18.1 Identifying Key Employees: Officers, 5% Owners & 1% Owners (> $150,000)

18.1 Identifying Key Employees: Officers, 5% Owners & 1% Owners (> $150,000)

[!NOTE] The Anti-Abuse Sentinel of Qualified Retirement Plans Enacted as part of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Internal Revenue Code (IRC) §416 was established to prevent closely held businesses and professional corporations from designing tax-qualified retirement plans that disproportionately channel tax-deferred wealth to business owners and corporate executives while providing negligible retirement benefits to rank-and-file employees. When a plan allocates an overwhelming percentage of its cumulative assets to business owners and corporate leadership, the plan becomes top-heavy.

The cornerstone of all top-heavy testing is the precise statutory identification of Key Employees under IRC §416(i)(1). For Third-Party Administrators (TPAs) and retirement plan consultants preparing for the ASPPA QKA credential, determining who is—and who is not—a Key Employee is the indispensable first step. An erroneous classification corrupts the top-heavy ratio, miscalculates mandatory minimum employer contributions, and exposes the plan to disqualification under IRC §401(a)(10)(B).

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The Critical Distinction: Key Employee vs. Highly Compensated Employee

A pervasive source of error on the ASPPA QKA examination is confusing a Key Employee under IRC §416(i)(1) with a Highly Compensated Employee (HCE) under IRC §414(q). While both classifications identify higher-tier personnel, they serve completely independent statutory objectives, utilize disparate compensation thresholds, apply different ownership and officer tests, and evaluate distinct lookback windows.

+---------------------------------------------------------------------------------------------------+
|                         STATUTORY PURPOSE AND JURISDICTIONAL BOUNDARIES                           |
+---------------------------------------------------------------------------------------------------+
|                                                                                                   |
|   KEY EMPLOYEE (IRC §416(i)(1)):                                                                  |
|   • Scope: Used EXCLUSIVELY for Top-Heavy Testing under IRC §416.                                 |
|   • Application: Determines Top-Heavy Ratio (60% benchmark) and triggers Top-Heavy Minimum       |
|     Contributions (IRC §416(c)) and Accelerated Vesting (IRC §416(b)).                            |
|   • Prohibition: NEVER used for ADP/ACP testing, §410(b) coverage, or §401(a)(4) nondiscrimination.|
|                                                                                                   |
|   HIGHLY COMPENSATED EMPLOYEE (IRC §414(q)):                                                      |
|   • Scope: Used for Nondiscrimination and Minimum Coverage Testing.                               |
|   • Application: Drives the ADP Test (§401(k)), ACP Test (§401(m)), Ratio Percentage Test         |
|     (§410(b)), Average Benefits Test (§410(b)(2)), and General Nondiscrimination (§401(a)(4)).     |
|   • Prohibition: NEVER used to determine top-heavy status or top-heavy minimum contributions.     |
|                                                                                                   |
+---------------------------------------------------------------------------------------------------+

Side-by-Side Comparison: Key Employee vs. HCE

[!IMPORTANT] An Employee Can Be an HCE and a Non-Key Employee: A senior software engineer or sales director who earns $185,000 in 2024, owns 0% of company stock, and holds no executive officer authority is an HCE under IRC §414(q). However, because they are neither an officer nor an owner, they are a Non-Key Employee under IRC §416(i)(2). If the plan is top-heavy, this non-key HCE is legally entitled to receive the mandatory top-heavy minimum contribution!

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The Three Statutory Categories of Key Employees

Under IRC §416(i)(1)(A) and Treas. Reg. §1.416-1, Q&A T-12, an employee is a Key Employee for a plan year if, at any time during the determination year, the employee satisfies at least one of the following three independent statutory tests:

                                 IRC §416(i)(1) KEY EMPLOYEE TESTS
                                                 │
         ┌───────────────────────────────────────┼───────────────────────────────────────┐
         ▼                                       ▼                                       ▼
   CATEGORY 1: OFFICER                     CATEGORY 2: >5% OWNER                   CATEGORY 3: >1% OWNER
• §415 Comp > Threshold:               • Owns > 5.000% of employer.            • Owns > 1.000% of employer.
  - 2023: $215,000                       - Capital or profits interest.          - Capital or profits interest.
  - 2024: $220,000                       - Voting power or stock value.          - Voting power or stock value.
  - 2025: $230,000; 2026: $235,000     • NO compensation requirement!          • Annual §415 Comp > $150,000.
• Subject to Statutory Cap:            • Ownership at ANY time in year.        • $150,000 is NEVER indexed!
  Max 50 (or max[3, 10% workforce])    • §318 Family attribution applies.      • §318 Family attribution applies.

