Key Employee Definition: Section 416 Tests and FMLA Rules

Under federal tax law, the key employee definition comes from Internal Revenue Code Section 416, and it captures anyone who, at any point during the plan year, meets one of three tests: serving as an officer with compensation above an inflation-adjusted threshold ($235,000 for 2026), owning more than 5% of the business, or owning more than 1% of the business while earning more than $150,000.¹² The label exists mainly to police whether a company’s retirement plan is tilted too heavily toward its top people. A separate “key employee” definition appears in the Family and Medical Leave Act and governs job restoration after leave; the two are unrelated, and mixing them up is a common error.

The Three Section 416 Tests

An employee needs to meet only one of the tests during the plan year to be classified as key. The tests rest on ownership and compensation data, not on job title or tenure.

Officer Earning Above the Indexed Threshold

An employee who serves as an officer and earns more than $235,000 for the 2026 plan year is a key employee.² The base figure written into the statute is $130,000, and the IRS adjusts it annually in $5,000 increments.¹

“Officer” means someone with genuine authority over the business, not just a ceremonial title. The number of employees who can be treated as officers is capped: no more than 50 people, or, in a smaller workforce, the greater of three employees or 10% of the total headcount.¹

More Than 5% Owner

Any employee owning more than 5% of the business is a key employee no matter what they earn. For a corporation, that means holding more than 5% of the outstanding stock or of the total voting power. For a partnership or LLC, it means more than 5% of the capital or profits interest.¹

More Than 1% Owner Earning Over $150,000

An employee who owns more than 1% of the business and earns more than $150,000 in annual compensation also qualifies. Unlike the officer figure, the $150,000 line is fixed in the statute and does not adjust for inflation. The law authorizes cost-of-living adjustments only for the officer compensation threshold, so $150,000 has stayed put since the provision was enacted.¹

Ownership Reaches Further Than It Looks

The ownership tests do not stop at what an employee holds in their own name. Constructive ownership rules under IRC Section 318 pull in shares and business interests held by family members and by certain related entities.³

Family attribution treats you as owning whatever your spouse (unless legally separated), children, grandchildren, and parents own. If your spouse holds 4% of the company and you hold 2%, the IRS treats you as a 6% owner and you clear the 5% test, even though your personal stake is below the line.³

Entity attribution goes further. Stock held by a partnership, estate, or trust is treated as proportionally owned by the partners or beneficiaries. If a trust owns 20% of the company and you hold a 30% beneficial interest in that trust, you are treated as owning 6% of the company. For a grantor trust, the person treated as the trust’s owner for tax purposes is considered to own all its stock directly.⁴ These rules exist to keep owners from spreading shares across relatives or trusts to duck the classification.

One important limit: ownership is attributed, but compensation is not. For the 1% test, the $150,000 must come from the employee’s own earnings.

How Compensation Is Measured

Compensation for the officer and 1%-owner tests follows the broad Section 415(c)(3) definition, measured over the plan year. An employer can also use the amount that would appear on the employee’s W-2 for the calendar year ending within the plan year.⁵

Under either method, pre-tax salary reductions count. Amounts an employee diverts into a 401(k), a Section 125 cafeteria plan, or a health savings account are added back into the compensation figure for testing. This keeps employees from lowering their measured pay through elective deferrals.⁵ Whichever definition the employer picks must be used consistently across all key employee determinations.

The Determination Date and the Look-Back

Key employee status for a plan year is set using data from the preceding plan year. The formal determination date is the last day of the prior plan year, so for 2026 the employer looks at who qualified at any point during the 2025 plan year, based on 2025 ownership and compensation.⁵

Once someone is classified as a key employee based on the prior year’s numbers, that status stays fixed for the full current plan year. It does not change if their pay drops mid-year or they sell their ownership stake. A brand-new plan is the one exception: in its first year, the determination date is the last day of that same year, and the data comes from that year.⁵

Why the Label Matters: Top-Heavy Testing

Identifying key employees is the first step in testing whether a retirement plan is “top-heavy.” A defined contribution plan such as a 401(k) is top-heavy if, on the determination date, the combined account balances of all key employees exceed 60% of the combined balances of every plan participant.¹ This trips small businesses more often than expected. When an owner has been contributing for years alongside a smaller group of newer employees, the owner’s balance can easily dominate.

