13.1 IRC §414(q) Statutory Tests: 5% Owners & Compensation Lookback ($160,000 Threshold)

13.1 IRC §414(q) Statutory Tests: 5% Owners & Compensation Lookback ($160,000 Threshold)

[!NOTE] The Gateway to Qualified Plan Nondiscrimination Compliance In qualified retirement plan administration, no compliance test can be performed until the employee census is cleanly bifurcated into two mutually exclusive groups: Highly Compensated Employees (HCEs) and Non-Highly Compensated Employees (NHCEs). Codified at IRC §414(q) and governed by Treasury Regulation §1.414(q)-1T, the HCE definition establishes the dividing line for the ADP and ACP tests under IRC §401(k)(3) and §401(m)(2), the minimum coverage requirements under IRC §410(b), the general nondiscrimination standards under IRC §401(a)(4), and the top-heavy aggregation rules under IRC §416. A classification error at the HCE determination stage fatally corrupts every subsequent compliance calculation.

For administrators and Third-Party Administrators (TPAs) preparing for the ASPPA QKA credential, mastering the dual statutory tests of IRC §414(q), understanding the interaction between the determination year and the lookback year, and properly grossing up testing compensation are among the most essential competencies tested.

---

The Dual Statutory Tests: IRC §414(q)(1)

Under IRC §414(q)(1), an individual is classified as an HCE for a given plan year if they satisfy either of two independent statutory tests:

+---------------------------------------------------------------------------------------------------+
|                           IRC §414(q) DUAL STATUTORY TEST ARCHITECTURE                           |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   ┌───────────────────────────────────────────────┐   ┌───────────────────────────────────────┐   |
|   │              THE 5% OWNER TEST                │   │         THE COMPENSATION TEST         │   |
|   │             (IRC §414(q)(1)(A))               │   │          (IRC §414(q)(1)(B))          │   |
|   ├───────────────────────────────────────────────┤   ├───────────────────────────────────────┤   |
|   │ • Owns MORE than 5% (5.0001%+) of employer    │   │ • Earned compensation in excess of    │   |
|   │   capital, profits, stock, or voting power.   │   │   statutory threshold ($160k in 2025) │   |
|   │ • Direct ownership OR constructive ownership  │   │   during the preceding LOOKBACK YEAR. │   |
|   │   under IRC §318 family attribution.          │   │ • If elected by employer, must also   │   |
|   │ • Timing: At ANY time during determination    │   │   be in the Top-Paid 20% Group (TPG). │   |
|   │   year OR lookback year.                      │   │ • Timing: Preceding 12-month lookback.│   |
|   ├───────────────────────────────────────────────┤   ├───────────────────────────────────────┤   |
|   │ RESULT: AUTOMATIC HCE STATUS                  │   │ RESULT: HCE STATUS FOR TESTING YEAR   │   |
|   │ Compensation level is completely irrelevant!  │   │ Current year earnings are irrelevant! │   |
|   └───────────────────────────────────────────────┘   └───────────────────────────────────────┘   |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

1. The 5% Owner Test: IRC §414(q)(1)(A)

An employee is treated as an HCE under the 5% owner test if the employee was a 5% owner at any time during the determination year or the lookback year.

Key statutory parameters of the 5% owner test include:

• The 'More Than 5%' Rule: Under IRC §416(i)(1)(B)(iii) (incorporated by IRC §414(q)(2)), a 5% owner is any person who owns more than 5 percent 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. For an unincorporated entity, it means owning more than 5 percent of the capital or profits interest.
  • Critical Distinction: An individual who owns exactly 5.0000% is NOT a 5% owner! The individual must own at least 5.0001% or greater.
• The 'Any Time' Rule: If an individual holds more than 5% ownership for even a single day during either the determination year or the lookback year, they are an HCE for the entire determination year. Selling all shares, gifting equity, or retiring mid-year does not extinguish 5% owner HCE status for that year.
• Direct vs. Attributed Ownership: Ownership includes stock owned directly as well as stock constructively owned through the family attribution rules of IRC §318 (spouses, children, grandchildren, and parents).
• Irrelevance of Compensation: A 5% owner is an HCE regardless of how little compensation they earn. A 5% owner earning $5,000 per year as a part-time board member is an HCE.

