Two familiar terms, three actual definitions
Most employers use "highly compensated" and "key employee" as if they were interchangeable. They're not. Section 125 nondiscrimination testing actually uses three distinct classifications, each drawn from a different part of the tax code, and which one applies depends on which test is running. An employee can meet one, two, or all three, and getting the classification wrong for even one person can change a test's outcome.
The short version: "highly compensated" under the core §125 tests includes any officer regardless of pay. The stricter §414(q) definition used for DCAP testing does not. That single difference, the officer prong, is where most classification mistakes happen.
Highly Compensated Employee — §414(q)
This is the strictest of the three definitions and the one most people picture when they hear "HCE." Someone is a highly compensated employee under §414(q) if either is true:
- They own more than 5% of the company (directly, or through attribution rules for family members), or
- Their compensation exceeded $160,000 for the prior plan year (the 2026 indexed threshold).
Notably, this definition has no officer prong. Being an officer alone does not make someone an HCE under §414(q). Because §129(d)(2) explicitly cross-references this strict definition for Dependent Care FSA testing, a modestly-paid officer with no meaningful ownership stake is not treated as highly compensated for DCAP purposes, even though the same person may be treated as highly compensated under the broader §125(e) definition below.
"Highly Compensated Individual" — §125(e)
This is the broader definition used for the three core Section 125 tests (Eligibility, Contributions & Benefits, Key Employee Concentration). Someone qualifies if any of these is true:
- They're an officer of the company, regardless of salary, or
- They own more than 5% of the company, or
- Their compensation exceeds $160,000 for the prior plan year.
The officer prong is the key difference from §414(q). A newly hired officer earning $70,000 counts as highly compensated here, even though they wouldn't under the stricter DCAP definition.
"Highly Compensated Individual" — §105(h)
Health FSA testing uses yet a third definition, built around relative pay rank rather than a fixed dollar line. Someone is highly compensated for §105(h) purposes if any of these is true:
- They're among the top 25% of all employees by compensation, or
- They're one of the 5 highest-paid officers in the company, or
- They own more than 10% of the company.
Because this definition is based on ranking rather than a fixed threshold, who qualifies can shift from year to year even if nobody's pay actually changes, simply because the rest of the workforce's pay moved around them.
Key Employee — §416(i)
A separate classification entirely, used specifically for the Key Employee Concentration test. Someone is a key employee if any of these is true:
- They own more than 5% of the company, or
- They own more than 1% and their compensation exceeds $150,000 (a fixed statutory figure, not inflation-indexed), or
- They're an officer with compensation exceeding $235,000 for 2026.
Side-by-side: 2026 thresholds
| Definition | Used for | Officer prong? | Ownership threshold | Compensation threshold |
|---|---|---|---|---|
| HCE — §414(q) | DCAP tests (§129) | No | >5% | >$160,000 |
| HCI — §125(e) | Core §125 tests | Yes, any officer | >5% | >$160,000 |
| HCI — §105(h) | Health FSA tests | Top 5 officers by pay | >10% | Top 25% by pay |
| Key Employee — §416(i) | Key Employee Concentration | Yes, if comp >$235,000 | >5%, or >1% with comp >$150,000 | See ownership column |
Why the difference actually matters
The same person can be classified differently across tests running on the same census. A company officer earning $90,000 with no ownership stake is highly compensated under §125(e) (officer prong), likely not an HCE under §414(q) (no officer prong, comp too low), possibly not highly compensated under §105(h) (depends on their pay rank relative to everyone else), and not a key employee under §416(i) (comp below $235,000, no meaningful ownership). Four tests, four different answers, one employee. Getting this wrong in either direction can produce a false pass or a false fail on the underlying test. For how these definitions actually get applied across all nine tests, see our full Section 125 testing overview.
FAQ
Can one employee meet more than one of these definitions?
Yes, and it's common. An officer earning over $235,000 who also owns more than 5% of the company would be a key employee, a highly compensated employee under §414(q), and highly compensated under §125(e) all at once. The definitions overlap heavily but aren't identical, so each test still has to check independently.
Why does the officer prong matter so much?
It's the single biggest difference between definitions. Any officer counts as highly compensated under §125(e) regardless of salary, but that same officer does not count as an HCE under the strict §414(q) definition used for DCAP testing unless they separately clear the ownership or compensation threshold. A modestly-paid officer can be classified differently depending entirely on which test is being run.
Do these dollar thresholds change every year?
The §414(q) compensation threshold and the §416(i) officer threshold are both indexed for inflation and adjusted by the IRS annually. The 1% owner compensation threshold under §416(i) is a fixed statutory figure and does not adjust. Always confirm you're using the threshold for the correct plan year before relying on a classification.