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Category 1: Officers Exceeding the Statutory Compensation Threshold

To qualify as a Key Employee under the officer test, an employee must satisfy both a functional authority test and a compensation threshold, subject to statutory headcount ceilings.

1. The Legal Standard of an "Officer"

Under Treas. Reg. §1.416-1, Q&A T-13, whether an individual is an officer is determined on the basis of all the facts and circumstances, specifically the individual's authority and executive functions, rather than their formal job title:

• Executive Authority Governs: An officer is an administrative executive who is in regular and continued service. An individual who has the title of officer (e.g., "Vice President") but lacks executive administrative authority is not an officer for top-heavy testing. This is common in financial institutions where hundreds of loan officers and tellers carry nominal vice-president titles.
• Un-Titled Executives: Conversely, an employee who lacks a formal corporate officer title but exercises executive authority (e.g., directing corporate affairs, binding the corporation in major contracts) is treated as an officer.
• Unincorporated Entities: Sole proprietorships, partnerships, and limited liability companies (taxed as partnerships) do not have officers for top-heavy purposes (Treas. Reg. §1.416-1, Q&A T-15). In these entities, key employees can only arise under the 5% owner or 1% owner tests.

2. The Statutory Compensation Threshold

An officer is not a Key Employee unless their annual IRC §415 compensation for the determination year exceeds the statutory threshold under IRC §416(i)(1)(A)(i):

• 2023 Plan Year: $215,000
• 2024 Plan Year: $220,000
• 2025 Plan Year: $230,000
• 2026 Plan Year: $235,000 (indexed in $5,000 increments)

3. The Statutory Officer Headcount Limitation (The Officer Cap)

Under IRC §416(i)(1)(A), Congress placed a strict limitation on the maximum number of officers who can be classified as Key Employees. The number of officers treated as Key Employees cannot exceed:

$\text{Maximum Key Officers} = \min\left(50, \; \max\left(3, \; 10\% \times \text{Total Active Employees}\right)\right)$

+---------------------------------------------------------------------------------------------------+
|                     STATUTORY OFFICER LIMITATION SLIDING SCALE TABLE                              |
+---------------------------------------------------------------------------------------------------+
|   Total Active Employees (Workforce)  | Calculation Rule                  | Maximum Key Officers  |
|   ----------------------------------  | --------------------------------- | --------------------- |
|   1 to 30 Employees                   | Statutory Floor (Greater of 3/10%)| Exactly 3 Officers    |
|   31 to 500 Employees                 | 10% of Total Active Employees     | 10% of Workforce      |
|   501 or More Employees               | Statutory Absolute Ceiling        | Exactly 50 Officers   |
+---------------------------------------------------------------------------------------------------+

Exclusions in Determining Workforce Size

When determining the total active employee count for the 10% calculation, IRC §416(i)(1)(A) applies the exclusion rules under IRC §414(q)(5). The following employees are excluded from the total workforce denominator:

1. Employees who have not completed 6 months of service;
2. Employees who normally work less than 17.5 hours per week;
3. Employees who normally work during not more than 6 months during any year;
4. Employees who have not attained age 21;
5. Non-resident aliens with no U.S. source earned income; and
6. Employees covered by a collective bargaining agreement (if retirement benefits were the subject of good faith bargaining and non-union plans are tested).

4. Officer Ranking and Selection Rules

If the number of officers earning above the compensation threshold exceeds the statutory cap, the administrator must determine which officers are Key Employees:

• Rank by Compensation: Officers earning above the threshold are ranked in descending order based on their IRC §415 compensation during the determination year.
• Top Tier Selected: Only the highest-paid officers up to the statutory cap are classified as Key Employees.
• Excess Officers Are Non-Key: Officers who exceed the cap are classified as Non-Key Employees for top-heavy testing (even though they remain HCEs under §414(q)).
• Tie-Breaker Rule: If two officers have identical compensation at the cutoff line, the employer may select which officer is designated as key, or the plan document may specify a default selection method (such as seniority).