2. The Compensation Test: IRC §414(q)(1)(B)

An employee is treated as an HCE under the compensation test if the employee received statutory compensation from the employer in excess of the statutory dollar threshold during the lookback year.

Key statutory parameters of the compensation test include:

• The Dollar Threshold: The statutory compensation threshold is established under IRC §414(q)(1)(B)(i) and indexed annually for cost-of-living adjustments pursuant to IRC §415(d) in increments of $5,000.
• Lookback Application: Compensation earned in the current determination year is completely disregarded for the compensation test! An administrator examines only what the employee earned during the 12-month lookback period.
• Top-Paid Group (TPG) Election: Under IRC §414(q)(1)(B)(ii), an employer may elect in its plan document to restrict HCEs under the compensation test to those who are also in the top 20% of employees ranked by compensation during the lookback year.

---

Statutory Compensation Thresholds and Lookback Years

The statutory dollar threshold has escalated over recent limitation years as indexed under IRC §415(d). Because the compensation test looks exclusively at compensation earned in the lookback year, an administrator must identify the statutory threshold in effect for the lookback year, not the determination year:

[!IMPORTANT] The Lookback Threshold Rule (IRS Notice 97-45): Under IRS Notice 97-45, Part II, the dollar threshold applied to evaluate compensation in the lookback year is the statutory dollar limit in effect for the calendar year in which the lookback year begins. For example, when determining HCE status for the 2026 calendar plan year, the lookback year is the 2025 calendar year. The threshold applied to 2025 compensation is $160,000 (the threshold in effect for 2025). Testing candidates frequently fail this question by incorrectly applying the prior year's $155,000 limit to 2025 earnings or applying the determination year's limit without verifying the lookback year rate.

---

Side-by-Side Comparison: 5% Owner Test vs. Compensation Test

The following table contrasts the operational mechanics of the two statutory tests under IRC §414(q):

---

Determination Year and Lookback Year Mechanics

To apply IRC §414(q) accurately, the administrator must establish the precise operational dates of the two statutory periods:

1. The Determination Year: The specific plan year for which testing is being performed. The determination year is always a 12-month period (unless the plan operates on a short initial or final plan year).
2. The Lookback Year: The 12-month period immediately preceding the determination year.

Calendar Plan Years vs. Fiscal Plan Years

• Calendar Plan Year: For a plan year running January 1, 2026 through December 31, 2026, the determination year is the 2026 calendar year. The lookback year is the 2025 calendar year (January 1, 2025 through December 31, 2025).
• Fiscal Plan Year: For a plan year running July 1, 2025 through June 30, 2026, the determination year is July 1, 2025 through June 30, 2026. The statutory lookback year is July 1, 2024 through June 30, 2025. Tracking compensation across non-calendar lookback years requires custom payroll reporting unless the employer adopts the Calendar Year Data Election under Notice 97-45 (detailed in Section 13.2).

+---------------------------------------------------------------------------------------------------+
|                     DETERMINATION YEAR VS. LOOKBACK YEAR TIMELINE ARCHITECTURE                     |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   LOOKBACK YEAR (Preceding 12 Months)              DETERMINATION YEAR (Testing Plan Year)         |
|   [January 1, 2025 ────► December 31, 2025]        [January 1, 2026 ────► December 31, 2026]      |
|   ├────────────────────────────────────────┤       ├────────────────────────────────────────┤     |
|   • Test Compensation against $160,000 cap │       • Perform ADP/ACP Nondiscrimination      │     |
|   • Test 5% Ownership at ANY time          │       • Test 5% Ownership at ANY time          │     |
|   • Calculate Top-Paid 20% Group (if chosen│       • Current Year Earnings Disregarded!     │     |
|                                                                                                   |
|   TIMING RULE:                                                                                    |
|   If 5% Owner in 2025 ────────────────────────────────────────────────────────► HCE for 2026!     |
|   If 5% Owner in 2026 ────────────────────────────────────────────────────────► HCE for 2026!     |
|   If Lookback Comp > $160k in 2025 ───────────────────────────────────────────► HCE for 2026!     |
|   If Lookback Comp = $0 (New Hire in 2026) ───────────────────────────────────► NHCE for 2026!    |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

---

The "First-Year Non-Owner Rule": The Golden Safe Harbor

One of the most consequential principles in qualified retirement plan compliance is the First-Year Non-Owner Rule:

$\text{Lookback Year Compensation for Year-1 Hire} = \$0 \implies \$0 \le \text{Threshold} \implies \mathbf{NHCE}$

The Operational Principle

Because the compensation test under IRC §414(q)(1)(B) evaluates only compensation paid by the employer during the lookback year, an employee hired during the determination year had zero ($0) compensation from that employer in the preceding year.

