Key Employee Definition: What It Means and IRS Criteria Explained
Understand the IRS criteria for defining key employees and its implications on retirement plans and tax reporting.
Understanding the definition of a “key employee” is crucial for businesses to comply with IRS regulations. This designation affects how tax and retirement plan rules are applied within an organization, making it essential for companies to grasp the IRS criteria for identifying key employees.
IRS Criteria
The IRS defines key employees using specific guidelines outlined in Internal Revenue Code (IRC) Section 416(i). These criteria help pinpoint individuals whose roles or compensation levels may impact a company’s compliance with tax and retirement plan requirements.
Ownership Threshold
Ownership is a key factor in determining whether someone qualifies as a key employee. Per IRC Section 416(i)(1)(A), an individual is classified as a key employee if they directly or indirectly own more than 5% of the business. Indirect ownership includes shares held by family members, as defined by attribution rules in IRC Section 318. For example, if an employee owns 4% and their spouse owns 2%, their combined ownership exceeds the 5% threshold, classifying them as a key employee. This rule ensures individuals with significant control within a business are properly identified.
Compensation Requirements
Compensation is another criterion the IRS uses to define a key employee. An individual qualifies if their annual earnings exceed a specified amount, which is adjusted annually for inflation. For 2023, this threshold is $215,000. This metric helps identify employees whose compensation levels reflect a significant influence on company operations and finances.
Officer Status
The IRS also considers officer status when determining key employee classification. To qualify, an individual must be among the company’s top officers, although the number of officers considered is limited by company size. As specified in IRC Section 416(i)(1)(A), no more than 50 officers, or for smaller companies, the greater of three officers or 10% of employees, may be classified as key employees. This ensures that only those in leadership roles with material influence are included.
Retirement Plan Implications
The classification of key employees has a significant impact on retirement plan administration, particularly in non-discrimination testing required under the Internal Revenue Code. Plans such as 401(k)s must undergo annual tests, such as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to ensure they do not disproportionately favor key employees. If a plan fails, employers may need to correct the imbalance by refunding excess contributions to key employees or increasing contributions for non-key employees.
Key employee classification is critical for top-heavy plan rules. A plan is deemed top-heavy if key employees’ account balances exceed 60% of total plan assets. In these cases, employers must contribute at least 3% of compensation to non-key employees’ accounts to maintain plan compliance. This requirement ensures retirement benefits are distributed equitably among all employees.
Employers can design retirement plans to address these challenges, such as adopting safe harbor provisions to bypass certain non-discrimination tests. Safe harbor plans automatically meet ADP and ACP requirements if specific contribution conditions are met, simplifying compliance for organizations with a high concentration of key employees.
Reporting and Tax Considerations
Accurate reporting and tax compliance for key employees require a deep understanding of tax regulations and accounting standards. Companies must ensure compensation, benefits, and stock options for key employees are precisely reflected in financial statements, adhering to standards like ASC 718, which governs share-based payment transactions and requires detailed disclosures on stock-based compensation.
Tax rules for key employees also encompass executive perks and deferred compensation plans. For instance, golden parachute payments exceeding specific thresholds are subject to excise taxes under IRC Section 280G. Similarly, deferred compensation plans for key employees must comply with IRC Section 409A to avoid penalties, including a 20% additional tax on non-compliant compensation. Proper tax planning and compliance checks are essential to mitigate potential liabilities.