By Kris Tower
Scott is a 59-year-old business owner with a metal machining factory. He also co-owns a small outfitter company with his oldest son and they have a growing team of eight guides and three office personnel. He already offers a 401(k) plan as part of his employee benefits package to his factory workers, but he's considering a different 401(k) for his smaller team with the outfitter company. Scott's wife, Lori, owns a new startup looking to offer a 401(k) plan to their team of 12.
In the above scenario, Scott and Lori are facing the dilemma of "attribution of ownership," even though they may not realize it yet. Qualified retirement plans, such as 401(k) and IRA plans, are forbidden from discriminating in favor of highly compensated employees (HCE). A highly compensated employee is classified as either:
- A business owner in the company who holds greater than 5% interest during the current plan year or the preceding year, or
- An employee with an annual compensation of $120,000 or more from the preceding year.
In Scott and Lori's case, they both qualify as highly compensated employees. What's more important is that because they're married, they are given "attribution of ownership" for each other's companies, regardless of their personal tax filing status.
What is attribution of ownership and who does it affect?
The Internal Revenue Code Section 318(a)(1) expressly states:
"In general an individual shall be considered as owning the stock owned, directly or indirectly, by or for -- (i) his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and (ii) his children, grandchildren, and parents." (Cornell Law School, March 2019)
Translation: a business owner whose spouse owns another company is legally treated as if they equally own their spouse's company. The challenge is when the attribution of ownership translates to offering qualified retirement plans as a plan sponsor.
Using the earlier example of Scott and Lori, since Scott offers his metal machining factory workers a 401(k) plan, he is legally obligated to offer the same 401(k) plan to the team members of his outfitter company. Even further, since Scott and Lori are married, Lori may also be legally obligated to offer the same 401(k) plan to the employees at her startup. While it's not guaranteed Lori has to offer the same plan to her employees or any plan at all, it's wise to consider the possibility and undergo testing for the purpose of determining attribution of ownership.
And, yes, attribution of ownership applies to a number of familial relationship connections as you saw earlier in the excerpt from the Internal Revenue Code 318. An individual's spouse, children, and grandchildren are all attributed ownership of the individual's company. In the case of Scott and Lori, their children have attribution of ownership of Scott and Lori's companies.
A parent is attributed ownership of their child's company until the child turns age 21. With Scott and Lori, if any of their children start a company, Scott and Lori are both attributed ownership of their children's company until the child turns age 21. For adult children, the attribution of ownership is only applicable if the individual owns more than 50% the business owned by their adult children or grandchildren.
It's important to note the attribution of ownership is not synonymous with actual ownership of stock. Attribution of ownership is simply used as lines of connection to follow during nondiscrimination testing of qualified retirement plans in favor of highly compensated employees. The key to determining attribution of ownership is to gather census data with ownership details for each business. It's wise to have a third-party administrator oversee the determination and then design and test the proposed plan in light of the determination.
Are there exceptions to attribution of ownership for entrepreneurs?
There are some exceptions to the attribution of ownership requirements, a few of which are previously detailed. The first and most common exception to the attribution of ownership is in the matter of divorce. If a married couple gets divorced, there is still the legal obligation of attribution of ownership for each spouse until the end of the calendar year when the divorce is finalized.
Attribution of ownership for each spouse doesn't necessarily end at the start of the calendar year following the divorce finalization. There are some qualified retirement plans that determine attribution of ownership based on ownership for the current calendar year and the preceding calendar year. Even if a divorce is finalized, attribution of ownership may still be assigned for certain determinations until the end of the calendar year following the calendar year when the divorce is finalized. For example, if Scott and Lori got a divorce in 2019, they would both be wise to consider themselves under attribution of ownership for each other's companies through the end of 2020.
Attribution of ownership still applies for couples who are estranged but not yet legally separated or are in the process of a divorce yet to be finalized. It's a good idea to not make changes to employee compensation until divorce proceedings or legal separation are finalized.