+---------------------------------------------------------------------------------------------------+
|                     OFFICER LIMITATION WORKED EXAMPLE (40-EMPLOYEE FIRM)                          |
+---------------------------------------------------------------------------------------------------+
|   Workforce Demographics:                                                                         |
|   • Total non-excludable active employees: 40                                                     |
|   • Officer Cap: Greater of 3 or 10% of 40 (4.0) = 4 Officers maximum                             |
|   • Five executives carry officer authority and earn above the 2024 threshold ($220,000):        |
|                                                                                                   |
|     Officer Name       Title                    2024 §415 Comp    Key Employee Status             |
|     ----------------   ----------------------   --------------    -------------------             |
|     1. Arthur Vance    Chief Executive Officer  $450,000          KEY EMPLOYEE (Rank 1)           |
|     2. Brenda Smith    Chief Financial Officer  $380,000          KEY EMPLOYEE (Rank 2)           |
|     3. Carlos Ortiz    Chief Operating Officer  $310,000          KEY EMPLOYEE (Rank 3)           |
|     4. Diana Chang     Chief Technology Officer $275,000          KEY EMPLOYEE (Rank 4 - Cap Met) |
|     5. Evan Ross       VP of Business Dev.      $240,000          NON-KEY EMPLOYEE (Exceeds Cap)  |
|                                                                                                   |
|   Conclusion: Evan Ross earns above $220,000 but falls beyond the 4-officer cap. Evan is a        |
|   NON-KEY employee for top-heavy purposes (though Evan remains an HCE under §414(q)).             |
+---------------------------------------------------------------------------------------------------+

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Category 2: More-than-5% Owners

Under IRC §416(i)(1)(A)(ii), any employee who is a more-than-5% owner at any time during the determination year is automatically a Key Employee.

The "More Than" Rule

Notice the precise statutory terminology: more than 5%.

• An individual who owns exactly 5.000% of the voting power or outstanding stock is NOT a 5% owner.
• The individual must own at least 5.0001% (or 5.01%) to satisfy the definition.

Zero Compensation Requirement

There is no compensation requirement whatsoever for a 5% owner:

• A retired founder or passive shareholder who receives $0 in compensation during the determination year but owns 5.1% of the company is a 5% owner.
• An active owner drawing a nominal salary of $10,000 per year is a Key Employee.

Measuring Ownership in Different Entities

• Corporations: Owning more than 5% of the outstanding stock of the corporation OR stock possessing more than 5% of the total combined voting power of all stock of the corporation.
• Unincorporated Entities (LLCs, Partnerships): Owning more than 5% of the capital or profits interest in the entity.

[!WARNING] No Controlled Group Aggregation for Ownership: Under IRC §416(i)(1)(C), the controlled group and affiliated service group rules of IRC §414(b), (c), and (m) do NOT apply in determining whether an employee is a 5% owner or 1% owner. Ownership is tested on an entity-by-entity basis. If an individual owns 4% of Corporation A and 4% of Corporation B (which form a parent-subsidiary controlled group), the individual is NOT a 5% owner of either entity, because ownership is not aggregated across corporate entities to establish owner status!

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Category 3: More-than-1% Owners with Compensation > $150,000

Under IRC §416(i)(1)(A)(iii), an employee is a Key Employee if they satisfy two cumulative criteria:

1. Ownership Requirement: The employee owns more than 1% (at least 1.0001%) of the outstanding stock, voting power, or capital/profits interest of the employer at any time during the determination year; AND
2. Compensation Requirement: The employee receives annual IRC §415 compensation from the employer exceeding $150,000 during the determination year.

The Unindexed $150,000 Threshold Trap

This is one of the most celebrated traps on the ASPPA QKA examination:

• While the officer threshold is indexed annually ($215,000 in 2023, $220,000 in 2024, $230,000 in 2025, $235,000 in 2026);
• And while the HCE compensation threshold is indexed annually ($150,000 in 2023, $155,000 in 2024, $160,000 in 2025);
• The $150,000 compensation threshold for 1% owners is FIXED BY STATUTE and is NEVER INDEXED FOR INFLATION! It has remained exactly $150,000 since its enactment.

