The IRS has posted on its website a summary of the rules for identifying highly compensated employees (HCEs) for a plan’s initial plan year or a short plan year. The summary explains that there are two tests for determining if an employee is an HCE under Code § 414(q)—an ownership test and a compensation test. Under the ownership test, an employee is an HCE if the employee is a 5% owner at any time during the plan year being tested (the determination year) or the preceding 12-month period (the lookback year). (The Code defines a 5% owner as an owner of more than 5% of the employer.) Under the compensation test, an employee is an HCE if the employee received compensation from the employer in excess of a specified dollar threshold during the lookback year. For example, in a calendar-year plan, an employee receiving compensation in excess of $120,000 in 2016 (the dollar threshold for that lookback year) would be an HCE in the 2017 determination year. An employee is an HCE if the employee satisfies either test.
Examples in the summary apply the tests to initial and short plan year scenarios, highlighting three important rules for identifying HCEs:
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Lookback Year Is Always 12 Months. The lookback year is always the preceding 12-month period. An example applies this rule to a plan with a fiscal plan year ending on September 30 that was amended in 2016 to adopt a calendar-year plan year, creating a short plan year beginning October 1, 2016 and ending December 31, 2016. Under the ownership test, the HCEs for the short plan year were the employees who were 5% owners of the employer at any time during the short plan year or the lookback year, which was the preceding 12-month period—October 1, 2015 through September 30, 2016.
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Ownership Test Applies at Any Time During Determination or Lookback Year. An employee who is a 5% owner of the employer at any time during the determination year or the lookback year is an HCE. Four examples illustrate that this is true even if the determination year is an initial plan year or a short plan year. For example, an employee who was a 1% owner of the employer during 2015 and a 5% owner in 2016 is an HCE for the initial plan year of a calendar-year plan established on January 1, 2016.
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Compensation Threshold for Short Plan Year Is Determined on 12-Month Lookback Year. Examples illustrate how the compensation threshold is applied for a short plan year. For example, HCEs for the short plan year of October 1, 2016 through December 31, 2016 are determined using the compensation threshold and data for the 12-month period preceding October 1, 2016. If an individual was not an employee for the entire lookback year, the individual’s compensation for that period is still measured against the dollar threshold for the entire year—the threshold amount is not prorated.
The summary also notes two design alternatives that are available for the compensation test (neither alternative applies to the ownership test). The “top-paid group election” limits HCEs to those employees with compensation in excess of the dollar threshold who are also are in the top 20% of employees ranked by compensation. The “lookback calendar-year election” allows non-calendar-year plans to use the calendar year ending within the determination year as the lookback year. Either election, once made, remains applicable in subsequent plan years unless revoked.
Comment: Identifying HCEs for initial or short plan years can be tricky, so plan sponsors and advisors must understand the rules for making HCE determinations in those circumstances. While this summary is a helpful resource, it is not comprehensive. For example, it does not explain that the top-paid group and lookback calendar-year elections apply for all HCE determinations for all of an employer’s retirement and welfare plans (other than multiemployer plans). Nor does it explain that the obligation to reflect HCE elections in the plan document does not apply to plans without a definition of HCE. Finally, we note that EP Issue Snapshots cannot be used or cited as precedent.