401(k)'s legal for family business?

[Guest Eric Cernyar]

At least one retirement planning "professional" has told me that an employee-owned S-corp cannot set up a 401(k) plan if it only has one employee, who also happens to be the sole owner, or if it only has two employees, who are husband and wife, one or both of whom are 100% owners of the business. The others I've spoken to don't have a clue.

I would like to know for sure b/c, starting next year, one should be able to accumulate far more under a 401(k) plan (with employer contributions of up to 25% of compensation plus employee deferrals of up to $11K per employee) than could be accumulated under any other qualified plan (e.g., non-401(k) profit sharing plans, SEP IRAs, and SIMPLE IRAs). I've done the math. Over the long term, the additional tax deferral benefits far outweigh the administrative costs charged by groups such as 401keasy.com or the 16 hours or so a year I will have to spend administering it and filling out a 5500.

Is what these "professionals" say true, and if so, could someone point me to the applicable Internal Revenue Code provisions (U.S.C.) or IRS regulations (C.F.R.) that stand in the way?

[rcline46]

Simply put - THEY ARE WRONG!

They must come up with the cites, regs, whatever to justify their position. These same idiots keep trying to say partners can't contribute to 401(k)s because they are not employees.

They cannot come up with anything to justify their postion.

(caveat - domestics cannot have a qualified plan because running a household is not a 'trade or business'.

[GBurns]

While I have not yet researched to find the answer to the original post, I must point out to rcline46... You did not give any cites, regs or whatever to justify your position either.

Fair is fair.

[rcline46]

Look to the instructions for who can file Form 5500 EZ. That should answer your questions quite nicely.

However, being in the business for 26 years, when someone tells me no, they have to support their position. Like the saying goes, I refuse to have a battle of wits with an unarmed person.

[Guest Eric Cernyar]

I am most interested in finding out whether a 401(k) for my business could be "tax qualified" under 26 U.S.C. 401 et seq. Whether it is ERISA qualified is another matter. The distinction is important for asset protection planning purposes. ERISA-qualified plans are excludable from a debtor's bankruptcy estate under 11 USC 541©(2). To be ERISA-qualified, it must be established for the benefit of the employee participants. 29 U.S.C. 1002(2)(A). However, 29 CFR 2510.3-3©, a regulation promulgated by the Labor Dep't to implement ERISA, says that "an individual and his or her spouse shall not be deemed to be employees with respect to a trade or business, whether wholly incorporated or unincorporated, which is wholly owned by the individual or by the individual and his/her spouse." Accordingly, at least one court has reasoned that a 401(k) set up by a corporation that employs only a husband and/or spouse who also happen to be the only owner(s) of the corporation cannot be ERISA qualified and therefore must be included in the bankruptcy estate. See In re Stephan Jay Lawrence, Debtor, 235 B.R. 498 (S.D. Fl. 1999).

Assuming the aforementioned case is good law, I may not be able to set up an ERISA-qualified plan unless I hire a third person. But in any event, I have not found any legal authority that would prevent someone in my situation from setting up a tax-qualified 401(k) plan.

[Belgarath]

I agree with rcline. The fact that they can have a 401(k) is so incontrovertibly established that you shouldn't waste your time proving they can. Tell them to prove that you can't - because they can't prove it. To Eric Cernyar - this is an area which is under constant litigation in the courts. The Supreme Court, in Patterson V. Shumate, upheld that a participant's interest in an "ERISA qualified plan" was exempt from bankruptcy proceedings. Everyone hoped that this would settle the matter. However, as you mentioned, bankruptcy trustees developed a new strategy of challenging the qualified status of the plan, since the "one person" plans are not subject to Title I of ERISA. They have had some success with this for bankruptcy purposes. Also some failures. I don't track the "legal scorecard" but my impression is that they have had far more failures than successes. Any attorneys out there to comment on this? Regardless of the bankruptcy issues, for IRS purposes, assuming you have a proper plan document and follow the normal plan rules, etc., it will indeed be a qualified plan for other purposes.

[Guest edemby]

While I am not positive, I think the advice you received may be correct. As I recall, qualified plans, such as 401(k) plans are plans for "employees." Since there are technically no employees in an S corporation that only employs owners of the S corporation, a 401(k) plan cannot be set up. But you may want to check into this a little further.

[Guest Eric Cernyar]

If so, then the self-employed and sole-owner/employee corps could not set up qualified plans of any kind. SEP IRAs, SIMPLE IRAs, money purchase, and profit sharing plans are all "qualified plans" (if they meet the requisite conditions) under 26 USC 401.

For the advice I've received from so-called professionals to be true, there should be a statutory provision or IRS regulation that singles out 401(k)s and makes them unavailable to persons in my situation. I am not aware of any such provision or regulation.

