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Highly Compensated Employees (HCEs)

bulletCode 414(q) Highly compensated employee
bullet(1) In general
bullet(2) 5-percent owner
bullet(3) Top-paid group
bullet(4) Compensation
bullet(5) Excluded employees
bullet(6) Former employees
bullet(7) Coordination with other provisions
bullet(8) Special rule for nonresident aliens
bullet(9) Certain employees not considered highly compensated and excluded employees under pre-ERISA rules for church plans
bullet414(q) Regulations, annotated to show changes
bulletRegulation table of contents

414(q) Highly compensated employee

(1) In general

The term "highly compensated employee" means any employee who --

(A) was a 5-percent owner at any time during the year or the preceding year, or

(B) for the preceding year --

(i) had compensation from the employer in excess of $80,000, and

(ii) if the employer elects the application of this clause for such preceding year, was in the top-paid group of employees for such preceding year.
The Secretary shall adjust the $80,000 amount under subparagraph (B) at the same time and in the same manner as under section 415(d), except that the base period shall be the calendar quarter ending September 30, 1996.

(2) 5-percent owner

An employee shall be treated as a 5-percent owner for any year if at any time during such year such employee was a 5-percent owner (as defined in section 416(i)(1)) of the employer.

(3) Top-paid group

An employee is in the top-paid group of employees for any year if such employee is in the group consisting of the top 20 percent of the employees when ranked on the basis of compensation paid during such year.

(4) Compensation

For purposes of this subsection, the term "compensation" has the meaning given such term by section 415(c)(3).

(5) Excluded employees

For purposes of subsection (r) and for purposes of determining the number of employees in the top-paid group, the following employees shall be excluded--

(A) employees who have not completed 6 months of service,

(B) employees who normally work less than 17-1/2 hours per week,

(C) employees who normally work during not more than 6 months during any year,

(D) employees who have not attained age 21, and

(E) except to the extent provided in regulations, employees who are included in a unit of employees covered by an agreement which the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and the employer.

Except as provided by the Secretary, the employer may elect to apply subparagraph (A), (B), (C), or (D) by substituting a shorter period of service, smaller number of hours or months, or lower age for the period of service, number of hours or months, or age (as the case may be) than that specified in such subparagraph.

(6) Former employees

A former employee shall be treated as a highly compensated employee if--

(A) such employee was a highly compensated employee when such employee separated from service, or

(B) such employee was a highly compensated employee at any time after attaining age 55.

(7) Coordination with other provisions

Subsections (b), (c), (m), (n), and (o) shall be applied before the application of this subsection.

(8) Special rule for nonresident aliens

For purposes of this subsection and subsection (r), employees who are nonresident aliens and who receive no earned income (within the meaning of section 911(d)(2)) from the employer which constitutes income from sources within the United States (within the meaning of section 861(a)(3)) shall not be treated as employees.

(9) Certain employees not considered highly compensated and excluded employees under pre-ERISA rules for church plans

In the case of a church plan (as defined in subsection (e)), no employee shall be considered an officer, a person whose principal duties consist of supervising the work of other employees, or a highly compensated employee for any year unless such employee is a highly compensated employee under paragraph (1) for such year.

Sec. 1.414(q)-1 Highly compensated employee.

[NOTE:  Most of this regulation is a temporary regulation, 1.414(q)-1T.  However, parts of Q&A9 have been finalized.  The temporary and final regulation are presented here as a single document to prevent having to go back and forth between the two.  Those portions that are final appear in red print.]

[NOTE:  Subsequent changes to 414(q) have invalidated several portions of these rules.  Those portions which do not conform to subsequent changes in the law are indicated in italics.]

The following questions and answers relate to the definition of "highly compensated employee" provided in section 414(q). The definitions and rules provided in these questions and answers are provided solely for purposes of determining the group of highly compensated employees.

Table of contents.

bulletQ&A-1 General applicability of section 414(q).
bulletQ&A-2 Definition of highly compensated employees.
bulletQ&A-3 Definition of highly compensated active employees.
bulletQ&A-4 Definition of highly compensated former employees.
bulletQ&A-5 Definition of separation year.
bulletQ&A-6 Definition of employer.
bulletQ&A-7 Definition of employee.
bulletQ&A-8 Definition of 5-percent owner.
bulletQ&A-9 Definition of top-paid group.
bulletQ&A-10 Definition of officer and rules on inclusion of officers in highly compensated group.  [Omitted}
bulletQ&A-11 Rules with respect to family aggregation.  [Omitted]
bulletQ&A-12 Definition of family member.  [Omitted]
bulletQ&A-13 Definition of compensation.
bulletQ&A-14 Rules with respect to the relevant determination periods.
bulletQ&A-15 Transition rule applicable to plan years beginning in 1987 and 1988 for certain employers that have plans that must comply with the provisions of section 401(k)(3) or 401(m)(2).

Q-1: To what employee benefit plans and statutory provisions is the definition of highly compensated employee contained in section 414(q) applicable?

A-1: (a) In general.

This definition is applicable to statutory provisions that incorporate the definition by reference.

(b) Qualified retirement plans--

(1) In general.

Generally, this definition is incorporated in many of the nondiscrimination requirements applicable to pension, profit-sharing, and stock bonus plans qualified under section 401(a). See, e.g., the nondiscrimination provisions of sections 401(a) (4) and (5), 401(k)(3), 401(l), 401(m), 406(b), 407(b), 408(k), 410(b) and 411(d)(1). The definition is also incorporated by certain other provisions with respect to such plans, including the aggregation rules of section 414(m) and section 4975 (tax on prohibited transactions).

(2) Not applicable where not incorporated by reference.

This definition is not applicable to qualified plan provisions that do not incorporate it. See, e.g., section 415 (limitations on contributions and benefits), with the exception of section 415(c)(3)(C) and 415(c)(6) (special rules for permanent and total disability and employee stock ownership plans respectively).

