Can a business or individual adopt a separate Solo 401(k) plan for another entity or business?
One must first determine whether adopting the additional Solo 401(k) would violate the Controlled Group Rules set up by the IRS and Department of Labor.
The Controlled Group Rules were created essentially to protect employees from a business owner or executive establishing a separate 401(k) plan for another business and thereby not offering those employees the benefits inherent in participating in a 401(k) qualified retirement plan.
The IRS and Department of Labor were concerned that business owners wanting to establish a qualified retirement plan, but not wanting the burden of having to provide benefits to all eligible employees, would create a new separate business which would have no employees other than the owner or executive and then adopt a solo 401(k) plan for that company. Since the new company would be wholly owned by the business owner and would not have any full-time employees, the business owner could establish his or her own solo 401(k) plan and, thus, enjoy all the benefits of having a qualified retirement plan without having to provide any benefit to the employees from the other company.
What is a controlled group of corporations?
As per Internal Revenue Code Section 414 , a controlled group is any two or more corporations connected through stock ownership in any of the following ways:
- 80% of stock of each (subsidiary) corporation is owned by another member of the group
- Parent corporation must own 80% of the stock of at least one of the other members of the group
- The rules are subject to the stock attribution rules under Internal Revenue Code Section 318
- The same five or fewer individuals own at least 80% of the stock of the corporations
- “Individual” includes ownership by an estate or trust
- “Ownership” includes having a controlling interest and effective control of the corporations
- The rules are subject to the stock attribution rules under Internal Revenue Code Section 318
- Combination of a Parent-subsidiary and a Brother-sister group
How does one determine who is part of a controlled group?
To determine whether one is part of a controlled group, one must take into account the stock attribution rules. The purpose of the stock attribution rules is to attribute shares, or interest in a company held by certain family members, to the person in question and determine whether that person is part of a controlled group. Internal Revenue Code Section 318 governs the stock attribution rules. Pursuant to Internal Revenue Code Section 318, an individual shall be considered as owning the stock, owned directly or indirectly, by or for –
(i) his/her spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance)
(ii) his/her children, grandchildren, parents
Can the companies in a controlled group be treated as separate companies?
The IRS does have a procedure through which a company can request to be treated as a Separate Line of Business (see IRC §414(r)). The following are limitations for these requests:
- Must have a valid business purpose
- Must have at least 50 employees within each line of business
- Restrictions on HCE ratios in each separate line of business
- Must notify IRS to request their approval
Do all members of a controlled group have to participate in one plan?
No. Members of a controlled group may each have a different plan. Similarly, two or more members of the controlled group may adopt a single plan. In either case, all employees of the controlled group must be taken into account for testing purposes.
For example, if one company is owned by a shareholder with greater than 80% and has no employees, but that same person also has ownership of over 80% in another company with full-time employees, a single plan may be adopted for both companies. However, the adopted plan must provide benefits to the eligible employees from the second company.
In other words, the rules are in place to restrict the owner(s) of a business with full-time employees from establishing a new company with no employees and adopting a Solo 401(k) plan that would exclude the full-time employees from the other company. The IRS and Department of Labor wanted to make sure that all eligible employees of a company that is part of a controlled group receive all available retirement benefits.
Controlled Group Examples
Example 1: Joe owns 90% of Company A that has 3 employees. Joe wants to adopt a qualified retirement plan, but does not want to offer any benefits to his employees. Joe decides he will establish a new company that has no employees and adopt a Solo 401(k) Plan through that new company. Before proceeding, Joe talks with a tax attorney about his idea. Joe’s tax attorney quickly points out that since Joe would own more than 80% of Company A and the newly established company, both companies would be part of a controlled group. This would prohibit Joe from establishing a plan for the new company without offering the employees from Company A the same plan benefits.
Example 2. Joe owns 45% of Company A and Joe’s son, Mike, owns the remaining 55% interest. Company A has 5 full-time employees. Joe and Mike want to establish a 401(k) plan so they make tax-deferred contributions, but don’t want to provide the employees with any plan benefits. Joe and Mike come up with the idea of forming a new company that will have no employees other than themselves and adopt a 401(k) plan through the new company. Joe talks this over with his tax attorney and learns that since Joe and Mike are father and son, under Internal Revenue Code Section 318 they will be treated as owning each other’s shares, giving them each over 80% interest in Company A and, thus, triggering the controlled group rules. Hence, Joe and Mike would be limited from opening a 401(k) plan for the new business and not offering plan benefits to the employees from Company A. Joe and Mike could establish a plan for the new company, but the controlled group rules would require that the plan benefits be provided to all eligible employees from both companies.
