was paid during the 6 month period that Corporation X was in business. Jack is an HCE in the 2017 plan year because his compensation exceeded $120,000 in 2016, the lookback year.

Example 7: Same facts as Example 6, except Jack’s compensation from Corporation X during the 6 month period during which Corporation X was in business was $60,000. Jack is not an HCE in the 2017 plan year because his compensation was less than $120,000 in 2016, the lookback year.

Short plan year:

An employee is an HCE if he or she is an employee during the short plan year and his or her compensation during the 12 month period immediately preceding the plan year (lookback year) exceeded the dollar limitation under IRC Section 414(q)(1) for the lookback year.

Example 8: A retirement plan has an October 1 to September 30 plan year. Effective October 1, 2016, the plan is amended to change to the calendar year effective January 1, 2017. There is a short plan year that begins on October 1, 2016, and ends on December 31, 2016. The plan sponsor does not make the top-paid group election. For the short plan year that begins on October 1, 2016, and ends on December 31, 2016, the HCEs under the compensation test are the employees whose compensation exceeded $120,000 from Corporation X during the lookback year – October 1, 2015, to September 30, 2016.

Audit Tips

  • Wage information for employees can usually be found through a census, Forms W-2, and the employer’s ADP test.
  • Compensation for purposes of HCE determinations must be based on Section 415(c) compensation, which may not be the plan’s definition of compensation.
  • IDRS may contain additional information about the wage information and ownership percentages submitted by the employer.
  • Top-paid group election changes should be evidenced by amendments to the written plan document.

Additional resources

 

 

Page Last Reviewed or Updated: 21-Apr-2017