(c) Other employee benefit plans or arrangements.

This definition is incorporated by various sections relating to employee benefit provisions. See, e.g., section 89 (certain other employee benefit plans), section 106 (accident and health plans), 117(d) (qualified tuition reduction), section 125 (cafeteria plans), section 129 (dependent care assistance programs), section 132 (certain fringe benefits), section 274 (certain entertainment, etc. expenses), section 423(b) (employee stock purchase plan provisions), section 501(c) (17) and (18) (certain exempt trusts providing benefits to employees), and section 505 (certain exempt organizations or trusts providing benefits to individuals). See the respective sections for the applicable effective dates.

(d) ERISA.

This definition is not determinative with respect to any provisions of Title I of the Employee Retirement Income Security Act of 1974 (ERISA), unless it is explicitly incorporated by reference (e.g., section 408(b)(1)(B)).

Q-2: Who is a highly compensated employee?

A-2: The group of employees (including former employees) who are highly compensated employees consists of both highly compensated active employees (see A-3 of this section 1.414(q)-1T) and highly compensated former employees (see A-4 of this section 1.414(q)-1T). In many circumstances, highly compensated active employees and highly compensated former employees are considered separately in applying the provisions for which the definition of highly compensated employees in section 414(q) is applicable. Specific rules with respect to the treatment of highly compensated active employees and highly compensated former employees will be provided in the regulations with respect to the sections to which the definition of highly compensated employees is applicable.

Q-3: Who is a highly compensated active employee?

A-3: (a) General rule.

For purposes of the year for which the determination is being made (the determination year), a highly compensated active employee is any employee who, with respect to the employer, performs services during the determination year and is described in any one or more of the following groups applicable with respect to the look-back year calculation and/or determination year calculation for such determination year. See A-14 for rules relating to the periods for which the look-back year calculation and determination year calculation are to be made.

(1) Look-back year calculation.
(i) 5-percent owner.

The employee is a 5-percent owner at any time during the look-back year (i.e., generally, the 12-month period immediately preceding the determination year; see A-14. (See A-8 of this section 1.414(q)-1T.)

(ii) Compensation above $75,000.

The employee receives compensation in excess of $75,000 during the look-back year.  [NOTE:  This threshold has substantially increased from its current base of $80,000.]

(iii) Compensation above $50,000 and top-paid group.

The employee receives compensation in excess of $50,000 during the look-back year and is a member of the top-paid group for the look-back year. (See A-9 of this section 1.414(q)-1T.)  [The top-paid group rules are now an optional part determining HCEs by reference to compensation.]

(iv) Officer.

The employee is an "includible officer" during the look-back year. (See A-10 of this section 1.414(q)-1T.)  [NOTE:  Officer status is no longer relevant to HCE determination.]

(2) Determination year calculation.
(i) 5-percent owner.

The employee is a 5-percent owner at any time during the determination year. (See A-8 of this section 1.414(q)-1T.)

(ii) Top-100 employees.

The employee is both (A) described in paragraph (a)(1)(i), (ii) and/or (iv) of this A-3, when such paragraphs are modified to substitute the determination year for the look-back year, and (B) one of the 100 employees who receive the most compensation from the employer during the determination year.  [NOTE:  This rule is repealed.]

(b) Rounding and tie-breaking rules.

In making the look-back year and determination year calculations for a determination year, it may be necessary for an employer to adopt a rule for rounding calculations (e.g., in determining the number of employees in the top-paid group). In addition, it may be necessary to adopt a rule breaking ties among two or more employees (e.g., in identifying those particular employees who are in the top-paid group or who are among the 100 most highly compensated employees). In such cases, the employer may adopt any rounding or tie-breaking rules it desires, so long as such rules are reasonable, nondiscriminatory, and uniformly and consistently applied.  [NOTE:  The top 100 employee rule is repealed.]

(c) Adjustments to dollar thresholds--

(1) Indexing of dollar thresholds.

The dollar amounts in paragraph (a)(1) (i) and (ii) of this A-3 are indexed at the same time and in the same manner as the section 415(b)(1)(A) dollar limitation for defined benefit plans.

(2) Applicable dollar threshold.

The applicable dollar amount for a particular determination year or look-back year is the dollar amount for the calendar year in which such determination year or look-back year begins. Thus, the dollar amount for purposes of determining the highly compensated active employees for a particular look-back year is based on the calendar year in which such look-back year begins, not the calendar year in which such look-back year ends or in which the determination year with respect to such look-back year begins.  [NOTE:  The dollar amount now matters only with regard to the look-back year, not the determination year.]

(d) Employees described in more than one group.

An individual who is a highly compensated active employee for a determination year, by reason of being described in one group in paragraph (a) of this A-3, under either the look-back year calculation or the determination year calculation, is not disregarded in determining whether another individual is a highly compensated active employee by reason of being described in another group under paragraph (a). For example, an individual who is a highly compensated active employee for a determination year, by reason of being a 5-percent owner during such year, who receives compensation in excess of $50,000 during both the look-back year and the determination year, is taken into account in determining the group of employees who are highly compensated active employees for such determination year by reason of receiving more than $50,000, and being in the top-paid group under either or both the look-back year calculation or determination year calculation for such determination year.  [While the example refers to matters that are now repealed, the principle is still true.]

(e) Examples.

The following examples, in which the determination year and look-back year are the calendar year, are illustrative of the rules in paragraph (a) of this A-3. For purposes of these examples, the threshold dollar amounts in paragraph (a)(1) (ii) and (iii) of this A-3 are not increased pursuant to paragraph (c) of this A-3.