[GBurns]

rcline46

The point that you seem to miss is that you say that whenever someone says no they have to support their position. Why is it that when someone says yes they dont have to support their position in the same manner.

As I said Fair is fair. It is only logical that all positions should be supported.

Length of service does not experience give nor competence exhibit.

As to the snide remark about doing battle etc, I will let that pass, I am sure the readers of this Board have their own opinions that decorum demands that they not comment. It is sometimes better to not say something than to open one's mouth etc etc.

[Guest Eric Cernyar]

I will try to provide some support for my tenuous belief that 401(k)'s are available to those in my situation.

The Code imposes a number of hurdles to those in my situation, all of which, however, are surmountable.

The highly compensated employee provisions (401(k)(3)) can be overcome by fulfilling the safe harbor provisions of 401(k)(12)© (non-elective employer contribution of 3%) and (D) (written notice of each employees' rights and obligations).

The top-heavy provisions of 416 can be overcome the same way.

Again, I've looked for other regulatory obstacles, have not found them, but I am not 100% confident that I'm right. Which is why I posted this question in the first place. I figure others who do this for a living will know better than me.

I appreciate all the feedback that I have received, supported and unsupported.

[Michael Devault]

It may be helpful to look at section 1.401-1(B)(3) of the income tax regulations. Basically, it says that plans must benefit employees in general. It goes on to say that "Among the employees to be benefited may be persons who are officers and shareholders."

Since officers and shareholders are treated as employees, it would seem logical that they can participate in a qualified plan, just as long as the plan doesn't discriminate in their favor.

[GBurns]

I recently checked with some of the largest 401(k) investment and plan providers to small group and could not find one that would provide a plan as you described. I did not bother to go into whether or not the IRC allows it because even if it did and you could not find a provider or administrator and trustee etc you would not be able to set up the plan.

However, I did get the feeling that it could be done in certain restricted circumstances by some of them, but they just were not set up to do it.

There was an article in the August 17, 2001 WSJ in the Mutual Funds section titled " The One-Man Band gets A Gift From 401(k) Rules". The article gives some leads to a few potential providers who are thinking of providing this. Maybe they can help.

You might also want to ask Paychex they are probably the largest provider of services to very small groups.

[rcline46]

To GBURNS, my comment was to those 'professionals' who say no. There is so much misinformation on even the most basic issues that I have to insist that the challengers provide support for their position. That way they become armed and an intelligent discourse can happen. The outcome is usually decided by the challenger self-educating and the challenge melts away.

The question of partners participating in 401(k) plans, self-employeds participating in any plan, owners participating in plans comes up with great frequency because everyone stops once they see the word 'employee'. If they would only keep reading their questions would be answered.

[Belgarath]

Eric - I think folks are just trying too hard on this. Section 401(k) of the IRC, and the accompanying regulations thereunder, specify the rules for 401(k) plans. There is nothing in 401(k) or the regulations which precludes the employer in the situation you described from sponsoring a 401(k) plan.

One word of caution - since an S-corp, make sure you use only the W-2 income - you cannot use the "pass-through" income from an S-corp when calculating contributions to a qualified plan.

Hope this helps.

[Larry M]

Eric,

with respect to the ERISA coverage, a qualified plan covering only the sole proprietor or proprietor and spouse is not an ERISA plan and does not carry the same creditor protection elements (although many state laws do extend protection to such plans).

However, it is relatively easy and inexpensive to include a non-owner in such a plan if you wish. The non-related individual can be a part timer earning minimal wages and for whom a nominal contribution is made. As long as there is another participant, no matter how small his/her benefit, and even if not fully vested, the entire plan becomes an ERISA plan.

So, you, as a sole proprietor can have a tax qualified plan which is ERISA protected (and governed) for a relatively small additional cost - the extra administrative cost may be more than the contribution to the part time employee.

[Guest jbwcpa]

Same subject, new question. Suppose we havel a 401(k) plan with one participant, who happens to be the sole owner of our hypothetical employer sponser, and has W-2 wages of $40,000. What happens to the ADP and Top-Heavy tests. Would he automatically fail both?

[rcline46]

So what if top heavy? Owner is getting the larger of 3% or highest allocation to any key. Or keys don't get TH.

ADP - passes by regulation, there is NO NCE deferral which means it is not -0-.

[Tom Poje]

and, begining in 2002, you have the possibility to have a safe harbor 401(k) in which, if only the HCE deferred, and the safe harbor was a match-with no other contributions, the plan passes all testing even if there were a bunch of NHCEs. (not likely to happen but it could)

The regs are the regs, and given the right conditions, seem to favor the HCEs. Just because there are no NHCEs or the NHCEs have zippo, doesn't mean you always fail.

[actuarysmith]

Owners of an S-Corp who receive a W2 from the company are technically called "Shareholder-Employees". Therefore, they are employees for purposes of establishing a plan.