Therefore, a newly hired employee who does not own (directly or constructively) more than 5% of the employer CANNOT be an HCE in their first year of employment, regardless of how much compensation they earn in that first year!

Illustrative Scenarios: The First-Year Rule in Practice

• Scenario A: The Million-Dollar Chief Executive Officer

  • On January 1, 2026, Apex Corporation hires a new Chief Executive Officer, Victoria, with a starting base salary of $800,000 and a signing bonus of $200,000. She owns zero equity in Apex Corporation.
  • Determination Year: 2026 (Calendar Plan Year).
  • Lookback Year: 2025.
  • Victoria's 2025 Compensation from Apex: $0.
  • Victoria's 2026 Actual Earnings: $1,000,000.
  • Classification for 2026 Testing: NHCE! Because Victoria did not work for Apex in 2025, her lookback compensation was $0, which does not exceed $160,000. She owns 0% of the firm. Victoria is an NHCE for the entire 2026 plan year.
  • Testing Benefit: Victoria can defer the statutory maximum under §402(g) ($23,500 in 2026), and her high deferral rate flows entirely into the NHCE Average Deferral Percentage (ADP), significantly boosting the plan's ADP benchmark and making it much easier for the plan to pass nondiscrimination testing!
  • Transition to Year 2: In the 2027 determination year, Victoria's lookback year will be 2026. Her 2026 compensation ($1,000,000, capped at §401(a)(17)) will far exceed the statutory threshold. She will become an HCE in 2027.

• Scenario B: The Equity Partner Hire

  • On July 1, 2026, Apex Corporation hires Ethan as Chief Financial Officer with a salary of $200,000, and grants him a 6.0% voting equity stake in the company on his hire date.
  • Classification for 2026 Testing: HCE immediately! Although Ethan's lookback compensation was $0, he holds more than 5% ownership during the 2026 determination year. Under IRC §414(q)(1)(A), 5% ownership at any time during the determination year triggers automatic HCE status.

---

Statutory Compensation Baseline for HCE Testing: Treas. Reg. §1.414(q)-1T

When determining whether an employee's compensation exceeded the statutory threshold in the lookback year, what definition of compensation must the administrator use?

Mandatory Statutory §415 Compensation

Under Treasury Regulation §1.414(q)-1T, Q&A-13, compensation for IRC §414(q) purposes must be defined in accordance with IRC §415(c)(3). Furthermore, under IRC §415(c)(3)(D), compensation MUST include all pre-tax elective salary deferrals and cafeteria reductions.

$\text{HCE Testing Compensation} = \text{Taxable Remuneration} + \S402(g) + \S125 + \S132(f)(4) + \S457(b)$

Mandatory Gross-Up Elements

1. IRC §402(g)(3) Elective Deferrals: 401(k) pre-tax elective deferrals, 403(b) salary reductions, SARSEP contributions, and SIMPLE IRA deferrals.
2. IRC §125 Cafeteria Plan Reductions: Pre-tax employee payroll deductions for group health insurance, dental, vision, Health FSAs, and Dependent Care FSAs.
3. IRC §132(f)(4) Qualified Transportation Reductions: Pre-tax salary reductions for transit passes, commuter highway vehicles, and qualified parking.
4. IRC §457(b) Eligible Deferred Compensation: Non-qualified governmental or tax-exempt deferred compensation deferrals.

The Plan Document Custom Definition Trap

Plan documents frequently adopt custom definitions of compensation for allocation purposes (e.g., "base pay only, excluding bonuses and overtime").

[!WARNING] The Custom Compensation Trap: A plan's allocation compensation definition has zero legal authority in determining HCE status! An employer cannot classify an employee earning $140,000 in base salary and $50,000 in bonuses as an NHCE by pointing to a plan document that excludes bonuses. Statutory §415 compensation ($190,000) governs HCE threshold testing. Total compensation including bonuses, overtime, commissions, and pre-tax deferrals must be counted.