Example (1). Employee A, who is not at any time a 5-percent owner, an officer, or a member of the top-100 within the meaning of paragraph (a)(1) (i), or (iv), or (a)(2) (i) or (ii), but who was a member of the top-paid group for each year, is included in or excluded from the highly compensated groups as specified below for the following years:

 

               Year Compensation  Status           Comments
               ---- ------------  ------           --------
               1986   $45,000      N/A     Although prior to 414(q) effective
                                            date, 1986 constitutes the look-back year for
                                            purposes of determining the highly 
                                            compensated group for the 
                                            1987 determination year.
               1987    80,000      Excl    Excluded because A was not an              
                                            employee described in paragraph
                                           (a)(1) (ii) or (iii) of this A-3
                                            for the look-back year (1986).
               1988    80,000      Incl    Included because A was an employee described
                                            in paragraph (a)(1) (ii) or (iii) of this A-3
                                            for the look-back year (1987).
               1989    45,000      Incl    Included because A was an employee described
                                             in paragraph (a)(1)(ii) or (iii) of this A-3
                                             for the look-back year (1988).
               1990    45,000      Excl    Excluded because A was not an
                                             employee described in paragraph
                                             (a)(1) (ii) or (iii) of this A-3
                                              for the look-back year (1989).

Example (2). Assuming the same facts as those given in Example (1), except that A is a member of the top-100 employees within the meaning of paragraph (a)(2)(ii) of this A-3 for the 1987 year and 1990 year, the results are as follows:

            Year Compensation  Status          Comments
            ---- ------------  ------          --------
            1986   $45,000      N/A     Although prior to 414(q) effective date, 1986
                                         constitutes the look-back year for purposes of
                                         determining the highly compensated group for the
                                         1987 determination year.
            1987    80,000      Incl    Included because A was an employee described in
                                          paragraph (a)(1)
                                         (ii) or (iii) of this A-3 
                                         for the determination year 
                                         (1987) and was described in 
                                          paragraph (a)(2)(ii) of this 
                                          A-3 in that year.
            1988    80,000      Incl    Included because A was an employee
                                          described in paragraph 
                                          (a)(1)(ii) or (iii) of 
                                          this A-3 for the look-
                                          back year (1987).
            1989    45,000      Incl    Included because A was an employee
                                          described in paragraph 
                                          (a)(1)(ii) or (iii) of this 
                                           A-3 for the look-back year 
                                          (1988).
            1990    45,000      Excl    Excluded even though in top-100
                                           employees during 1990 determination year
                                           because A was not an employee described in
                                           paragraph (a)(1)(ii) or (iii) of
                                           this A-3 for the look-back year
                                          (1989) or for the determination
                                          year (1990).

[The top-100 rule was repealed.]

Q-4: Who is a highly compensated former employee?

A-4: (a) General rule.

Except to the extent provided in paragraph (d) of this A-4, a highly compensated former employee for a determination year is any former employee who, with respect to the employer, had a separation year (as defined in A-5 of this section 1.414(q)-1T) prior to the determination year and was a highly compensated active employee as defined in A-3 of this section 1.414(q)-1T for either such employee's separation year or any determination year ending on or after the employee's 55th birthday. Thus, for example, an employee who is a highly compensated active employee for such employee's separation year, by reason of receiving over $75,000 during the look-back year, is a highly compensated former employee for determination years after such employee's separation year.

(b) Special rule for employees who perform no services for the employer in the determination year.

For purposes of this rule, employees who perform no services for an employer during a determination year are treated as former employees. Thus, for example, an employee who performed no services for the employer during a determination year, by reason of a leave of absence during such year, is treated as a former employee for such year.

(c) Dollar amounts for pre-1987 determination years.

For determination years beginning before January 1, 1987, the dollar amounts in paragraph (a)(1)(B) and (C) of A-3 of this section 1.414(q)-1T are $75,000 and $50,000 respectively.

(d) Special rule for employees who separated from service before January 1, 1987--

(1) Election of special rule.

Employers may elect to apply paragraph (d)(2) of this A-4 in lieu of paragraph (a) of this A-4 in determining whether former employees who separated from service prior to January 1, 1987, are highly compensated former employees. If this election is made with respect to any qualified plan, it must be provided for in the plan. If the employer makes this election with respect to any employee benefit plan, such election must be used uniformly for all purposes for which the section 414(q) definition is applicable. The election, once made, cannot be changed without the consent of the Commissioner.

(2) Special definition of highly compensated former employee.

A highly compensated former employee includes any former employee who separated from service with the employer prior to January 1, 1987, and was described in any one or more of the following groups during either the employee's separation year (or the year preceding such separation year) or any year ending on or after such individual's 55th birthday (or the last year ending before such employee's 55th birthday):

(i) 5-percent owner.

The employee was a 5-percent owner of the employer at any time during the year.

(ii) Compensation amount.

The employee received compensation is excess of $50,000 during the year.

The determinations provided for in this paragraph (b)(2) may be made on the basis of the calendar year, the plan year, or any other twelve month period selected by the employer and applied on a reasonable and consistent basis.

(e) Rules with respect to former employees--

(1) In general.

For specific provisions with respect to the treatment of former employees and of highly compensated former employees, refer to the rules with respect to which the section 414(q) definition of highly compensated employee is applicable.

(2) Former employees excluded in determining top-paid group, top-100 employees and includible officers.

Former employees are not included in the top-paid group, the group of the top-100 employees, or the group of includible officers for purposes of applying section 414(q) to active employees. In addition, former employees are not counted as employees for purposes of determining the number of employees in the top-paid group.  [The top-100 and officer rules have been repealed.]

 Q-5: What is a separation year for purposes of section 414(q)?

A-5: (a) Separation year--

(1) In general.