Controlled Group Compensation Aggregation

While entity ownership is not aggregated across related entities under IRC §414, compensation is aggregated across the entire controlled group under IRC §416(i)(1)(C). If an employee owns 2% of Subsidiary X and earns $90,000 from Subsidiary X and $75,000 from Subsidiary Y (a member of the same controlled group), their aggregated §415 compensation is $165,000. Because $165,000 exceeds $150,000, the employee is a Key Employee!

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Family Attribution Rules under IRC §318

For both the 5% owner test and the 1% owner test, ownership is not limited to direct legal title. Under IRC §416(i)(1)(B)(iii), the constructive ownership rules of IRC §318 apply to attribute stock ownership between related individuals.

1. The Family Attribution Perimeter

Under IRC §318(a)(1), an individual is considered as owning the stock owned, directly or indirectly, by or for:

• Their Spouse (unless legally separated under a decree of divorce or separate maintenance);
• Their Children (including legally adopted children);
• Their Grandchildren; and
• Their Parents.

                              IRC §318 FAMILY ATTRIBUTION WEB
                                             │
                 ┌───────────────────────────┼───────────────────────────┐
                 ▼                           ▼                           ▼
              PARENTS                     SPOUSE                     CHILDREN
          (Attributed to               (Attributed to             (Attributed to
           Child & v.v.)               Spouse & v.v.)              Parent & v.v.)
                                                                         │
                                                                         ▼
                                                                   GRANDCHILDREN
                                                                  (Attributed to
                                                                  Grandparent & v.v.)

2. Strictly Excluded Relationships (Non-Attribution)

Stock ownership NEVER attributes between:

• Siblings: Brothers and sisters do not attribute stock to each other.
• In-Laws: Mother-in-law, father-in-law, son-in-law, and daughter-in-law do not attribute stock.
• Grandparents to Grandchildren-in-law: Non-direct lineage does not attribute.
• Aunts, Uncles, Nieces, Nephews, Cousins: Zero attribution.

3. Prohibition Against Double Family Attribution

Under IRC §318(a)(5)(B), stock constructively owned by an individual by reason of family attribution cannot be attributed again to another family member under the family rules ("no double family attribution").

• Example: Robert owns 100% of Acme Corp. Robert's daughter, Chloe, is attributed 100% of Robert's stock. Chloe's husband, David (Robert's son-in-law), does not receive attribution from Chloe of Robert's stock! Stock cannot flow from Robert -> Chloe -> David. (David would only own stock if he owned it directly or through his own parents/grandparents).

4. Operational Impact: The Employed Relative

If an owner who holds 100% of a company employs their 19-year-old child as a summer clerk earning $5,000, that child is deemed to own 100% of the stock via family attribution from the parent. Consequently, the child is a more-than-5% owner and is classified as a Key Employee for top-heavy testing, despite earning only $5,000 and working part-time!

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Definition and Rights of Non-Key Employees

Under IRC §416(i)(2), the statutory definition of a Non-Key Employee is deceptively simple: any employee who is not a key employee.

Who Is a Non-Key Employee?

1. Rank-and-File Staff: Production workers, clerical employees, managers, and professional staff who own 1% or less of the company, earn under the officer compensation threshold, or hold no executive authority.
2. Former Key Employees: An employee who was previously a key employee (e.g., in prior plan years) but who is not a key employee for the determination year being tested (Treas. Reg. §1.416-1, Q&A T-12).
3. Non-Key Highly Compensated Employees: Highly paid executives or technical specialists whose compensation exceeds the HCE threshold ($155,000 for 2024 / $160,000 for 2025) but who own 1% or less of the company and are not officers (or whose officer ranking falls outside the officer cap).

[!IMPORTANT] Non-Key Status Dictates Top-Heavy Protections: Every active Non-Key Employee who participates in a top-heavy plan and is employed on the last day of the plan year is entitled to receive the statutory Top-Heavy Minimum Contribution under IRC §416(c)(2), regardless of whether they are an HCE or an NHCE!