Example 3. Joe owns 78% of Company A and Tim, his friend, owns the remaining 22%. Company A has 12 full-time employees. Company A does not have a 401(k) Plan. Tim does some consulting on a part-time basis and wants to establish a new corporation for his consulting business as well as establish a Solo 401(k) plan. Tim speaks with his tax attorney to inquire whether he could adopt a Solo 401(k) plan for his new business without being required to offer benefits to the 12 full-time employees with Company A. Tim’s tax attorney told Tim that because he owns less than 80% of Company A, his new consulting company would not be part of a controlled group and, thus, he would not be required to offer 401(k) benefits from his new company to the Company A employees.
Example 4. Joe and Tim each own 50% of Company A, which has 4 full-time employees. Company A currently offers its employees 401(k) plan benefits. Joe and Tim are each over the age of 59 ½ and are interested in using some of their retirement funds to purchase real estate. Unfortunately, Company A’s retirement plan does not allow for non-traditional investments, such as real estate. Joe and Tim decide to establish a new corporation, which they will each own 50% of and then have that new company adopt a new 401(k) plan. Before proceeding, Joe and Tim decided to speak with their tax attorney to make sure this strategy would work. Joe and Tim’s tax attorney advised them that as the new company will be owned by the both of them, just like Company A, the controlled group rules would be triggered since the same five or fewer individuals own at least 80% of the stock of the two corporations. Thus, Jim and Tim would not be able to adopt a new 401(k) plan without offering the same benefits to the employees from Company A.
Affiliated Service Group
In light of Section 414(b) and (c) which requires that all employees of commonly controlled corporations or trades or businesses be treated as employees of a single corporation or trade or business, some business owners have attempted to circumvent these rules by arranging the ownership of related business entities in an artificial manner.
In order to prevent business owners from adopting a 401(k) plan through a newly established and wholly owned entity, Internal Revenue Code Section 414(m) was enacted. Section 414(m) was enacted to prevent such circumvention by expanding the idea of control to separate, but affiliated, entities. Proposed Treas. Reg. § 1.414(m) provides that all employees of the members of an affiliated service group shall be treated as if a single employer employed them.
What is an Affiliated Service Group?
An affiliated service group is one type of group of related employers and refers to two or more organizations that have a service relationship and, in some cases, an ownership relationship, described in IRC section 414(m). An affiliated service group can fall into one of three categories:
1. A-Organization groups (referred to as “A-Org”), consists of an organization designated as a First Service Organization (FSO) and at least one “A organization”,
2. B-Organization groups (referred to as “B-Org”), consists of a FSO and at least one “B organization”, or
3. Management groups.
First Service Organization
A First Service Organization (“FSO”) must be a “service organization”. Performance of services is the principal business of the organization as defined in section 414(m)(3), and Proposed Treas. Reg. § 1.414(m)-2(f) .
An “A” Organization refers to a corporation, partnership, or other organization. To be an A-Org, an organization must satisfy a two-part test:
1. Ownership Test: The organization is a partner or shareholder in the FSO (regardless of the percentage interest it owns in the FSO) determined by applying the constructive ownership rules as specified in section 318(a), and
2. Working Relationship Test: The organization “regularly performs services for the FSO,” or is “regularly associated with the FSO in performing services for third parties. Facts and circumstances are used to determine if a working relationship exists.
To be a B-Org, the organization must meet the following requirements:
1. A significant portion of its business must be the performance of services for a FSO, for one or more A-Org’s determined with respect to the FSO, or for both,
2. The services must be of a type historically performed by employees in the service field of the FSO or the A-Org’s, and
3. Ten percent or more of the interests in the organization must be held, in the aggregate, by persons who are highly-compensated employees (pursuant to IRC § 414(q)) of the FSO or A-Org.
Note – An A or B-Org need not be a service organization.