The separation year generally is the determination year during which the employee separates from service with the employer. For purposes of this rule, an employee who performs no services for the employer during a determination year will be treated as having separated from service with the employer in the year in which such employee last performed services for the employer. Thus, for example, an employee who performs no services for the employer by reason of being on a leave of absence throughout the determination year is considered to have separated from service with the employer in the year in which such employee last performed services prior to beginning the leave of absence.

(2) Deemed separation.

An employee who performs services for the employer during a determination year may be deemed to have separated from service with the employer during such year pursuant to the rules in paragraph (a)(3) of this A-5. Such deemed separation year is relevant for purposes of determining whether such employee is a highly compensated former employee after such employee actually separates from service, not for purposes of identifying such employee as either an active or former employee. Because employees to whom the provisions of paragraph (a)(2) of this A-5 apply are still performing services for the employer during the determination year, they are treated as active employees. Thus, for example, an employee who has a deemed separation year in 1989, a year during which he was a highly compensated employee, who continues to work for the employer until he retires from employment in 1995, is an active employee of the employer until 1995 and is either highly compensated or not highly compensated for any determination year during such period based on the rules with respect to highly compensated active employees. For determination years after the year of such employee's retirement, such employee is a highly compensated former employee because such employee was a highly compensated active employee for the deemed separation year.

(3) Deemed separation year.

An employee will be deemed to have a separation year if, in a determination year prior to attainment of age 55, the employee receives compensation in an amount less than 50% of the employee's average annual compensation for the three consecutive calendar years preceding such determination year during which the employee received the greatest amount of compensation from the employer (or the total period of the employee's service with the employer, if less).

(4) Leave of absence.

The deemed separation rules contained in paragraph (a)(2) and (3) of this A-5 apply without regard to whether the reduction in compensation occurs on account of a leave of absence.

(b) Deemed resumption of employment.

An employee who is treated as having a deemed separation year by reason of the provisions of paragraph (a) of this A-5 will not be treated as a highly compensated former employee (by reason of such deemed separation year) after such employee actually separates from service with the employer if, after such deemed separation year, and before the year of actual separation, such employee's services for and compensation from the employer for a determination year increase significantly so that such employee is treated as having a deemed resumption of employment. The determination of whether an employee who has incurred a deemed separation year has an increase in services and compensation sufficient to result in a deemed resumption of employment will be made on the basis of all the surrounding facts and circumstances pertaining to each individual case. At a minimum, there must be an increase in compensation from the employer to the extent that such compensation would not result in a deemed separation year under the tests in paragraph (a)(2) of this A-5 using the same three-year period taken into account in such paragraph.

(c) Examples.

Paragraphs (a) and (b) of this A-5 are illustrated by the following examples based on calendar years. For purposes of these examples the threshold dollar amounts in A-5(a) of this section 1.414(q)-1T have not been increased pursuant to A-5(b) of this section 1.414(q)-1T.

Example (1). Assume that in 1990 A is a highly compensated employee of X by reason of having earned more than $75,000 during the 1989 look-back year. In 1987, 1988 and 1989, A's years of greatest compensation received from X, A received $76,000, $80,000 and $79,000 respectively. In February of 1990, A received $30,000 in compensation. Because A's compensation during the 1990 determination year is less than 50% of A's average annual compensation from X during A's high three prior determination years, A is deemed to have a separation year during the 1990 determination year pursuant to the provisions of paragraph (a) of this A-5. Since A is a highly compensated employee for X in 1990, A's deemed separation year, A will be treated as a highly compensated former employee after A actually separates from service with the employer unless A experiences a deemed resumption of employment within the meaning of paragraph (b) of this A-5.

Example (2). Assume that in 1990 A is a highly compensated employee by reason of having been an officer (with annual compensation in excess of the section 415(c)(1)(A) dollar limitation) during the 1989 look-back year. A's compensation from X during 1990 is $37,000. A's average compensation from X for the three-year period ending with or within January, 1990, was $60,000. A's compensation during the 1990 determination year is not less than 50% of the compensation earned during the test period. Therefore, A is not deemed to have a separation year under paragraph (a)(2)(i) of this A-5.

Example (3). Assume that in 1990 C is 35 and a highly compensated employee of Z for the reasons given in Example (1) with the same compensation set forth in that example. During 1990, C leaves C's 40 hour a week position as director of the actuarial division of Z and starts working as an actuary for the same division, producing actuarial reports approximately 15 to 20 hours a week, approximately half of these hours at home. C contemplates returning to full-time employment with Z when C's child enters school. During the 1990 determination year, C's compensation is less than 50% of C's compensation during her high three preceding determination years. Therefore, C has a deemed separation year during the 1990 determination year. In 1991 C commences working 32 hours a week for X at X's place of business and receives compensation in an amount equal to 80 percent of her average annual compensation during her high three prior determination years. The C's increased compensation, considered in conjunction with the reasons for the reduction in service, the nature and extent of the services performed before and after the reduction in services, and the lack of proximity of C's age to age 55 at the time of the reduction are sufficient to establish that C has a deemed resumption of employment within the meaning of paragraph (b) of this A-5. Therefore, when C separates from service with the employer, C will not be treated as a highly compensated former employee by reason of C's deemed separation year in 1990.

Q-6: Who is the employer?

A-6: (a) Aggregation of certain entities.

The employer is the entity employing the employees and includes all other entities aggregated with such employing entity under the aggregation requirements of section 414(b), (c), (m) and (o). Thus, the following entities must be taken into account as a single employer for purposes of determining the employees who are "highly compensated employees" within the meaning of section 414(q):

(1) All corporations that are members of a controlled group of corporations (as defined in section 414(b)) that includes the employing entity.

(2) All trades or businesses (whether or not incorporated) that are under common control (as defined in section 414(c)) which group includes the employing entity.

(3) All organizations (whether or not incorporated) that are members of an affiliated service group (as defined in section 414(m)) that includes the employing entity.