Is attribution of ownership applicable for same-gender married couples?
Yes. The Internal Revenue Service issued Revenue Ruling 2013-17 in August 2013 recognizing same-gender marriages for tax administration purposes regardless of whether the married couple's current state of residence and/or employment allows same-gender marriage.
How does attribution of ownership affect which qualified retirement plan you may choose?
This is the crux of the conversation: What impact, if any, does attribution of ownership make on being a plan sponsor? For any business owner who wants to offer a qualified retirement plan, such as a 401(k) or IRA, the principle we want to focus on is nondiscrimination against rank-and-file employees, such as Scott's factory workers in our example. While Scott already offers a 401(k) plan for his factory workers, there's a chance he may consider a different qualified retirement plan for his outfitter company employees.
The problem is Scott is legally obligated to offer the same qualified retirement plan to all of the employees under his ownership control. Because he also co-owns the outfitter company with his son, even though his son is an adult, the attribute of ownership still applies for both Scott and his son because of their joint ownership and the existing qualified retirement plan for the factory.
This also means that Lori's choice of qualified retirement plans is limited to the existing plan Scott offers to his factory workers. There is an opportunity to find a different qualified retirement plan to offer to employees in all of their companies, but there is often a significant transition process and increased exposure and liability to consider as plan sponsors.
What do you need to know about highly compensated employees, key employees, and qualified retirement plans?
For nondiscrimination testing, the key term is "top-heavy qualified retirement plan" or "top-heavy contribution plan," meaning the accounts of key employees, including highly compensated employees, equal 60% or more of the plan benefits. A key employee is defined as either:
"An officer of the business sponsoring the retirement plan earning more than $180,000 (adjusted for inflation);
A 5% owner (owns more than 5%);
Or, a 1% owner (owns more than 1%) who earns more than $150,000 for the plan year." (IRS, May 2019)
Many family-owned businesses feature multiple family members as key employees. If any key employee experiences a contribution or deferral on their behalf, then minimum contributions must be made to non-key employee plan participants. It's important to also note family attribution does not apply when employee earnings are the sole determination of whether someone qualifies as a highly compensated employee or key employee.
What if my company is a holding company for other companies that offer qualified retirement plans?
Internal Revenue Code Section 1563(a) offers further explanation and latitude for attribution of ownership when it comes to controlled groups of corporations. (Cornell Law School, March 2019) The technicalities of the attribution of ownership between companies vary according to business entity structure, such as LLC, S Corp, C Corp, and so forth. Under Internal Revenue Code 318, anything owned by a C Corporation is automatically attributed to any individual with a minimum of 50% ownership. The determination of ownership value includes any ownership stake by the individual's spouse.
On the other end of the equation, an individual's attribution of ownership is not applied to a corporation. As an example, Scott's ownership of his metal machining company gives him attribution of ownership, but the metal machining company does not have ownership over any of Scott's other businesses, such as his outfitter company or Lori's startup.
What's the best step for determining attribution of ownership?
If you're considering offering qualified retirement plans to your employees as a plan sponsor, it's wise to do your due diligence to determine your likely attribution of ownership. A trusted financial professional can help you consider your options and responsibilities that may come as a highly compensated employee or key employee who may influence the 60% threshold, to prevent inadvertent discrimination for your qualified financial plan. At the end of the day, it's wise to consider how your offer to compensate and facilitate your employees in their investment future is a true win-win for all involved.
About the author: Kris Tower is a managing director of American Portfolios Financial Services, a Certified Financial Planner, a Certified Plan Fiduciary Advisor, and an Accredited Investment Fiduciary. He is the president of the Colorado Financial Planning Association. He also serves on the Financial Industry Advisory Committee to the Colorado Securities Commissioner. Securities offered through American Portfolios Financial Services, Inc., Member: FINRA, SIPC. Advisory services offered through Novem Group, an SEC-Registered Investment Adviser, which is not affiliated with American Portfolios Financial Services, Inc.