What is Considered Performance of Services?
The principal business of an organization will be considered the performance of services if capital is not a material income-producing factor for the organization, even though the organization is not engaged in a field listed in Proposed Treas. Reg. § 1.414-(m)-2(f)(2) .
Whether capital is a material income-producing factor must be determined by reference to all the facts and circumstances of each case. In general, capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business as reflected, for example, by a substantial investment in inventories, plant, machinery or other equipment.
Capital is a material income-producing factor for banks and similar institutions. Capital is not a material income-producing factor if the gross income of the business consists principally of fees, commissions or other compensation for personal services performed by an individual.
Regardless of whether the above subparagraph applies, an organization engaged in any one or more of the following fields is a service organization:
- Actuarial science
- Performing arts
An organization will not be considered as performing services merely because:
- It is engaged in the manufacture or sale of equipment or supplies used in the above fields,
- It is engaged in performing research or publishing in the above fields,
- An employee provides one of the enumerated services to the organization or other employees of the organization, unless the organization is also engaged in the performance of the same services for third parties
Affiliated Service Group Examples
Example 1: Bob Brown, a doctor, is incorporated as Bob Brown, P.C. and this professional corporation is a partner in the Jones Surgical Group. Bob Brown and Bob Brown, P.C., are regularly associated with the Jones Surgical Group in performing services for third parties. The Jones Surgical Group is an FSO. Bob Brown, P.C. is an A-Org because it is a partner in the medical group and is regularly associated with the Jones Surgical Group to perform services for third parties. Thus, Bob Brown, P.C. and the Jones Surgical Group would constitute an affiliated service group. As a result, the employees of Bob Brown, P.C. and the Jones Surgical Group must be aggregated and treated as if they were employed by a single employer per section 414(m).
Example 2: The Ewing, Frank and Gold Partnership is a law partnership with offices in numerous cities. EFG, of New City P.C., is a corporation that is a partner in the law firm. EFG, of New City P.C. provides paralegal and administrative services for the attorneys in the law firm. All of the employees of the corporation work directly for the corporation, and none of them work directly for any of the other offices of the law firm.
The law firm is an FSO. The corporation is an A-Org because it is a partner in the FSO and is regularly associated with the law firm in performing services for third parties.
The corporation and the partnership would together constitute an affiliated service group. Therefore, the employees of EFG of New City, P.C. and the employees of The Ewing, Frank, and Gold Partnership must be aggregated and treated as if they were employed as a single employer per section 414(m).
Example 3: Richards & Associates is a financial services organization that has 11 partners. Each partner of Richards owns one percent of the stock in Ames Corporation. Ames provides services to the partnership of a type historically performed by employees in the financial services field. A significant portion of the business of Ames consists of providing services to Richards. Considering Richards as an FSO, the Ames Corporation is a B-Org because:
1. A significant portion of its business is in the performance of services for the partnership of a type historically performed by employees in the financial services field. and,
2. More than 10% of the interests in the Ames Corporation is held, in the aggregate, by the highly-compensated employees of the FSO (consisting of the 11 common owners of Richards and Associates). Accordingly, the Ames Corporation & Richards and Associates constitute an affiliated service group. Therefore, the employees of the Ames Corporations and Richards and Associates must be aggregated and treated as if they were employed by a single employer per section 414(m).
Example 4: Douglas Properties, Inc. sells land that it has purchased and developed. Curt is a 25% shareholder of Douglas and a 50% shareholder of Curt and Son Construction Company, Inc. Douglas Properties regularly engages the services of Curt and Son. Although it appears that Douglas Properties could be an FSO, the affiliated service group rules do not apply because Douglas Properties is not a service organization.
The Broad Scope of the Affiliated Service Group Rules & The Solo 401(k) Plan
The affiliated service group rules are extremely broad and can trigger the controlled group rules in many unexpected cases. For this reason it is extremely important to work with a trained tax and ERISA professionals to determine whether the affiliated service group rules would trigger the controlled group rules and, hence, prevent the adoption of a solo 401(k) Plan or activate the need to offer plan benefits to certain employees. In other words, if the affiliated service rules are violated, the controlled group rules would apply and can prevent a business owner from adopting a solo 401(k) Plan due to employees from an affiliated owned company.