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    Controlled Group Rules: Yours...Mine...Ours?

    In other articles, we have gone to great lengths to explain the importance of determining who the "employer" is for employee benefit purposes (see links right: The Aggregation of Employers and Employees . . . What You Don't Know Can Hurt You; The Aggregation of Employers And Employees... Controlled Groups; The Aggregation of Employers And Employees . . . Affiliated Service Groups; and The Aggregation of Employers And Employees . . . Leased Employees). This determination is extremely important for a number of employee benefit plan purposes. For example, unless you can accurately determine who the employer is for employee benefit plan purposes, you do not know which group of employees needs to be tested for purposes of satisfying the minimum coverage and participation rules for qualified retirement plans, whether your cafeteria plan is discriminatory, or whether you are an "applicable large employer" for purposes of health care reform's "play or pay" penalty.

    The purpose of this article is to alert our readers to a couple of situations which can be real "gotchas" for employee benefits advisors and their clients. For example, did you know that a married couple who each has their own business could be required to aggregate their qualified retirement plans for testing purposes? Or, that parents of a child under age 21 who each has their own business could be required to aggregate their plans for testing, even if the couple isn't married?

    Honey, Guess What I Learned Today?

    Mike is a newly self-employed computer engineer who left the giant FaceSpace to start his own app design firm. Mike considers himself quite lucky because his small operation does not require him to have any other employees that he has to worry about or take care of. Instead, he can focus all of his time and creative energy marketing his latest app, TaxJet, which scans in your Form W2, annual receipts and other information and submits your taxes to the IRS in under a minute. In fact, Mike's work has been so much in demand of late that he expects his net earnings for 2013 to top $255,000. Mike figures that he really doesn't need to pay Uncle Sam so much in the way of taxes and decides to set aside some of his earnings in a retirement plan.

    Mike visits his regular stockbroker, Chuck Squab, and asks for help establishing a simple retirement program so that he can shelter part of his 2013 earnings. Chuck meets with Mike and asks him the usual questions about his earnings level, the name and address of his business, and whether Mike has any employees that need to be covered under the retirement plan. Satisfied that Mike is a stand-alone, sole proprietor, Chuck suggests that Mike follow the "keep it simple stupid" approach by adopting a 25% of compensation money purchase pension plan which provides for immediate eligibility and 100% immediate vesting. Mike likes Chuck's direct approach and tells Chuck to go ahead and get things rolling as soon as possible.

    By December 15, Chuck has provided Mike with all of the necessary documents to establish the agreed-upon retirement program for 2013. Mike, true to his word, deposits $51,000 (the maximum allowable amount) on December 24, 2013, well before he is required to make his 2013 contribution. On Christmas Eve, he goes home to his lovely wife Jacqueline and their three kids.

    Jacqueline is herself a busy professional. She is an up-and-coming family law specialist who regularly handles high profile divorce cases. Jacqueline's law practice is operated by a professional corporation of which Jacqueline is the sole shareholder, board member and officer. In addition to herself, Jacqueline's professional corporation has three full-time employees. She starts her practice in 2013 and, only three years later, she is particularly pleased that she will be able to draw in excess of $255,000 in salary from the corporation that year. Her accountant, Max, tells her that she should seriously consider establishing a retirement plan for herself as well as for any of her eligible employees. At Max's suggestion, Jacqueline visits local pension consultant Pension & Such (P&S) for advice on establishing a retirement plan or plans in her professional corporation. P&S president Elaine asks Jacqueline numerous questions concerning her professional corporation, its employees, her other business holdings and the nature of her husband's employment and business activities. After Elaine learns that Jacqueline's husband Mike has already established his own retirement plan, Elaine excuses herself to make a quick phone call to her employee benefits counsel. Elaine asks the attorney whether there is a problem in allowing Jacqueline to set up her own retirement plans which are separate from the retirement plan established three years earlier by Mike.

    In his usual efficient and straightforward manner, the benefits attorney tells Elaine that there might be problem and that he will look into it and get back to her. He is also aware of the possibility that the independent businesses of spouses can be aggregated under the controlled group rules because the ownership attribution rules will generally treat an individual as owning his or her spouse's interest in a business. The attorney is also familiar with the exception to the spousal attribution rule which provides that a non-owner spouse will not be treated as owning an interest in the other spouse's business for a particular taxable year, if:

    • The nonowner spouse does not own any interest in the owner spouse's business directly at any time during the year;
    • The nonowner spouse is not a director, officer, fiduciary or an employee of the other spouse's business and does not participate in the management of the business at any time during the year;
    • No more than 50% of the business' gross income for the year is derived from royalties, rents, dividends, interest, and annuities; and
    • The owner spouse's interest in the business is not, at any time during the year, subject to conditions that (a) substantially restrict or limit the owner spouse's right to dispose of such interest, and (b) run in favor of the nonowner spouse or the nonowner spouse's children under the age of 21.

