It’s my annual “Taxes from A to Z” series! For the series, I’ll focus on terms that you might see on your tax forms and statements but not necessarily in the headlines. If you’re wondering whether you can claim wardrobe expenses or whether to deduct a capital loss, this is one series you won’t want to miss.
K is for Key Employee.
The term key employee is used in many different ways. You and I might consider a key employee as someone who is vital to your business or who is charged with making important decisions.
The Internal Revenue Service (IRS) has a different definition – at least when it comes to defining the term for purposes of retirement plans and cafeteria plans. The IRS defines a key employee during 2015 (and 2016) as an employee who is either of the following:
- An officer having annual pay of more than $170,000; or
- An employee who for 2016 is either of the following:
- A 5% owner of your business.
- A 1% owner of your business whose annual pay was more than $150,000.
Note the ownership or officer requirements: being highly compensated alone doesn’t matter for this purpose. You can be a highly-compensated employee and still not be a key employee.
(Remember that family aggregation rules apply which means that any individual who is a spouse, child, grandparent or parent of someone who is a 5% owner, or who, together with that individual, would own more than 5% of a company’s stock is a 5% owner.)
A non-key employee is – you guessed it – everyone else.
Why does the distinction matter? While we all know that folks at the top often get special privileges not afforded to everyone else (that awesome parking spot, for example), there are rules that prohibit companies from treating key employees differently from non-key employees when it comes to tax-favored benefits like certain qualified retirement plans. The so-called “top-heavy rules” are meant to ensure that non-key employees (meaning everybody else) receive a minimum benefit if the plan is top-heavy. The top-heavy rules are triggered when, as of the last day of the prior plan year, the total value of the plan accounts of key employees totals more than 60% of the entire plan. If that happens, the employer has to fix it – generally, by topping up the plans of non-key employees to 3% of compensation (subject to a vesting schedule).
When it comes to cafeteria plan benefits, like a flexible spending arrangement or group-term life insurance coverage (typically what we think of as tax-favored employee perks), the same rules for determining key employees apply. However, the rules for violating the rules are a little different. If a cafeteria plan favors key employees, meaning that key employees receive more than 25% of nontaxable benefits under the plan, an employer must report the value of taxable benefits that key employees could have selected (even if they didn’t) as wages.
Employee benefits can be a little tricky so if you need more information understanding your plan or your benefits, check with your HR person or plan administrator as well as your tax professional.
(For more on employee perks and benefits, click here.)