(4) Any other entities required to be aggregated with the employing entity pursuant to section 414(o) and the regulations thereunder.

(b) Priority of aggregation provisions.

The aggregation requirements of paragraph (a) of this A-6 and of A-7(b) of this section with respect to leased employees are applied before the application of any of the other provisions of section 414(q) and this section.

(c) Line of business rules.

The section 414(r) rules with respect to separate lines of business are not applicable in determining the group of highly compensated employees.

Q-7: Who is an employee for purposes of section 414(q)?

A-7: (a) General rule.

Except as provided in paragraph (b) of this A-7, the term "employee" for purposes of section 414(q) refers to individuals who perform services for the employer and are either common-law employees of the employer or self-employed individuals who are treated as employees pursuant to section 401(c)(1). This rule with respect to the inclusion of certain self-employed individuals in the group of highly compensated employees is applicable whether or not such individuals are eligible to participate in the plan or benefit arrangement being tested.

(b) Leased employees--

(1) In general.

The term "employee" includes a leased employee who is treated as an employee of the recipient pursuant to the provisions of section 414(n)(2) or 414(o)(2). Employees that an employer treats as leased employees under section 414(n), pursuant to the requirements of section 414(o), are considered to be leased employees for purposes of this rule.

(2) Safe-harbor exception.

For purposes of qualified retirement plans, if an employee who would be a leased employee within the meaning of section 414(n)(2) is covered in a safe-harbor plan described in section 414(n)(5) (a qualified money purchase pension plan maintained by the leasing organization), and not otherwise covered under a qualified retirement plan of the employer, then such employee is excluded from the term "employee" unless the employer elects to include such employee pursuant to the provisions of paragraph (4) of this paragraph (b).

(3) Other employee benefit plans.

The exception in paragraph (b)(2) of this A-7 is not applicable to the determination of the highly compensated employee group for purposes of the sections enumerated in section 414(n)(3)(C). Thus, for example, a leased employee covered by a safe-harbor plan is considered to be an employee in applying the nondiscrimination provisions of section 89 to statutory benefit plans. Consequently, an employer with leased employees covered in a safe-harbor plan may have 2 groups of highly compensated employees, one with respect to its retirement plans and another with respect to its statutory benefit plans.  [Section 89 is repealed.  However, the principle is still true.]

(4) Election with respect to leased employee exclusion.

An employer may elect to include the employees excepted under the provisions of paragraph (b)(2) of this A-7 in determining the highly compensated group with respect to an employer's retirement plans. Thus, for example, by electing to forego the exception in paragraph (b)(2) of this A-7, an employer may achieve more uniform highly compensated employee groups for purposes of its retirement plans and welfare benefit plans. The election to include such employees must be made on a reasonable and consistent basis and must be provided for in the plan.

Q-8: Who is a 5-percent owner of the employer?

A-8: An employee is a 5-percent owner of the employer for a particular year if, at any time during such year, such employee is a 5-percent owner as defined in section 416(i)(B)(i) and section 1.416-1 A T-17&18. Thus, if the employer is a corporation, a 5-percent owner is any employee who owns (or is considered as owning within the meaning of section 318) more than 5 percent of the value of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation. If the employer is not a corporation, a 5-percent owner is any employee who owns more than 5 percent of the capital or profits interest in the employer. The rules of subsections (b), (c), and (m) of section 414 do not apply for purposes of determining who is a 5-percent owner. Thus, for example, an individual who is a 5-percent owner of a subsidiary corporation that is part of a controlled group of corporations within the meaning of section 414(b) is treated as a 5-percent owner for purposes of these rules.

Q-9: How is the top-paid group determined?  [NOTE:  Portions in red are finalized; portions in black are temporary]

A-9: (a) General rule.

An employee is in the top-paid group of employees for a particular year if such employee is in the group consisting of the top 20 percent of the employer's employees when ranked on the basis of compensation received from the employer during such year. The identification of the particular employees who are in the top-paid group for a year involves a two-step procedure:

(1) The determination of the number of employees that corresponds to 20 percent of the employer's employees, and

(2) The identification of the particular employees who are among the number of employees who receive the most compensation during this year.

Employees who perform no services for the employer during a year are not included in making either of these determinations for such year.

(b) Number of employees in the top-paid group --

(1) Exclusions.

The number of employees who are in the top-paid group for a year is equal to 20 percent of the total number of active employees of the employer for such year. However, solely for purposes of determining the total number of active employees in the top-paid group for a year, the employees described in section 1.414(q)-1T, A-9(b)(1)(i), (ii) and (iii)(B) are disregarded. Paragraph (g) of this A-9 provides rules for determining those employees who are excluded for purposes of applying section 414(r)(2)(A), relating to the 50-employee requirement applicable to a qualified separate line of business.

(i) Age and service exclusion.

The following employees are excluded on the basis of age or service absent an election by the employer pursuant to the rules in paragraph (b)(2) of this A-9:

(A) Employees who have not completed 6 months of service by the end of such year. For purposes of this paragraph (A), an employee's service in the immediately preceding year is added to service in the current year in determining whether the exclusion is applicable with respect to a particular employee in the current year. For example, given a plan with a calendar determination year, if employee A commences work August 1, 1989, and terminates employment May 31, 1990, A may be excluded under this paragraph (b)(1)(i)(A) in 1989 because A completed only 5 months of service by December 31, 1989. However, A cannot be excluded pursuant to this rule in 1990 because A has completed 10 months of service, for purposes of this rule, by the end of 1990.

(B) Employees who normally work less than 17 1/2 hours per week as defined in paragraph (d) of this A-9 for such year.

(C) Employees who normally work during less than 6 months during any year as defined in paragraph (e) of this A-9 for such year.

