Code Section 414: Definitions and Special Rules

Internal Revenue Code (IRC) Section 414 provides standardized definitions for the rules governing qualified retirement plans, such as 401(k)s. It ensures these plans operate fairly for all employees by establishing who is considered an “employer” when businesses are related, defining employee classes for testing, and setting rules for “compensation.”

Understanding these definitions is necessary for plan sponsors to maintain their plan’s tax-qualified status. The provisions form the basis for nondiscrimination testing, which verifies that a retirement plan does not unfairly favor business owners or high-earning employees over the general workforce. Adherence to these rules is required for the plan and its participants to receive favorable tax treatment.

Determining the Employer Aggregation Rules

This code establishes when separate business entities must be treated as a single employer for retirement plan purposes. These aggregation rules prevent business owners from splitting a company into multiple entities to circumvent nondiscrimination requirements. The two primary structures that trigger this aggregation are controlled groups and affiliated service groups.

The controlled group rules are based on ownership connections. A parent-subsidiary controlled group exists when one company, the parent, owns 80% or more of another company, the subsidiary. For example, if Corporation A owns 85% of Corporation B, they are considered a single employer for plan testing, meaning all employees of both corporations must be considered together.

A more complex arrangement is the brother-sister controlled group, which involves a small group of individuals owning multiple businesses. This relationship is established when two tests are met regarding five or fewer common owners: the 80% common ownership test and the 50% identical ownership test.

The first test requires that the same small group of people own at least 80% of each company. The second test requires that those same owners have more than 50% “identical” ownership across the companies, which is based on the smallest ownership stake each person has in any of the companies.

Beyond direct ownership, affiliated service group (ASG) rules target businesses that are connected through the performance of services. These rules address arrangements, common in professional fields like medicine or law, where services are split among multiple entities. An ASG is composed of a “First Service Organization” (FSO) and one or more other entities linked through ownership or services provided.

The “A-Org Test” identifies an ASG where one entity is a partner or shareholder in the FSO and regularly performs services for the FSO. The “B-Org Test” applies when a significant portion of an entity’s business involves providing services to an FSO, of a type historically performed by employees in that field, and 10% or more of the B-Org is owned by highly compensated employees of the FSO.

Identifying Key Employee Categories

Once the “employer” is defined through aggregation rules, the code provides definitions for categorizing employees for nondiscrimination testing. These classifications determine how contributions and benefits must be allocated. The most significant of these categories are the highly compensated employee, the key employee, and the leased employee.

The definition of a highly compensated employee (HCE) is central to most nondiscrimination tests, which compare the benefits of HCEs to those of non-highly compensated employees (NHCEs). An individual qualifies as an HCE through ownership or compensation. The ownership test classifies anyone who was a 5% owner of the business at any time during the current or preceding year as an HCE.

The compensation test identifies an employee as an HCE if they received compensation above a specific, inflation-adjusted dollar threshold in the preceding year. For testing in 2025, this threshold is based on compensation earned in 2024 that was over $155,000. An employer can also elect to apply a “top-paid group” limitation, where only employees in the top 20% of the company by pay are considered HCEs under the compensation test.

Another classification is the “key employee,” defined in IRC Section 416, which is used to determine if a retirement plan is “top-heavy.” A top-heavy plan is one where more than 60% of the total assets are held in the accounts of key employees, which triggers special minimum contribution and vesting requirements for non-key employees.

An employee is considered a key employee if, during the plan year, they meet any one of three criteria: being a greater than 5% owner, being a greater than 1% owner with annual compensation over $150,000, or being an officer with annual compensation exceeding $230,000 for 2025.

The code addresses the “leased employee” to prevent companies from avoiding their retirement plan obligations by using staffing firms. A leased employee is treated as an employee of the recipient company for plan purposes if three conditions are met. First, their services must be provided under an agreement between the company and a leasing organization.

Second, the individual must have provided services on a substantially full-time basis for at least one year, which is defined as working at least 1,500 hours. The third condition is that the services must be performed under the primary direction or control of the recipient employer.

Defining Compensation for Plan Purposes

The definition of “compensation” is a component of retirement plan administration, as it forms the basis for calculating contributions and performing annual nondiscrimination tests. It is a common operational error for employers to use a definition of compensation that does not match what is specified in their official plan document.

A plan’s definition of compensation is not always the same as an employee’s gross pay. The code establishes “safe harbor” definitions that are automatically considered nondiscriminatory. These include using the wages reported in Box 1 of an employee’s Form W-2 or wages subject to federal income tax withholding as defined in IRC Section 3401. Another safe harbor is the definition under Section 415, a more inclusive measure for calculating contribution limits.

Plans are permitted to use alternative definitions, such as excluding pay like bonuses or overtime, but they must demonstrate that the definition does not discriminate in favor of HCEs. This is done by performing a test to show that the average percentage of total pay included for HCEs is not significantly higher than the average percentage for NHCEs.

If a plan document defines compensation as W-2 wages, but the employer mistakenly calculates 401(k) contributions based on a definition that excludes bonuses, this failure must be corrected. Corrections often involve the employer making additional contributions to the affected employees’ accounts, with earnings.

Special Rules and Exceptions

The code contains several special rules that act as exceptions or provide specific protections in unique situations. These provisions address the complexities of large companies and the mechanics of combining retirement plans. Two of the most significant are the rules for separate lines of business and for plan mergers.

The separate line of business (SLOB) rules offer an exception to the employer aggregation rules. A large company that operates distinct and separately managed business lines may be permitted to apply nondiscrimination testing to the retirement plan of each line independently. This can be advantageous for a conglomerate where benefit structures differ significantly between divisions.

To qualify as a SLOB, the business line must be organized as a separate unit, have its own workforce and management, and maintain separate financial accountability. A requirement is that the business line must have at least 50 employees who meet certain age and service conditions. The employer must also formally notify the IRS of its election to use the SLOB rules by filing Form 5310-A.

Another provision provides a protection for participants when retirement plans are merged or consolidated. This rule is designed to prevent the dilution of an employee’s accrued benefits when their plan is combined with another, such as during a corporate acquisition.

The rule states that in any merger or transfer of plan assets, each participant must have a benefit immediately after the event that is equal to or greater than the benefit they were entitled to immediately before the event. For a defined contribution plan like a 401(k), this is satisfied by ensuring each participant’s account balance after the merger is the sum of their account balances from the pre-merger plans.