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Testing Timing: The Determination Year

Key Employee status is determined on the basis of the determination year.

• Under IRC §416(g)(4)(C) and Treas. Reg. §1.416-1, Q&A T-12, the determination year is the plan year containing the determination date.
• For an ongoing calendar year plan being tested for the 2025 plan year, the determination date is December 31, 2024. The plan year containing December 31, 2024 is the 2024 plan year.
• Therefore, Key Employee status for the 2025 top-heavy test is evaluated using ownership, officer status, and compensation from the 2024 determination year.

Repeal of the 5-Year Key Employee Lookback

Prior to the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), an employee was treated as a Key Employee if they met the criteria in the determination year or any of the 4 preceding plan years (the former 5-year lookback rule).

• EGTRRA permanently repealed this 5-year lookback rule.
• Today, Key Employee status is determined strictly based on the single 1-year determination year. If an individual was an owner in 2023 but sold 100% of their stock and stepped down from executive roles on January 1, 2024, they are NOT a Key Employee for the 2024 determination year (and thus not a Key Employee for the 2025 plan year top-heavy test).

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Comprehensive Worked Census Scenario

Apex Precision Tooling, Inc. maintains a calendar-year 401(k) profit-sharing plan. Apex employs 25 total active employees in 2024 (none meet the statutory exclusions under §414(q)(5)). The TPA is identifying Key Employees for the 2025 plan year top-heavy test (evaluated as of the December 31, 2024 determination date based on the 2024 determination year).

Census Data and Classification Analysis (2024 Determination Year):

Key Takeaways from the Census:

1. Workforce Officer Cap Applied: Apex has 25 employees. The officer cap is $\max(3, 10% \times 25 = 2.5) = 3$ officers. Four officers earned over $220,000 in 2024 (Harold $280k, George $245k, Fiona $230k, Martin $225k). The top 3 by compensation (Harold, George, Fiona) are Key Employees. Martin exceeds the cap and is forced into Non-Key Employee status!
2. Attribution Elevates Low-Paid Family Members: Chloe ($95k) and David ($35k) own 0% stock directly, but inherit Harold's 55% ownership under §318 family attribution. Both are Key Employees under Category 2 regardless of their salary.
3. 1% Owner Threshold Applied: Sarah owns 2% and earns $165,000 (> $150,000) -> Key Employee. Thomas owns 2% and earns $130,000 (<= $150,000) -> Non-Key Employee.

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Common ASPPA QKA Exam Traps

• Exam Trap 1: Conflating HCE and Key Employee Definitions: Exam questions routinely describe an employee earning $170,000 who is neither an officer nor an owner, and ask whether they receive the top-heavy minimum contribution. Candidates who confuse HCE with Key Employee assume the employee is a Key Employee and deny them the minimum. They are an HCE but a NON-KEY employee, fully entitled to the top-heavy minimum!
• Exam Trap 2: Indexing the $150,000 Threshold for 1% Owners: The question presents a 2% owner earning $152,000 in 2024 and tests whether they are a Key Employee, enticing candidates to assume the threshold indexed to $155,000 or $220,000. The $150,000 threshold under IRC §416(i)(1)(A)(iii) is unindexed and permanently frozen at $150,000!
• Exam Trap 3: Applying Sibling Attribution: A scenario gives a company owned 50% by Brother A and 50% by Sister B. Sister B's spouse works for the company. Candidates incorrectly attribute Brother A's stock to Sister B, and then from Sister B to Brother A's children, or attribute between the siblings. There is NO sibling attribution under IRC §318.
• Exam Trap 4: Misapplying the Officer Headcount Cap: In a firm of 20 employees with 5 officers all earning $250,000, candidates often classify all 5 as Key Employees. The cap is the greater of 3 or 10% (max 50); for 20 employees, the cap is exactly 3. Only the top 3 highest-earning officers are Key Employees.
• Exam Trap 5: Assuming Exactly 5.0% Ownership Qualifies: A question states a partner owns exactly 5.00% of an LLC and earns $100,000. IRC §416(i)(1)(A)(ii) requires MORE THAN 5% (> 5.000%). Exactly 5.00% is NOT a 5% owner!