What is a Highly Compensated Employee?
Hello, it’s Phil Hodgen. Welcome to the Friday Edition, your every-other-week international tax missive.
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The UK SIPP book – roadmap
This week we continue with the UK SIPP book. The next several newsletters will cover the Code’s income tax treatment of a U.S. participant in a SIPP on contributions, plan earnings, and distributions. After we have dealt with the Code, I will turn to the treaty and how those rules affect contributions, plan earnings, and distributions.
We start the Code’s income tax treatment of SIPPs — which the Code perceives as nonexempt employee’s benefit trusts — with a critical question. The plan participant is either a regular employee or a “highly compensated employee.” As you might guess, highly compensated employees receive worse tax treatment. 🙂
This is the first of three newsletters that define “highly compensated employee” because there are two ways in which an employee can become a highly compensated employee by earning money, and a third way that an employee can be a highly compensated employee even at peanut-sized wages.
Chapter 11. “Highly Compensated Employee”
11.1 Introduction
The U.S. tax treatment of employer contributions to and distributions from a SIPP will depend on whether the SIPP participant is a highly compensated employee and whether the SIPP is discriminatory. Both terms are defined in the Internal Revenue Code.
In this chapter, I help you make the decision of whether the SIPP participant is a “highly compensated employee”. The answer will almost always be “yes.”
The next chapter will help you decide whether the SIPP itself is a “discriminatory” plan. Again, the answer will almost always be “yes.”
11.1.1 Why “highly compensated employee” matters
Highly compensated employees who are participants in nonexempt employees’ benefits trusts (like SIPPs) do not determine their U.S. income tax liability using the default rules for contributions to and distributions. These rules are found at IRC 402(b)(1) and (2), respectively. Instead, highly compensated employees calculate their U.S. income tax liability using exceptions to the default rules, found at IRC 402(b)(4).
You can only know which rule to apply–default rule or exception–after you know whether the plan participant is (or is not) a highly compensated employee. We will look at the U.S. income taxation of contributions and distributions to a SIPP in future chapters. For now, let’s classify the participant.
11.1.2 Two ways to be a highly compensated employee
IRC 402(b)(4)(C) tells us where to find the definition of highly compensated employee, by cross-reference to IRC 414(q).
There are three ways for a SIPP participant to be a “highly compensated employee.”
- One way is to be “highly compensated” in one of two ways. IRC 414(q)(1)(B).
- The third way is to be an owner of the employer. IRC 414(q)(1)(A).
11.1.3 The Code: “highly compensated employee” IRC 414(q)(1) states the rule:
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.
11.1.4 Notices
The IRS publishes a notice every year with the indexed values for the upcoming tax year. Here are the values for 2025 and 2026:
- 2025: $160,000 (Notice 2024-80)
- 2026: $160,000 (Notice 2025-67)
11.2 The highly-compensated path to highly compensated employee classification
11.2.1 $160,000 for 2025 and 2026
An employee who received compensation above an indexed threshold value might be a highly compensated employee. IRC 414(q)(1)(B)(i). Currently the threshold is $160,000 for 2026 and 2026.
“Might be” a highly compensated employee is the technically correct way to look at it. Merely earning more than the threshold is enough under one method. But the other method also requires the employee to be in the top 20% of all employees (ranked by compensation).
- No employer election. Is the participant’s compensation above $160,000? IRC 414(q)(1)(B)(i).
- With an employer election. Is the participant’s compensation above $160,000 AND the participant is in the top 20% of employees, ranked by compensation? IRC 414(q)(1)(B)(ii).
11.2.2 The only thing that matters is total compensation
Thus, if an employer makes the specified election, someone whose compensation far exceeds $160,000 (for 2025 and 2026) will not be a highly compensated employee if there are enough other employees who earn more.
In reality, the second method will never be used for a SIPP. The way you calculate the “top 20%” guarantees that a U.S. participant in a SIPP will always be in the top 20%, even if everyone in the company earns more than him. The technical explanation will follow below.
