Find out the definition of key employee and the formula used in its determination.

Key employee definition, formula and examples

A key employee is one who is a major stakeholder in a business and may also be involved in the decision-making of the company. These employees also tend to receive high compensation and special benefits. The key employee may also hold a key position in the company, contribute largely to the profits, maintain the reputation of the company and/or provide capital or credit lines.

Due to their large influence in the organization and in the decision-making, they may tend to make some decisions in their favor. To curb this, some organizations such as the internal revenue authority provide key employee definition to companies for retirement planning purposes.

The IRS makes this differentiation to ensure that there is no discrimination in the provision of retirement services by the company. The sponsoring company needs to identify its key employees in its initial steps of designing a retirement plan. This way, the IRS (internal revenue services) is assured that the company is not only sponsoring its key employees but also other employees in the company. This makes sure that the retirement plans do not lean more to the key employees.

Key employee definition formula

The IRS formula defines a key employee based on their ownership in the company and/or annual compensation. A key employee should satisfy any of the following qualities during the retirement plan year to be considered a key employee for the purposes of internal revenue services (IRS)

  • A person who owns more than 5% of the company.
  • An individual who owns 1% of the company plus $150,000 annual compensation and above.
  • An officer who receives a given amount of compensation or more. For 2015-2016, the figure is 170,000.

Highly compensated employees can also be considered as key employees. These are employees who meet either the compensation or ownership test. They:

  • Have more than 5% stake in the company in the year of the retirement plan and the previous year.
  • Are paid more than a given amount in the preceding year. The limit for 2016 was $120,000.

This means that majority of highly compensated employees are key employees for the purposes of IRS plan provided they meet the ownership or compensation limit.

Based on company ownership, a person can be a key employee provided they own at least 5% even without earning a high salary. If one decides to reduce the ownership to less than 5%, one continues being a key employee until the plan year comes to an end and a highly compensated employee until the end of the following year.

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