How Highly Compensated Individuals Can Avoid Excess IRS Scrutiny

If you are what the IRS considers a highly compensated employee (HCE) at your job, it’s important to understand what that means and how it can impact your finances, as well as how to avoid excess scrutiny from the IRS come tax time.

Avoiding IRS scrutiny for highly compensated individuals means understanding tax laws

What is a Highly Compensated Employee?

What constitutes high compensation might seem like it’s relative, but the IRS has very specific definitions that they use to identify who falls into this category, and it doesn’t only apply to millionaires and billionaires. The criteria include owning more than 5% interest in a business in the current or preceding year, being paid at least $125,000 (in 2019) or $130,000 (in 2020) and being in the top 20% of employees ranked by compensation amount. You don’t have to meet all of the criteria to be considered an HCE; if you own more than 5% and only make $40,000 a year, you are still labeled as such by the IRS.

Avoiding Unnecessary IRS Scrutiny

If you are an HCE, it’s important to understand how that impacts your own personal financial planning so you don’t attract unwanted attention from the IRS.

Understand the Rules

First and foremost, it’s important that you know the rules for “high compensation” so you can make the right financial decisions. For example, the rule about owning more than 5% includes any of your stock options and any equity in the company that belongs to immediate relatives (spouse, children, parents, and grandchildren). So setting up a company where you only own 3% but your spouse and four children each own 1% would still make you an HCE.

Be Careful with Retirement Contributions

One of the places that many people get in trouble under the HCE rules is with retirement contributions. Businesses must go through some tests to make sure that 401(k) retirement plans are not discriminatory, so a highly compensated employee can only contribute up to 2% more than the average employee. If you have employees who contribute very little on average, you may not be able to legally max out annual retirement contributions. There are some ways around this, so talk to your tax advisor about retirement savings if you are an HCE.

Consider Deferred Compensation

Your company may offer deferred compensation plans, paying out a percentage of your salary (and taxes) at a later date, often after you retire or quit. This can keep you under the threshold for HCEs, but it does have some risks associated with it.

Work with a Tax Advisor

The best way to avoid running into issues if you are an HCE is to work with a tax advisor who understands the rules and can help you navigate all the potential pitfalls to maximize your income, minimize taxes and penalties, and avoid unwanted scrutiny by the IRS.

If you are a highly compensated employee, talk to Cantley Dietrich today to learn more about your options and avoid the scrutiny of the IRS.