IRS Explains How to Identify HCEs in an Initial or Short Plan Year

In April, the Internal Revenue Service (IRS) published guidance clarifying the definition of highly compensated employees (HCEs), a key concept for nondiscrimination testing of both retirement plans and cafeteria plans.

The guidance was published on the IRS’s Employee Plans (EP) Snapshots website, and answers questions on how to determine HCE status in the plan’s first plan year of whenever there is a short plan year (that is, less than 12 months). The HCE definition is found in 26 U.S.C. §414(q). There are two ways an employee will be classified as an HCE, based on ownership or on compensation:

1. The ownership test looks at whether the employee was at least a 5% owner of the business at any time during the current plan year being tested or the prior 12-month period.
2. The compensation test focuses on whether the employee received compensation in excess of the IRS-published threshold for the prior 12-month period. For example, if you were testing for the 2017 plan year, you would use the threshold for 2016 ($120,000).

The website contains eight helpful examples that underscore three important concepts for determining HCE status in the event of an initial or short plan year, to include:

• The prior year is always the immediately 12 months preceding the start of the current plan year. For example, consider a short plan year of October 1, 2016 – December 31, 2016. The prior year for determining HCE status would be October 1, 2015 – September 30, 2016.
• If the employee was a 5% owner at any time during the current plan year or prior 12-month period, the employee is considered an HCE.
• If the employee was not employed for the entire time of the prior 12-month period, you simply compare that person’s compensation with the applicable threshold without prorating for the time of employment.

Finally, the IRS resource confirms that there are two simplified alternatives for determining HCE status based on compensation:

1. Simply decide to use the top 20% of all employees (this will likely yield a higher number of HCEs, however).
2. For noncalendar plan years, simply decide to use the calendar year that begins during the prior 12-month period and ends during the current plan year

If elected, the employer must continue to use the alternative approach for nondiscrimination testing in subsequent years until and unless the employer revokes the election.