You may inadvertently put your 401(k) plan at risk if your company structure includes businesses that have common ownership and not all employees of all the businesses are given the same opportunity to participate in the plan. Under the tax code, businesses that are under common control may constitute a “controlled group.” All of the employees of the businesses that make up a controlled group are treated as being employed by a single employer. For example, you should be careful when setting up or acquiring a new venture – you may inadvertently create a controlled group that must be tested together.
Why does this matter? 401(k) and other employee benefit plans must be tested to ensure they cover a significant portion of employees and that benefits are not provided in a discriminatory manner. If a business is part of a controlled group and has a 401(k) plan that covers only the employees of that business, and not all businesses in the group, the plan may not pass the applicable coverage or nondiscrimination tests that apply to retirement plans. Failing these tests may lead to disqualification of the plan (and loss of tax benefits), and at the least, to costly correction programs.
The controlled group rules were established to discourage business owners from separating highly compensated employees and nonhighly compensated employees into separate companies with substantially different retirement benefits – with the highly compensated employees typically receiving much higher benefits. Congress enacted the controlled group rules to address these discriminatory arrangements. The rules do not cover just intentionally discriminatory plans; they cover all plans in a controlled group.
What is a controlled group? Businesses, such as corporations, limited liability companies, partnerships, and sole proprietorships, all have owners of some type. In situations where one business owns another, or where multiple businesses have common owners, the businesses may be a controlled group. In general, if the common ownership interests exceed 80% of the stock, LLC membership interests, or partnership interests, the group will be a controlled group that must be tested on a combined basis. Ownership of interests may be attributed among family members, trusts, and other groups. The rules for determining controlled group status can be complicated, but any significant ownership among businesses should be reviewed for this issue.
Does combined testing affect other groups of businesses? In addition to controlled groups of businesses, the tax code combines “affiliated service groups” for testing. These groups, or ASGs, are formed when affiliated businesses have a service provider relationship between them. The ASG rules are quite complicated, but affect only businesses that provide services.
What types of testing must be done on a controlled group or ASG basis? Retirement plans, some health plans, and cafeteria plans must be tested on an employee-wide basis across the controlled group or ASG. If a plan is not offered to enough employees, or if combined testing shows that benefits are discriminatory in favor of highly compensated employees, the businesses can incur significant tax and administrative costs to resolve the problem.
It is critical for you to know whether your business is part of a controlled group of businesses or an affiliated service group and to discuss your plan with a knowledgeable benefits attorney to ensure your plans retain their tax advantages.