    In light of the questions raised by Elaine, the attorney decides to do additional research. As we have mentioned in other articles on controlled groups (see links right, The Aggregation of Employers And Employees...Controlled Groups), the IRS has applied state community property laws to the determination of whether a controlled group exists in at least one non benefit plan case. Unfortunately, the attorney is unable to find any employee benefit cases dealing with the aggregation of spouses' businesses in community property states. Fortunately, he is thorough and discusses the issue with a number of IRS officials both at the Los Angeles Key District Office and at the IRS National Office. The attorney is somewhat surprised to learn that the prevailing opinion of the IRS (albeit an informal opinion) is that the two independent, but community property, businesses of Mike and Jacqueline would indeed be aggregated under the controlled group rules and would not fit within the independent business exception because each spouse in a community property state is generally treated as owning an undivided interest in the other spouse's businesses. As a result, it would seem that the exception for an independent spousal business would never apply in a community property state where the businesses in question were the community rather than separate property of each owner spouse. Jacqueline learned from Elaine that this meant that she would have to take into account not only herself and her professional corporation's employees, but also Mike (and any employees he may hire) in the process of designing her business' retirement plans. She was grateful to have received this information before she established her retirement plans, rather than later. Being a regular reader of See The Benefits, Elaine was able to explain that this did not necessarily mean that Jacqueline's plans would have to cover Mike, but rather that he would have to be included in her plans' minimum coverage and participation testing.

    Unfortunately for Mike, his retirement plan should have taken into account Jacqueline's professional corporation and all of its employees. In fact, because Mike's plan was a "standardized prototype plan," the plan document required that his plan automatically cover all of the eligible employees of Mike's business as well as any employees of other employers required to be aggregated with Mike's business under Code sections 414(b), (c) and (m) (the rules that define controlled groups of corporations, businesses under common control, and affiliated service groups). This means that Mike's plan, unbeknownst to him, should have been making contributions on behalf of Jacqueline and each of her employees from the inception of Jacqueline's law firm.

    Obviously, this is not what Mike had in mind when he went to Chuck to establish a retirement plan. This appears to be one of those situations where the special laws applicable to community property states can and do interact with the qualification rules for retirement plans (and welfare plans) to yield a different result for community property businesses (that is aggregation) than would occur in a separate property state. If you don't think this is fair, write your Senator and Representative.

    There Are Times When I Wish We Hadn't Had Kids!

    By the way, while you are writing your elected representatives, you might also want to point out another apparent trap for the unwary (and the wary) which has to do with the attribution rules as they apply to children under age 21. Under the controlled group attribution rules, a parent is treated as owning the interests owned by the parent's children who are under age 21. Further, each child under age 21 is treated as owning his or her parent's interest in a business. A literal application of this rule results in a finding that, even in separate property states, the separate businesses of each parent would still be aggregated and treated as a controlled group. This is because the attribution rules attribute the 100% ownership of each parent's separate business to his or her child who is under age 21 and the controlled group rules treat that child's ownership of a parent's business as a controlled group with the business of the other nonowner parent. How's that for justice?! If you really want to add insult to injury, consider what happens if there is marital discord and the spouses divorce. Even after the parents divorce, the attribution rules to and from their children under age 21 still seem to apply and would appear to aggregate the separate businesses of the ex-spouses! For that matter, this overbroad rule of aggregation would also apply even where the child's parents were never married.

    Once again, here is a good reason to go talk to your Senator and Representative because these rules, like the rules relating to the spousal exception discussed above, were made by Congress and are not subject to change by the IRS. It seems to us that to clarify or change the application of these rules, Congress will have to change the law.

    What To Do?

    As you can see, it is one thing to know something about the general rules pertaining to the aggregation of businesses for employee benefit purposes. Certainly, it is another thing to understand how these rules can be affected by other laws and rules, such as community property laws. This type of interaction and the sometimes startling results are what make practicing employee benefits interesting.

    If you are in a community property state, and you and your spouse each operate independent and "separate" businesses, we strongly recommend that you explain these circumstances to your pension and other employee benefit plan advisors and obtain written advice from them regarding the application of these rules.

    As we have advised many clients in the past, when you are in doubt as to the application of these rules, it probably does not hurt to disclose the situation to the IRS and obtain a favorable determination letter from the IRS which reviews and covers your situation.