This means that highly compensated employee status for a U.S. participant in a SIPP will always and only depend on “compensation” amount.
11.2.3 Use the preceding year’s compensation
Determine whether you are a highly compensated employee based on compensation received for the preceding year–not the current tax year. IRC 414(q)(1)(B)(i) says (emphasis added):
The term “highly compensated employee” means any employee who . . . (B) for the preceding year (i) had compensation from the employer in excess of [the indexed compensation amount].
If you are deciding whether a SIPP participant is a highly compensated employee for the 2025 income tax year, you will be looking at 2024 compensation.
11.2.4 Compensation includes the employer’s SIPP contribution
“Compensation” is defined in IRC 414(q)(4) by cross-reference to IRC 415(c)(3):
Compensation. For purposes of this subsection, the term “compensation” has the meaning given such term by section 415(c)(3).
And IRC 415(c)(3) is not particularly helpful. The relevant portion is IRC 415(c)(3)(A):
(A) In general. The term “participant’s compensation” means the compensation of the participant from the employer for the year.
The useful definitions are in the Regulations. “Compensation” means, when you boil it down, (1) something that came from the employer, and (2) was included in gross income of the employee. Reg. §1.415(c)-2(a).
Salary is obviously included in compensation. For our purposes, the employer’s SIPP contribution is included in gross income, too. IRC 402(b)(1) says (emphasis added):
Contributions to an employees’ trust made by an employer during a taxable year of the employer which ends with or within a taxable year of the trust for which the trust is not exempt from tax under section 501(a) shall be included in the gross income of the employee in accordance with section 83 (relating to property transferred in connection with performance of services), except that the value of the employee’s interest in the trust shall be substituted for the fair market value of the property for purposes of applying such section.
11.2.5 Examples
Here are two examples that show how inclusion of the employer’s SIPP contribution will push the U.S. employee’s status to “highly compensated employee.” Assume in both cases that the only two items of compensation are salary and the SIPP contribution.
Example 1.
An employee receives salary in GBP equivalent to $140,000 in 2025. No other fringe benefits or oddities are provided by the employer. In determining the employee’s status as a highly compensated employee for 2026, the employee’s total compensation is $140,000 (salary only), below the threshold for 2026 of $160,000. Therefore, the employee will not be a highly compensated employee in 2026.
Example 2.
An employee receives salary in GBP equivalent to $140,000 in 2025. The employer also makes a SIPP contribution in the GBP equivalent amount of $25,000. The SIPP contribution is included in the employee’s gross income by IRC 402(b)(1). No other fringe benefits or oddities are provided by the employer. In determining the employee’s status as a highly compensated employee for 2026, the employee’s total compensation is $140,000 (salary) plus $25,000 (SIPP contribution) for a total of $165,000, above the threshold for 2026 of $160,000. Therefore, the employee will be a highly compensated employee in 2026.
11.2.6 Conclusion
A U.S. person who is an employee will be a highly compensated employee for the current tax year if total compensation in the previous year exceeds an inflation-adjusted threshold. For determining highly compensated employee status for tax years 2025 and 2026 the threshold is $160,000. This includes all compensation items, and specifically includes the employer’s SIPP contribution made on behalf of the employee.
Next time: why the employer cannot make an election to limit highly compensated employee status to the top 20% (by compensation) employees of the company. To give you an example of why you would want to do that:
Assume a limited company has 10 employees. The U.S. employee’s total compensation is $400,000, but Ranked by total compensation, a U.S. employee is number 3. Two other employees earn more than $400,000 per year.
The employer makes the election indicated by IRC 414(q)(1)(B)(ii), so that only the top 20% of employees will be highly compensated employees. As a result, the U.S. employee, earning $400,000 per year in total compensation, is not a highly compensated employee for purposes of determining his U.S. income tax liability with respect to the SIPP.
That would be great, right? Unfortunately, it won’t work. I will tell you why–next time.
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