Key Employee Concentration Test
Published: October 20, 2026 · Last reviewed: October 20, 2026 · Est. reading time 10 minutes
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In plain language: The key employee concentration test checks whether a company's owners and top officers get too large a share of the tax-free benefits in its cafeteria plan. If they get more than 25 percent of the total, those key employees lose the tax break for that year. Other employees keep theirs.
Technical definition: The key employee concentration test is the Internal Revenue Code Section 125(b)(2) rule. A cafeteria plan fails for a plan year when qualified benefits provided to key employees, as defined in Section 416(i)(1), exceed 25 percent of the qualified benefits provided to all employees under the plan.
Key Employee Concentration Test at a Glance
The table below summarizes the core attributes of the key employee concentration test for quick reference.
| Attribute | Detail |
|---|---|
| Also known as | Key employee test, 25 percent concentration test, Section 125(b)(2) test |
| Category | Cafeteria plan nondiscrimination test |
| Lines of business | Employee benefits, group health premium conversion |
| Industries most affected | Professional practices, family-owned businesses, closely held companies |
| Related forms or endorsements | IRC Section 125(b)(2), IRC Section 416(i)(1), Proposed Treas. Reg. 1.125-7 |
| Who bears the risk | Key employees, who lose the tax exclusion when the plan fails |
| Common solution | Annual testing, plan limits on key employee elections, or a simple cafeteria plan |
| Also interacts with | Eligibility test, contributions and benefits test, premium-only plan |
Key Takeaways
- The key employee concentration test fails a cafeteria plan year when key employees receive more than 25 percent of all qualified benefits under the plan.
- The test matters in agency work because a small employer with high-earning owners and few other participants can fail it easily.
- A common misunderstanding is that a failed test makes the whole plan taxable, when only the key employees lose the tax exclusion.
- Agencies help clients avoid surprises when they ask the plan administrator to run the test before the plan year ends.
What Is the Key Employee Concentration Test in Insurance?
The key employee concentration test is one of the nondiscrimination rules that a cafeteria plan must pass for its tax benefits to work as intended. A cafeteria plan lets employees choose between cash and qualified benefits, such as health premiums or flexible spending accounts, on a pre-tax basis. The test stops a plan from serving mainly as a tax shelter for owners and top officers.
Congress added the rule in Section 125(b)(2). Key employee has the meaning in Section 416(i)(1): certain officers paid above an indexed threshold, 5 percent owners, and 1 percent owners paid more than $150,000. The 2007 proposed regulations look at whether a participant was a key employee at any time during the preceding plan year. Testing takes place as of the last day of the plan year.
The consequence of a failure falls only on key employees. Under the proposed regulations, each key employee must include in income the maximum taxable benefit that the employee could have elected for that plan year. Non-key employees keep their tax-free treatment.
Consider a firm with two key employees and four other employees. Each person elects $2,000 of qualified benefits, for a total of $12,000. The key employees receive $4,000, or 33 percent of the total. Because 33 percent is more than 25 percent, the plan fails the test for that year.
How Does the Key Employee Concentration Test Work?
- The plan year. Employees elect qualified benefits through the cafeteria plan, such as health premiums, a health flexible spending account, or dependent care.
- The identification. The plan administrator identifies the key employees under Section 416(i)(1), using status from the preceding plan year.
- The calculation. On the last day of the plan year, the administrator divides the qualified benefits that key employees received by the qualified benefits that all employees received.
- The result. A share of 25 percent or less passes, and a share above 25 percent fails.
- The tax outcome. After a failure, key employees include the affected amounts in income for the year in which the plan year ends, and other employees keep the exclusion.
Claim Examples Involving Key Employee Concentration Test
Family-owned manufacturer with large owner elections
A family-owned manufacturer organized as a C corporation had three owner-officers who were key employees. The owners elected $45,000 of qualified benefits, mostly family medical premiums and dependent care. Together, the other 22 employees elected $105,000. The owners received 30 percent of all qualified benefits, so the plan failed. Each owner had to include in income the maximum taxable benefit the owner could have elected for that plan year.
Premium-only plan that relies on the safe harbor
A 15-employee insurance agency offered a premium-only plan that let every employee pay health premiums with pre-tax dollars. The plan satisfied the safe harbor percentage test for eligibility. Under the 2007 proposed regulations, a premium-only plan that meets that test is deemed to satisfy the nondiscrimination rules, including the key employee concentration test. The agency kept the testing records with its plan documents.
Mid-year test catches a likely failure
A medical practice asked its third-party administrator to run a projected test in July. The projection showed key employees at 27 percent of qualified benefits, mostly from large dependent care elections. The plan document allowed the administrator to limit key employee elections to keep the plan in compliance. After the reduction, the final year-end test came in under 25 percent.
