Just Doesn't smell right!

[TBob]

This situation just doesn't smell right to me but I can't put my finger on it.

Father owns 100% of two corporations. Business B derives all of its income from Business A.

Father transfers ownership of Business B to his two children (X age 10 and Y age 5). Business B pays each of the children a heafty salary. Business B sets up a separate 401(k) Plan for X and Y. Their salary is enough to allow them to defer the maximum plus to receive a safe harbor non-elective contribution a sizeable profit sharing contribution (integrated).

Business B has no employees other than X and Y. It's obvious, based on their ages, that X and Y perform no services to Business B for which they are paid. Father now derives all of his income from Business A which has several other employees and its own 401(k) Plan.

I am sure that I am leaving out some vital information but it seems clear to me that Father is paying X & Y through Business B solely to put more into a qualified plan. What's wrong with this picture or am I just being paranoid?

[Mike Preston]

Unless X and Y are being paid legitimately, you are not paranoid.

Are they stars in the television ad campaign for A?

I would refer this to ERISA counsel.

[Blinky the 3-eyed Fish]

Because the children are under 21, their shares are attributed to the father. Transferring ownership had no affect on the controlled group issue here, so the purpose escapes me. Because this is a controlled group are the 2 plans being tested together? Business B certainly wouldn't pass coverage on it's own with only HCE's there. Is that your issue?

And/or are you concerned that a 5 and 10 year-old are receiving large salaries? This of course does not pass any sort of smell test, and although I have no specific experience on how an IRS reviewer would handle the situation, I could only imagine it would not be favorably.

[david rigby]

Facts and circumstance. See Mike's advice.

BTW, the net impact might be the additional FICA taxes.

[Mike Preston]

I agree that there doesn't seem to be an advantage to setting this up in a separate corporation because of the attribution issue.

But I think the net impact is the transfer of wealth from one generation to the next, which might (especially in light of the estate tax elimination sunset) be more valuable than the FICA taxes paid.

[Alf]

Both corporations are treated as a single employer. Also, it is illegal for a company to provide benefits under a 401(k) plan to individuals who are not employees of the sponsoring employer (in substance, not just form).

[J2D2]

To follow along on Alf's comment - If the children are not performing services for B that would support the salaries they are being paid, isn't there a risk that the IRS might determine that the salaries really are dividends?