(D) Employees who have not had their 21st birthdays by the end of such year.

(ii) Nonresident alien exclusion.

Employees who are nonresident aliens and who receive no earned income (within the meaning of section 911(d)(2)) from the employer that constitutes income from sources within the United States (within the meaning of section 861(a)(3)) are excluded.

(iii) Collective bargaining exclusion--
(A) In general.

Except as provided in paragraph (B) of this paragraph (b)(1)(iii), employees who are included in a unit of employees covered by an agreement that the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and the employer, which agreement satisfies section 7701(a)(46) and section 301.7701-17T (Temporary), are included in determining the number of employees in the top-paid group.

(B) Percentage exclusion provision.

If 90 percent or more of the employees of the employer are covered under collective bargaining agreements that the Secretary of Labor finds to be collective bargaining agreements between employee representatives and the employer, which agreements satisfy section 7701(a)(46) and section 301.7701-17T (Temporary), and the plan being tested covers only employees who are not covered under such agreements, then the employees who are covered under such collective bargaining agreements are not counted in determining the number of noncollective bargaining employees who will be included in the top-paid group for purposes of testing such plan. In addition, such employees are not included in the top-paid group for such purposes. Thus, if the conditions of this paragraph (b)(1)(iii)(B) are satisfied, a separate calculation is required to determine the number and identity of noncollective bargaining employees who will be highly compensated employees by reason of receiving over $50,000 and being in the top-paid group of employees for purposes of testing those plans that cover only noncollective bargaining employees.  [The full $80,000 threshold (adjusted) now applies to HCEs by virtue of compensation, including those in the top-paid group.]

(2) Alternative exclusion provisions --
(i) Age and service exclusion election.

An employer may elect, on a consistent and uniform basis, to modify the permissible exclusions set forth in paragraph (b)(1)(i) (A), (B), (C), and (D) of this A-9 by substituting any shorter period of service or lower age than that specified in such paragraph. These exclusions may be modified to substitute a zero service or age requirement.

(ii) Election not to apply percentage exclusion provision.

An employer may elect not to exclude employees under the rules in paragraph (b)(1)(iii)(B) of this A-9.

(iii) Method of election.

The elections in this paragraph (b)(2) must be provided for in all plans of the employer and must be uniform and consistent with respect to all situations in which the section 414(q) definition is applicable to the employer. Thus, with respect to all plan years beginning in the same calendar year, the employer must apply the test uniformly for purposes of determining its top- paid group with respect to all its qualified plans and employee benefit plans. If either election is changed during the determination year, no recalculation of the look-back year based on the new election is required, provided the change in election does not result in discrimination in operation.  [NOTE:  See also Notice 97-45 regarding elections.]

(c) Identification of top-paid group members.

With the exception of the paragraph (b)(1)(iii) of this A-9 exclusion for certain employees covered by collective bargaining agreements, the exclusions in paragraph (b)(1) of this A-9 are not applicable for purposes of identifying the particular employees in the top-paid group. Thus, for example, even if an employee who normally works for less than 17 1/2 hours is excluded in determining the number of employees in the top-paid group such employee may be a member of the top-paid group. Similarly, if during a determination year, employee A receives over $75,000 and is one of the top-100 employees ranked by compensation, then employee A is a highly compensated active employee for such determination year. This is true even though employee A has worked less than six months and thus may be excluded in determining the number of persons in the top-paid group for the determination year.  [The top-100 rule is obsolete, but the principle shown in the example is still true.]

(d) Example.

Paragraphs (b) and (c) of this A-9 are illustrated by the following example:

Example. Employer X has 200 active employees during the 1989 determination year, 100 of whom normally work less than 17 1/2 hours per week during such year and 80 of whom normally work less than 15 hours per week during such year. X elects to exclude all employees who normally work less than 15 hours per week in determining the number of employees in the top-paid group. Thus, X excludes 80 employees in determining the number of employees in the top-paid group. X's top-paid group for the 1989 determination year consists of 20% of 120 or 24 employees. All 200 of X's employees must then be ranked in order by compensation received during the year, and the 24 employees X paid the greatest amount of compensation during the year are top-paid employees with respect to X for the 1989 determination year.

(e) 17 1/2 hour rule--

(1) In general.

The determination of whether an employee normally works less than 17 1/2 hours per week is made independently for each year based on the rules in paragraph (e)(2) and (3) of this A-9. In making this determination, weeks during which the employee did not work for the employer are not considered. Thus, for example, if an employee normally works twenty hours a week for twenty-five weeks during the fall and winter school quarters, 10 hours a week for the 12 week spring quarter, and does not work for the employer during the three-month summer quarter, such employee is treated as normally working more than 17 1/2 hours per week under the rule of this paragraph (e).

(2) Deemed above 17 1/2.

An employee who works 17 1/2 hours a week or more, for more than fifty percent of the total weeks worked by such employee during the year, is deemed to normally work more than 17 1/2 hours a week for purposes of this rule.

(3) Deemed below 17 1/2.

An employee who works less than 17 1/2 hours a week for fifty percent or more of the total weeks worked by such employee during the year is deemed to normally work less than 17 1/2 hours a week for purposes of this rule.

(4) Application.

The determination provided for in paragraph (e)(1), (2), and (3) of this A-9 may be made separately with respect to each employee, or on the basis of groups of employees who fall within particular job categories as established by the employer on a reasonable basis. For example, under the rule of this paragraph (e)(4) an employer may exclude all office cleaning personnel if, for the year in question, the employees performing this function normally work less than 17 1/2 hours a week. This is true even though one or more employees within this group normally work in excess of 17 1/2 hours. The election to make this determination on the basis of individuals or groups is operational and does not require a plan provision.

(5) Application based on groups.