An employer with more than one plan cannot test each in isolation. Plans have to be grouped into a required aggregation group that covers every plan a key employee participates in, plus any other plan needed to satisfy minimum coverage or nondiscrimination rules. The 60% test is applied to the combined balances of the whole group.⁵

What the Employer Must Do If the Plan Is Top-Heavy

Once a defined contribution plan is top-heavy, the employer must contribute at least 3% of each non-key employee’s compensation for the year. The minimum drops only if the highest contribution rate for any key employee that year is under 3%, in which case it matches that lower rate. Employee elective deferrals do not count toward this minimum; it must be a separate employer contribution.¹

For a top-heavy defined benefit plan, each non-key employee must accrue a minimum annual benefit equal to 2% of average compensation times years of service, capped at 20% (reached at 10 years).⁶

Top-heavy plans also have to use accelerated vesting for employer contributions to non-key employees. The plan document must specify one of two options, and it must do so in advance, even for years the plan is not currently top-heavy:⁷⁸

Three-year cliff vesting, where the employee owns nothing until completing three years of service and then becomes 100% vested at once.
Six-year graded vesting, at 20% after two years, 40% after three, 60% after four, 80% after five, and 100% after six.

A safe harbor 401(k) that receives only elective deferrals and the required safe harbor employer contributions is exempt from top-heavy testing. If the employer makes any additional discretionary contributions on top of the safe harbor minimums, the exemption is lost and the plan has to be tested normally.⁷

What Happens If the Rules Are Ignored

A top-heavy plan that fails to provide the required minimum contributions or the required vesting is not qualified for that year. When a plan loses qualified status, the trust behind it loses its tax exemption and has to file its own income tax return and pay tax on investment earnings. Highly compensated employees may have to include their entire vested balance in taxable income for the disqualified year. Non-highly compensated employees typically include only the employer contributions made during the disqualified years, and only to the extent vested. Distributions from a disqualified plan cannot be rolled into an IRA or another plan.⁹

Other Benefits That Use the Same Definition

The Section 416 definition also drives nondiscrimination testing for a couple of other employer benefits.

A Section 125 cafeteria plan must keep no more than 25% of its total tax-free benefits flowing to key employees. If key employees get a disproportionate share, they lose the tax-free treatment and the benefits become taxable income to them.¹⁰

Employer-provided group-term life insurance under Section 79 has a parallel rule. If the plan discriminates in favor of key employees in eligibility or benefit amounts, key employees lose the normal exclusion for the first $50,000 of coverage and must include the full cost of their coverage in income.¹¹ In both situations, the tax penalty falls on the key employees, not on rank-and-file participants.

The FMLA Uses the Same Words for a Different Rule

Federal labor law borrows the phrase but not the meaning. Under the Family and Medical Leave Act, a key employee is a salaried worker who ranks among the highest-paid 10% of all employees working within 75 miles of their worksite.¹² The 10% is measured against everyone in that radius, salaried and hourly, whether or not they are personally eligible for FMLA leave.¹³

The consequence is narrow. An employer can deny job restoration to an FMLA key employee after their leave if reinstating them would cause “substantial and grievous economic injury” to the business. This is the only situation where an employer can lawfully refuse to bring back someone returning from FMLA leave.¹² The employer has to notify the employee of this possibility when the leave starts, or as soon as the key employee determination is made. Missing the notice deadline means the employer forfeits the right to deny reinstatement, even if the economic harm is real.¹⁴ FMLA key employee status does not affect the right to take leave itself, only the guarantee of returning to the same job.

1
Office of the Law Revision Counsel. 26 USC 416 – Special Rules for Top-Heavy Plans
2
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
3
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
4
Office of the Law Revision Counsel. 26 US Code 318 – Constructive Ownership of Stock
5
eCFR. 26 CFR 1.416-1 – Questions and Answers on Top-Heavy Plans
6
Office of the Law Revision Counsel. 26 US Code 416 – Special Rules for Top-Heavy Plans
7
Internal Revenue Service. Is My 401(k) Top-Heavy?
8
Internal Revenue Service. Fixing Common Plan Mistakes – Top-Heavy Errors in Defined Contribution Plans
9
Internal Revenue Service. Tax Consequences of Plan Disqualification
10
Office of the Law Revision Counsel. 26 US Code 125 – Cafeteria Plans
11
Office of the Law Revision Counsel. 26 USC 79 – Group-Term Life Insurance Purchased for Employees
12
Office of the Law Revision Counsel. 29 US Code 2614 – Employment and Benefits Protection
13
eCFR. 29 CFR 825.217 – Key Employee, General Rule
14
eCFR. 29 CFR 825.219 – Rights of a Key Employee