Key Employee Concentration Test vs. Contributions and Benefits Test: What Is the Difference?
The key employee concentration test and the contributions and benefits test are both cafeteria plan nondiscrimination rules, but they look at different groups. The table below compares the concentration test, which caps the key employee share, with the contributions and benefits test, which checks whether the plan favors highly compensated participants.
| Comparison area | Key Employee Concentration Test | Contributions and Benefits Test |
|---|---|---|
| Primary use case | Limiting the share of qualified benefits that key employees receive | Making sure benefits and contributions do not favor highly compensated participants |
| Coverage / concept type | Fixed 25 percent concentration limit | Comparison of benefits available and elected by each group |
| Typical exclusions | Employees who are not key employees under Section 416(i)(1) | Participants who are not highly compensated |
| Who is most affected by errors | Owners and top officers | Highly compensated participants |
| Common mistakes | Assuming a small plan cannot fail | Confusing highly compensated employees with key employees |
What Are the Most Common Mistakes With Key Employee Concentration Test?
- Assuming a small cafeteria plan is exempt from testing, when only plans that meet a safe harbor, such as a qualifying simple cafeteria plan, get relief.
- Using the wrong definition and treating every highly compensated employee as a key employee, which produces an incorrect test result.
- Counting sole proprietors, partners, or 2 percent shareholders of an S corporation as participants, when they cannot participate in a cafeteria plan.
- Waiting until after the plan year ends to test, which leaves no time to limit key employee elections under the plan terms.
- Failing to report the taxable amounts for key employees after a failed test, which creates payroll tax and reporting problems.
How to Explain Key Employee Concentration Test to a Client
Explaining Key Employee Concentration Test to a personal lines client
Personal lines clients rarely deal with this test, but it can affect a business owner's paycheck. The test checks whether owners and top officers get too much of the tax-free benefits in a company's cafeteria plan. If they do, their benefits become taxable for that year, while other employees keep the tax break.
Explaining Key Employee Concentration Test to a small business owner
Your cafeteria plan has to pass a test that limits how much of its tax-free benefits go to owners and officers. If key employees get more than 25 percent of the total, you and your key staff lose the tax break for that year. We recommend that your plan administrator run the test before year end, so there is still time to adjust.
Explaining Key Employee Concentration Test to a CFO or risk manager
The Section 125(b)(2) test caps qualified benefits to key employees at 25 percent of the plan total, measured as of the last day of the plan year. A failure shifts tax liability to key employees only, but it still creates payroll correction work and an unhappy leadership team. We should review plan design, election limits, and safe harbor options each year against your census data.
Frequently Asked Questions About Key Employee Concentration Test
Who counts as a key employee for this test?
A key employee is a participant who meets the Section 416(i)(1) definition. That group includes officers paid above an IRS threshold that adjusts over time, 5 percent owners, and 1 percent owners paid more than $150,000. The 2007 proposed regulations use key employee status during the preceding plan year.
What happens if a cafeteria plan fails the key employee concentration test?
A failed test does not disqualify the whole plan. Key employees must include the affected benefits in income for the year, while other employees keep their tax-free treatment. The employer must then report the extra taxable income for the key employees.
Does the key employee concentration test apply to a premium-only plan?
A premium-only plan is a cafeteria plan, so the nondiscrimination rules apply to it. Under the 2007 proposed regulations, a premium-only plan that passes the safe harbor percentage test for eligibility is deemed to satisfy the nondiscrimination rules. Plan sponsors should keep records that show the safe harbor was met.
How is the key employee test different from the highly compensated employee tests?
The key employee concentration test uses the key employee group and a fixed 25 percent limit. The eligibility test and the contributions and benefits test look at highly compensated individuals and participants instead. Both groups often overlap, but they are not the same.
Can a small business avoid the key employee concentration test?
An eligible small employer can adopt a simple cafeteria plan under Section 125(j). An employer that averaged 100 or fewer employees during either of the two preceding years can qualify. A simple cafeteria plan that meets its contribution, eligibility, and participation rules is treated as meeting the nondiscrimination requirements.
Do business owners count in the test?
Business owners who are employees of a C corporation can participate and are often key employees. Sole proprietors, partners, and 2 percent shareholders of an S corporation are not employees for Section 125 purposes and cannot participate. Their benefits are therefore not part of the cafeteria plan test.
Sources and References
- Legal Information Institute, Cornell Law School. 26 U.S. Code § 125, Cafeteria plans.
- Legal Information Institute, Cornell Law School. 26 U.S. Code § 416, Special rules for top-heavy plans.
- Federal Register. Employee Benefits; Cafeteria Plans (proposed regulations, 2007).