(i) Groups of employees who perform the same job are not required to be considered as one category for purposes of the rule in paragraph (e)(4) of this A-9. Thus, for example, an employer supermarket may determine its highly compensated employees by excluding part-time grocery checkers if such personnel normally work less than 17 1/2 hours a week while continuing to include full-time personnel performing this function. In general, 80 percent of the positions within a particular job category must be filled by employees who normally work less than 17 1/2 hours a week before any employees may be excluded under this rule on the basis of their membership in that job category.

(ii) Alternatively, an employer may exclude employees who are members of a particular job category if the median number of hours of service credited to employees in that category during a determination or look-back year is 500 or less.

(f) 6-month rule--

(1) In general.

The determination of whether employees normally work during not more than 6 months in any year is made on the basis of the facts and circumstances of the particular employer as evidenced by the employer's customary experience in the years preceding the determination year. An employee who works on one day during a month is deemed to have worked during that month.

(2) Application of prior year experience.

In making the determination under this paragraph (f), the experience for years immediately preceding the determination year will generally be weighed more heavily than that of earlier years. However, this emphasis on more recent years is not appropriate if the data for a particular year reflects unusual circumstances. For example, if fishermen working for employer X worked 9 months in 1987 and 1988, 8 months in 1989, and then, because of abnormal ice conditions, worked only 5 months in 1990, such fishermen could not be excluded under this rule in 1990. Furthermore, the data with respect to 1990 would not be weighed more heavily in making a determination with respect to subsequent years.

(3) Individual or group basis.

This determination may be made separately with respect to each employee or on the basis of groups of employees who fall within particular job categories in the manner set forth in paragraph (e)(4) of this A-9.

(g) Excluded employees under section 414(r)(2)(A) --

(1) In general.

This paragraph (g) provides the rules for determining which employees are excluded employees for purposes of applying section 414(r)(2)(A), relating to the 50-employee requirement applicable to a qualified separate line of business.

(2) Excluded employees --
(i) Age and service exclusion.

All employees are excluded who are described in section 1.414(q)-1T, A- 9(b)(1)(i) (relating to exclusions based on age or service). For this purpose, the rules in section 1.414(q)-1T, A-9(e) and (f) (relating respectively to the 17section -hour rule and the 6-month rule) apply. However, the election in section 1.414(q)-1T, A-9(b)(2)(i) (permitting the employer to elect reduced minimum age or service requirements) does not apply.

(ii) Nonresident alien exclusion.

All employees are excluded who are described in section 1.414(q)-1T, A-9(b)(1)(ii) (relating to the exclusion of nonresident aliens with no U.S.-source income from the employer).

(iii) Inclusion of employees covered under a collective bargaining agreement.

All employees are included who are described in section 1.414(q)-1T, A-9(b)(1)(iii)(A) (relating to employees covered under a collective bargaining agreement) and who are not otherwise described in paragraph (g)(2)(i) or (ii) of this A-9. For this purpose, the exclusion in section 1.414(q)-1T, A-9(b)(1)(iii)(B) and the related election in section 1.414(q)-1T, A-9(b)(2)(ii) do not apply.

(3) Applicable period.

The determination of which employees are excluded employees is made on the basis of the testing year specified in the regulations under section 414(r) and not on the basis of the determination year or the look-back year under section 414(q).

(h) Effective date.

The provisions of this A-9 apply to plan years and testing years beginning on or after January 1, 1994.

Q-10. For purposes of determining the group of highly compensated employees, which employees are officers and which officers must be included in the highly compensated group?

[Omitted.  Status as an officer is no longer relevant in HCE status.]

Q-11: To what extent must family members who are employed by the same employer be aggregated for purposes of section 414(q)?

[Omitted.  Family aggregation was repealed in 1996.  However, see Q&A 8 regarding attribution of ownership between family members and others.]

Q-12: Which individuals are family members for purposes of the aggregation rules in section 414(q)(6)(A) and A-11?

[Omitted.  Family aggregation was repealed in 1996.  However, see Q&A 8 regarding attribution of ownership between family members and others.]

Q-13: How is "compensation" determined for purposes of determining the group of "highly compensated employees."

A-13: (a) In general.

For purposes of section 414(q), the term "compensation" means compensation within the meaning of section 415(c)(3) without regard to sections 125, 402(a)(8), and 402(h)(1)(B) and, in the case of employer contributions made pursuant to a salary reduction agreement, without regard to section 403(b). Thus, compensation includes elective or salary reduction contributions to a cafeteria plan, cash or deferred arrangement or tax-sheltered annuity.

(b) Determination period.

For purposes of determining the group of highly compensated employees, compensation must be calculated on the basis of the applicable period for the determination year and look-back year respectively.

(c) Compensation taken into account.

Only compensation received by an employee during the determination year or during the look-back year is considered in determining whether such employee is a highly compensated active employee under either the look-back year calculation or determination year calculation for such determination year. Thus, compensation is not annualized for purposes of determining an employee' compensation in the determination year or the look-back year in applying the rules of paragraph (a) of this A-13.  [Note:  Determination year compensation is no longer relevant in determining HCE status.]

Q-14: What periods must be used for determining who is a highly compensated employee for a determination year?

A-14: (a) Determination year and look-back year--

(1) In general.  [Note:  For later guidance, see Notice 97-45.]

For purposes of determining the group of highly compensated employees for a determination year, the determination year calculation is made on the basis of the applicable year of the plan or other entity for which a determination is being made and the look-back year calculation is made on the basis of the twelve month period immediately preceding such year. Thus, in testing plans X and Y of an employer, if plan X has a calendar year plan year and plan Y has a July 1 to June 30 plan year, the determination year calculation and look-back year calculation for plan X must be made on the basis of the calendar year. Similarly, the determination year calculation and look-back year calculation for plan Y must be made on the basis of the July 1 to June 30 year. 

