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starting an owner only 401(k) plan after reclassifying the only employee


ldr

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Good afternoon to all,

A prospect, a doctor, has one employee who is currently paid W-2 wages.  He wants to terminate her as a W-2 employee and then engage her as a 1099-R independent contractor.  After all that is done, the next month he wants to start up an owner-only type of 401(k) plan that covers only himself and his wife, who he will bring onto the payroll.

Do you see issues with this?  We feel like it's a very aggressive posture to take but not necessarily an illegal one.

Your advice is always appreciated.

 

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I going to guess that the independent contractor is really still an employee. But if the employee really is an IC then you can do it.

I assume you are talking about a true short plan year after employee's termination date with prorated 415 limit or you are likely going to have first yer problems with coverage and testing in 2021 based on the W-2 service already.

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Hi Lou,

Yes, it was his intention to run a true short plan year with the prorated 415 limit.  He can still have the full $26,000 in deferrals plus whatever profit sharing can be allocated on whatever is left of the year.  Say if the employee was terminated as a W-2 employee on May 1, the doctor would start this plan up on June 1, and would have a short plan year from 06/01/2021 to 12/31/2021 and would pro-rate whatever has to be pro-rated.

We assume that the IC is, in reality, still an employee just being paid under a different arrangement, but we don't really know for a fact.  What would pass muster under audit?  Does she have to work for and collect 1099 wages from x number of other "clients" or spend x number of hours working for other enterprises?  Does she have to be able to set her own hours?  I have never been too clear on what really defines a true independent contractor.  

Does having "Microsoft proof" language in the basic plan document help any?

Thanks again.

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I know, Mike.  I get it.  I wouldn't recommend that a client do this - the whole idea began, I believe, with an investment advisor who called someone else here proposing this course of action and I got sent to investigate where the limits lie.

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With main question resolved, related topic, hope you don't mind I post it here.

Doctor 'employs' one full time doctor, but pays him as an IC.

Doctor wants to start a new 401k plan. Instead of excluding this IC completely, Dr. wants to pay enough W-2 to cover contributions, and the rest to be paid under guise of IC.

Not sure yet what to make of this, or whether to count all pay which may or may not make the IC doctor an HCE.

Trying to think about the implications...

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Then again - not to beat a dead horse and we are not going to allow this prospect to do this if he becomes a client - but just for my own satisfaction:

What exactly does the so-called "Microsoft proof" language in a basic plan document do for a client?  The Datair VS document has 3 paragraphs under the definition of Employee that I know came straight out of the results of that case.  However, in real life, what do they mean for the client? 

What concerns me most is their final paragraph:

"This Plan is to be construed to exclude all individuals who are not considered Employees for purposes of the Employer's payroll system, and the Plan Administrator is authorized to do so, despite the fact that its decision may result in the inadvertent loss of the Plan's tax qualification requiring an amendment of the Plan's eligibility provisions." (emphasis is mine).

So I read this to say that the Employer (who will wear all the hats) can legally exclude this lady because she is not an Employee for purposes of his payroll system, and that he is authorized to exclude her, but if a court disagrees with him, he can ultimately lose the tax qualified status of his plan and be force to amend the Plan's eligibility provisions to include her? So he may have saved pennies on whatever a contribution for her would have cost, but he will ultimately pay out thousands in lost tax deductions, penalties and interest, and have to cover her anyway, prospectively?  If I am reading this paragraph correctly, then there is no way in the world anybody should even think about trying such an arrangement.

Thoughts?

 

 

 

 

 

 

 

 

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Well if the language excludes them but the IRS determines that they are really an employee and not an independent contractor,  then you have a coverage failure in the that Plan covers 2 of 2 HCEs and 0 of 1 NHCE.

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17 minutes ago, TPApril said:

With main question resolved, related topic, hope you don't mind I post it here.

Doctor 'employs' one full time doctor, but pays him as an IC.

Doctor wants to start a new 401k plan. Instead of excluding this IC completely, Dr. wants to pay enough W-2 to cover contributions, and the rest to be paid under guise of IC.

Not sure yet what to make of this, or whether to count all pay which may or may not make the IC doctor an HCE.

Trying to think about the implications...

I don't think he can have it both ways. Either he's an independent contractor or an employee. Maybe someone smarter than me can up with  a fact pattern where the doctor is sometimes an employee of the other doctor and sometimes an independent contractor of the doctor but that's above my pay grade. I think you need an employment attorney for that one.

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14 hours ago, TPApril said:

With main question resolved, related topic, hope you don't mind I post it here.

Doctor 'employs' one full time doctor, but pays him as an IC.

Doctor wants to start a new 401k plan. Instead of excluding this IC completely, Dr. wants to pay enough W-2 to cover contributions, and the rest to be paid under guise of IC.

Not sure yet what to make of this, or whether to count all pay which may or may not make the IC doctor an HCE.

Trying to think about the implications...

I am with Lou here.   This comes from my days at the IRS back in the mid '80s.   A person is an employee or they are an interdependent contractor (IC).    You are NEVER both.

Here is the part that is relevant to the original question and here.....

The determination if a person is an IC or employee is based on a complex but objective test.   You can debate how the test applies to a fact set but you can't debate the determination is an objective test and is NOT subject to negotiation or employer decision.   You are either an employee or IC by law.   So this Dr can't do this becasue you can't be both.

in regards to the original question if the person really was an employee before (and they most likely were- as in 99.99% likely they were an employee) the Dr can't just wave some magic wand and declare the person an IC.   If nothing changes in the relationship between that dr and the former employee the IRS will disallow the change if caught.

 

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I wouldn't say NEVER. For example, you can be an employee for company A. You work there, totally under their control, from 8 to 5. Outside of those hours, you run a landscaping business. And your 8 to 5 employer hires your landscaping business to do the grounds. I could envision many other scenarios where someone could be both.

I grant you that in most situations, such a dual designation is crapola.

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15 minutes ago, Belgarath said:

I wouldn't say NEVER. For example, you can be an employee for company A. You work there, totally under their control, from 8 to 5. Outside of those hours, you run a landscaping business. And your 8 to 5 employer hires your landscaping business to do the grounds. I could envision many other scenarios where someone could be both.

I grant you that in most situations, such a dual designation is crapola.

This is along the same lines as the example on the IRS website:

https://www.irs.gov/government-entities/federal-state-local-governments/when-would-i-provide-a-form-w-2-and-a-form-1099-to-the-same-person

That said, I have never encountered such a situation in practice, and certainly don't think paying someone the first $X amount on a W-2, then the next $Y amount on a 1099, for the same job would ever work.

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