---

Definition of Non-Highly Compensated Employee (NHCE)

Under IRC §414(q)(5), the Internal Revenue Code establishes a purely negative definition for rank-and-file workers:

"The term 'non-highly compensated employee' means any employee who is not a highly compensated employee."

In retirement plan administration, NHCE status is not earned by having low wages; it is the default statutory classification for any worker who fails both the 5% owner test and the compensation test. NHCEs are the protected class under ERISA Title I and the Internal Revenue Code. The primary purpose of qualified plan compliance is ensuring that contributions, benefits, and coverage provided to NHCEs are nondiscriminatory relative to those provided to HCEs.

---

Comprehensive Worked Employee Census Scenarios

The following comprehensive census demonstrates the application of IRC §414(q) for the 2026 calendar determination year (Plan Year: Jan 1 – Dec 31, 2026). The lookback year is the 2025 calendar year, and the relevant lookback dollar threshold is $160,000. The plan sponsor has not elected the top-paid group.

Analytical Breakdown of Key Profiles:

1. Charles (First-Year Non-Owner): Despite earning $310,000 in 2026, Charles is an NHCE. He had no 2025 compensation with this employer and owns no equity. He will be tested as an NHCE in 2026, and his deferrals will support ADP testing.
2. Diane (Current-Year Compensation Spike): Diane earned $154,000 in 2025, falling just short of the $160,000 threshold. In 2026, her earnings surge to $210,000 due to commissions. Because the compensation test looks strictly at the lookback year, Diane remains an NHCE for all of 2026. Her 2026 earnings will make her an HCE for the 2027 plan year.
3. Evan (Determination Year Equity Acquisition): Evan's compensation is well below $160,000, but on January 1, 2026, he acquires a 5.5% stake. Because ownership is evaluated during both the determination year and the lookback year, Evan becomes an HCE immediately for 2026.
4. Fiona (Lookback Year Equity Retention): Fiona sold all her shares on December 15, 2025, and retired. Because she held more than 5% ownership during the lookback year (2025), she remains an HCE for the 2026 determination year under the "any time" rule.
5. George (The Exactly 5.0% Myth): George owns exactly 5.000% of the firm. Because the statute demands that an individual own more than 5 percent, George fails the 5% owner test. Since his lookback compensation ($145,000) does not exceed $160,000, he is an NHCE.

---

Common ASPPA QKA Exam Traps

• Exam Trap 1: The 'Exactly 5.0%' Trap: A question presents a shareholder holding exactly 5.000% of the stock. Candidates routinely classify them as an HCE. IRC §416(i)(1)(B)(iii) and §414(q)(2) explicitly require owning more than 5 percent. A 5.000% owner is an NHCE unless their compensation exceeds the threshold!
• Exam Trap 2: Classifying High-Earning First-Year Employees as HCEs: An exam scenario states that an executive was hired on March 1, 2026, earning $400,000. Candidates reflexively mark them as an HCE. If the executive owns no stock, they are an NHCE for their entire first year because their lookback year compensation was $0.
• Exam Trap 3: Applying Current-Year Dollar Thresholds to Lookback Compensation: For a 2025 plan year, the lookback year is 2024. Candidates often test 2024 compensation against the 2025 threshold ($155,000). Under Notice 97-45, 2024 compensation must be tested against the 2024 threshold ($150,000)!
• Exam Trap 4: Erasing HCE Status Upon Mid-Year Stock Sale: A scenario describes an owner who sells all their shares on January 15 of the determination year. Candidates assume they are an NHCE for the rest of the year. The rule states: 5% ownership at ANY time during the determination year or lookback year makes the individual an HCE for the entire determination year.
• Exam Trap 5: Excluding Pre-Tax Deferrals When Calculating Lookback Compensation: A question provides Box 1 W-2 wages of $150,000 and 401(k) pre-tax deferrals of $15,000 for 2025. Candidates compare $150,000 to the $160,000 threshold and conclude NHCE. Statutory §415 compensation mandates adding back pre-tax deferrals ($150,000 + $15,000 = $165,000), making the employee an HCE!