(2) Applicable year.

For purposes of this A-14, the applicable year is the plan year of the qualified plan or other employee benefit arrangement to which the definition of highly compensated employees is applicable as defined in the written plan document or otherwise identified in regulations pursuant to sections to which the definition of highly compensated employees is applicable. To the extent that the definition of highly compensated employees is applicable to entities of other arrangements that do not have an otherwise identified plan year, then either the calendar year of the employer's fiscal year may be treated as the plan year.

(3) Look-back year.

The look-back year is never less than a twelve month period.

(b) Calendar year calculation election--  [NOTE:  Notice 97-45 declares that SBJPA obsoleted this provision.  See that Notice for current election procedures.]

(1) In general.

An employer may elect to make the look-back year calculation for a determination year on the basis of the calendar year ending with or within the applicable determination year (or, in the case of a determination year that is shorter than twelve months, the calendar year ending with or within the twelve-month period ending with the end of the applicable determination year). In such case, the employer must make the determination year calculation for the determination year on the basis of the period (if any) by which the applicable determination year extends beyond such calendar year (i.e., the lag period). If the applicable year for which the determination is being made is the calendar year, the employer still may elect to make the calendar year calculation election under this A-14(b). In such case, the look-back year calculation is made on the basis of the calendar year determination year and, because there is no lag period, a separate determination year calculation under A-3(a)(2) of this section 1.414(q)-1 is not required.

(2) Lag period calculation.

In making the determination year calculation under A-3(a)(2) of this section 1.414(q)-1 on the basis of the lag period, the dollar amounts applicable under A-3(a)(1) (B) and (C) of this section 1.414(q)-1 are to be adjusted by multiplying such dollar amounts by a fraction, the numerator of which is the number of calendar months that are included in the lag period and the denominator of which is twelve.

(3) Determination of active employees.

An employee will be considered an active employee for purposes of a determination year for which the calendar year calculation election is in effect so long as such employee performs services for the employer during the applicable year for which the determination is being made. This is the case even if such employee does not perform services for the employer during the lag-period for such determination year.

(4) Election requirement.

If the employer elects to make the calendar year calculation election with respect to one plan, entity, or arrangement, such election must apply with respect to all plans, entities, and arrangements of the employer. In addition, such election must be provided for in the plan.

(c) Change in applicable years.

Where there is a change in the applicable year for which a determination is being made with respect to a plan entity, or other arrangement that is not subject to the calendar year calculation election, the look-back year calculation for the short applicable year is to be made on the basis of the twelve month period preceding the short applicable year (i.e., generally, the old applicable year) and the determination year calculation for the short applicable year is to be made on the basis of the short applicable year. In addition, the dollar amounts under A-3(a)(1) (B) and (C) are to be adjusted for such determination year calculation as if the short applicable year were a lag period under paragraph (b)(2) of this A-14.  [Determination year compensation is no longer relevant.  Lag period calculations are no longer relevant.]

(d) Example.

The following examples illustrates the rules of this A-14:

Example 1. Employer X has a single plan (Plan A) with an April 1 to March 31 plan year. Employer X makes no election to use the calendar year for the determination period. Therefore, in determining the group of highly compensated employees for the April 1, 1989 to March 31, 1990 plan year, the determination year is the plan year ending March 31, 1990 and the look-back year is the plan year ending March 31, 1989.

Example 2. Assume the same facts given above. With respect to the plan year beginning in 1990, employer X elects to use the calendar year for the determination period. Therefore, in determining the group of highly compensated employees for the April 1, 1990 to March 31, 1991 plan year, the lag-period determination year is the period from January 1, 1991, through March 31, 1991, and the applicable look-back year is the 1990 calendar year.

Example 3. Employer Y has a single plan (Plan B) with a calendar plan year. With respect to the plan year beginning in 1990, employer Y elects to make the look-back year calculation for the 1990 determination year on the basis of the calendar year ending with or within the 1990 determination year. Because employer Y's determination year is the 1990 calendar year there is no lag period and employer Y determines the group of highly compensated employees for purposes of the 1990 calendar plan year on the basis of such plan year alone.  [Lag period calculations and determination year calculations are no longer relevant.]

Q-15: Is there any transition rule in determining the group of highly compensated employees for 1987 and 1988?

A-15: (a) In general.

Solely for purposes of section 401(k)(3) and (m)(2) and solely for twelve-month plan years beginning in 1987 and 1988, an eligible employer may elect to define the group of highly compensated employees as the group consisting of 5-percent owners of the employer at any time during the plan year and employees who receive compensation in excess of $50,000 during the plan year. This rule would apply in lieu of the look-back year calculation and determination year calculation otherwise applicable under A-3(a) of this section 1.414(q)-1. In addition, an eligible employer may elect to make the determinations permitted under this transition rule on the basis of the calendar year ending in the plan year and the period by which such plan year extends beyond such calendar year, in accordance with the rules of A-14(b), in lieu of making the determinations under this transition rule on the basis of the plan year for which the determinations are being made.

(b) Eligible employers.

An employer is an eligible employer under this A-15 if such employer satisfies both of the following requirements:

(1) The employer does not maintain any top-heavy plan within the meaning of section 416 at any time during 1987 and 1988; and

(2) Under each plan of the employer to which section 401(k)(3) or 401(m)(2) is applicable, the group of eligible employees that comprises the highest 25% of eligible employees ranked on the basis of compensation includes at least one employee whose compensation is $50,000 or below. This requirement must be met separately with respect to each such plan of the employer.

(c) Uniformity requirement.

An eligible employer may not make the election under paragraph (a) of this A-15 unless the election applies to all of the plans maintained by the employer to which section 401(k)(3) or 401(m)(2) applies.

(d) Election requirements.

This election is operational and does not require a plan provision.