What is a key employee?

Key employees aren't your average workers. These employees are key to the overall success of a company. They typically influence the strategy of a business and may even have ownership of it. Without them, a business may struggle to survive in a competitive market. But while their role is essential in their organization, favoring them with regard to benefits can have legal consequences.

In this article, we'll define what a key employee is, explore the consequences of giving preference to key employees, and go over some strategies that companies can implement to attract and retain them without showing favoritism.

Takeaways from this blog post:

• Key employees are crucial to a company's operations due to their expertise and role. They can range from top management to essential staff members.
• While favoritism towards key employees may seem beneficial, it can lead to low morale and legal consequences within the workplace.
• When employers use a health reimbursement arrangement (HRA), like the QSEHRA and ICHRA, they can customize their health benefit to meet the needs of key employees and other workers.

What is a key employee?

Employers may use the term “key employee” to refer to any member of their team who is making significant contributions to their business. However, the IRS as a formal definition for this term. According to 26 USC § 416(i)(1)¹, a key employee is any officer who has an annual compensation of more than $220,000 (in 2024), a 5% or more owner of the company, or a 1% or more owner with an annual compensation of at least $150,000.

You may need² to report employee compensation for key employees if an employee controls 10% or more of the organization’s assets, income, activities, or expenses or if they have the authority to determine this and their income exceeds $150,000.

Importance of key employees

Key employees are crucial to a company's operations due to their specialized skills, knowledge, and experience. A key person on your team has unique talents that are difficult to replace, making them essential assets to your organization. These employees often directly impact the company's revenue, customer satisfaction, or overall business objectives. You can find key employees at various levels within an organization, from top management to essential staff members.

Some examples include:

• C-Suite executives
• Leading sales personnel
• Heads of product development
• Engineers
• Other difficult-to-replace personnel

Understanding the IRS definition of key employees

Because key employees are valuable to an organization, employers often offer ownership stakes or high salaries to keep them from leaving. This can lead to discrimination with employee benefits. As a result, the IRS sets³ rules for employee benefits.

The IRS states⁴ that if more than 25% of nontaxable benefits under a plan go to key employees, their wages must include the value of taxable benefits.

Additionally, if a key employee takes leave under the Family Medical Leave Act (FMLA), an employer can deny job reinstatement. According to the U.S. Department of Labor⁵, for an employer to deny restoration to a key employee, they must establish that rehiring the employee would result in significant economic harm to the company’s operations, rather than considering the impact of the employee's absence.

Favoritism towards key employees

Key employees are often seen as valuable assets to a company, playing a significant role in the business’s success. As a result, employers may sometimes feel compelled to offer special benefits or privileges to key employees to retain their talent and dedication. But, favoring your key employees can have negative effects on your organization's morale and bottom line.

Favoritism in the workplace can contribute to low morale among employees. When you consistently give certain employees preferential treatment or opportunities, it can create feelings of unfairness and resentment among other team members. This can lead to decreased motivation and productivity. It can also lower job satisfaction across the board. Managers and leaders need to maintain a fair and equitable work environment to promote teamwork.

If other employees feel that they are being unfairly treated or overlooked in favor of key employees, this can create a hostile work environment and lead to legal action against the company. That said, employers need to be aware of the legal consequences of showing preference for certain employees in terms of fringe benefits.

Favoring key employees can lead to organizations failing nondiscrimination testing and being subject to fines.

If you offer a defined contribution plan, such as a 401(k) or health reimbursement arrangement (HRA), you need to ensure your benefits plan isn’t top-heavy. According to the IRS⁶, a plan is top-heavy when the aggregate value (AV) of the key employees’ accounts exceeds 60% of the overall AV.

To avoid legal issues, employers should strive to create a fair and equitable benefits package that applies to all employees, regardless of their level of responsibility or authority within the company.

Employee benefits that work for everyone

Year after year, the most sought-after employee benefit remains the same: healthcare coverage. PeopleKeep's 2022 Employee Benefits Survey Report shows that 87% of employees value health benefits, such as health insurance.

But with the rising cost of health plans, it's hard for many employers to offer one. According to KFF⁶, the average annual cost of employer-sponsored health benefit premiums per employee was $23,968 for family coverage and $8,435 for single coverage in 2023. On top of that, traditional group health insurance plans throw all your employees in the same basket. There's no personalization. A group plan also comes with steep participation requirements and annual rate hikes.

If you want to offer an affordable, personalized health benefit, a health reimbursement arrangement (HRA) is the perfect choice for your team. An HRA is an IRS-approved, employer-funded health benefit. With an HRA, employers can reimburse employees tax-free for more than 200 eligible medical expenses, including their individual health insurance premiums. This cost-effective option allows employers to reimburse employees for their healthcare coverage instead of providing it for them.

Two of the most popular HRAs include:

• The qualified small employer HRA (QSEHRA): The QSEHRA is for small businesses with fewer than 50 full-time equivalent employees. It works for all W-2 employees regardless of their insurance status. With a QSEHRA, employers can reimburse employees for monthly premium payments, out-of-pocket costs, or both.
• The individual coverage HRA (ICHRA): The ICHRA works for businesses of all sizes. Eligible employees must have their own health insurance coverage to participate in this benefit. With an ICHRA, employers can reimburse employees for qualifying individual health insurance premiums, out-of-pocket costs, or both.

Business owners can also offer different allowance amounts to different workers based on their employee class. With the ICHRA, employers can use up to 11 different employee classes to categorize employees into groups, such as salaried employees and hourly employees. The ICHRA allows employers to legally offer a salaried employee more than an hourly employee if they choose to do so. But, all employees within the same class of employees must receive the same allowance amount. When employers utilize this feature with an ICHRA, it's easier to personalize benefits. This level of customization can help your organization attract and retain key employees.

However, if all your key employees fit a specific employee class, you’ll need to ensure you follow nondiscrimination rules to avoid your benefit becoming top-heavy.

Special benefits for key employees

Employers can offer key employees additional benefits or incentives to ensure their loyalty and commitment to the company. For example, you can reward a key employee for achieving a certain goal, reaching a milestone, or completing a difficult project.

While raises and promotions are always well-received, there are a variety of options when it comes to rewarding your hard-working employees:

• Monetary incentives: This is the most common form of reward. Employers can offer cash rewards, one-time spot bonuses, or gift cards to their best and brightest workers. They can also offer stock options or profit-sharing bonuses.
• Non-monetary rewards: Employers can offer additional paid time off (PTO), flexible schedules, or paid leave for volunteering.
• Employee stipends: Employers can also offer employee stipends. A stipend is a set amount of money given to employees for a specific reason. Employers can offer this additional compensation for employees to use on things like food, travel, or professional development. Companies often invest in professional development to help key employees grow and expand their skills, ultimately benefiting the company in the long run.
• Personalized gifts: Employers can give their talented employees plenty of company swag, such as personalized hats, jackets, laptop cases, umbrellas, and mugs.

If employers do wish to offer special benefits to key employees, they must do so in a transparent and non-discriminatory manner. Any special perks or privileges should be based on objective criteria, such as performance metrics, rather than personal favoritism.

Protect your investment with key person insurance

Along with health insurance, employers may want to consider key person insurance⁷, also known as key employee insurance. Key person insurance is a policy a company buys on the life of a key individual, such as a top executive, within the company. The company is the beneficiary and responsible for paying premiums.

If the key person covered by the life insurance policy dies, the company receives the death benefit. The organization can then use the money to recruit, hire, and train a replacement. The money from a key person insurance policy can also go toward closing down a business. Employers can pay off debts, distribute money to investors, or provide severance benefits to affected employees.

Key person disability insurance⁸ works similarly. A key person disability policy provides financial support to a business if a key employee becomes disabled. If the key employee is unable to work, the policy will cover lost revenue, the costs of hiring a replacement, and other related expenses not covered by standard disability insurance.

Keep in mind, if you want to take any type of policy out on a key employee, you must receive their consent first.

Conclusion

While key employees play a vital role in the success of a company, employers need to be mindful of the legal implications of favoring them when it comes to benefits. By maintaining fairness and consistency in the way benefits are distributed, employers can avoid potential legal issues and create a positive work environment for all employees.

Ready to offer an HRA that's tailored to your team? Schedule a call with a personalized benefits advisor now to get started!

1. https://www.law.cornell.edu/definitions/uscode.php?width=840&height=800&iframe=true&def_id=26-USC-1004659535-204952971&term_occur=999&term_src=
2. https://www.irs.gov/charities-non-profits/exempt-organization-annual-reporting-requirements-key-employee-compensation-reporting-on-form-990-part-vii
3. https://www.irs.gov/retirement-plans/is-my-401k-top-heavy
4. https://www.irs.gov/pub/irs-pdf/p15b.pdf
5. https://webapps.dol.gov/elaws/whd/fmla/9e4.aspx#:~:text=Under%20certain%20circumstances%2C%20an%20employer,miles%20of%20the%20employee's%20worksite.
6. https://www.irs.gov/retirement-plans/fixing-common-plan-mistakes-top-heavy-errors-in-defined-contribution-plans
7. https://www.investopedia.com/terms/k/keypersoninsurance.asp
8. https://www.iii.org/article/insuring-against-the-loss-of-key-personnel