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Owners of S-Corp transfer ownership to children


bzorc

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A client has asked me this question:

On 1/1/2023, ownership of A corp was transferred from Mr. & Mrs. A to the A's 3 children. As of 1/1/2024, can Mr. & Mrs. A have deductions through our Section 125 Cafeteria Plan for their insurance premiums?

Not quite sure on the family attribution rules as it relates to IRC 125 plans. Any responses would be appreciated, thanks!

 

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Not sure I fully understand the corporate structure you're describing, but regardless the Section 125 cafeteria plan rules prohibit more than 2% owners from participating.  That prohibition includes family attribution for both parents and children.  I think that gets you to your answer here.

Here's the family attribution rules:

IRC §1372:
(b) 2-percent shareholder defined.
For purposes of this section , the term “2-percent shareholder” means any person who owns (or is considered as owning within the meaning of section 318 ) on any day during the taxable year of the S corporation more than 2 percent of the outstanding stock of such corporation or stock possessing more than 2 percent of the total combined voting power of all stock of such corporation.

IRC §318:
(a) General rule.
For purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable—
(1) Members of family.
(A)  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.
(B)  Effect of adoption. For purposes of subparagraph (A)(ii) , a legally adopted child of an individual shall be treated as a child of such individual by blood.

Here's the 125 regs:

Prop. Treas. Reg. §1.125-1(g)(2):

(2) Self-employed  individual not an employee.

(i) In general. The term employee does not include a self-employed individual or a 2-percent shareholder of an S corporation, as defined in paragraph (g)(2)(ii) of this subsection. For example, a sole proprietor, a partner in a partnership, or a director solely serving on a corporation’s board of directors (and not otherwise providing services to the corporation as an employee) is not an employee for purposes of section 125, and thus is not permitted to participate in a cafeteria plan. However, a sole proprietor may sponsor a cafeteria  plan covering the sole proprietor’s employees (but not the sole proprietor). Similarly, a partnership or S corporation may sponsor  a cafeteria  plan covering employees (but not a partner  or 2-percent shareholder of an S corporation).

(ii) Two percent shareholder of an S corporation. A 2-percent shareholder of an S corporation has the meaning set forth in section 1372(b).

...

Example (1). Two-percent shareholders of an S corporation.
(i) Employer K, an S corporation, maintains a cafeteria plan for its employees (other than 2-percent shareholders of an S corporation). Employer K's taxable year and the plan year are the calendar year. On January 1, 2009, individual Z owns 5 percent of the outstanding stock in Employer K. Y, who owns no stock in Employer K, is married to Z. Y and Z are employees of Employer K. Z is a 2-percent shareholder in Employer K (as defined in section 1372(b)). Y is also a 2-percent shareholder in Employer K by operation of the attribution rules in section 318(a)(1)(A)(i).

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Brian Gilmore, just my curiosity:

When there is no final, interim, or temporary rule, many look to a proposed rule or other nonrule guidance as a source of cautious interpretation.

While I imagine Newfront and its smart lawyer would be careful not to suggest doing so, have you ever seen a cafeteria plan sponsor use its own interpretation, perhaps with its tax practitioner’s advice, about the meaning of employee as used in § 125?

For example, have you ever seen a plan that excludes an actual 2% shareholder, but treats as a § 125-eligible employee someone who is not a shareholder (and would be a deemed shareholder only by attribution from an adult child if one follows the proposed rule’s interpretation)?

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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Interesting theoretical question, but I have not seen anyone intentionally take that position--and for good reason.  I would consider it very aggressive to follow a different interpretation than the proposed cafeteria plan regs here.  These regs have notoriously been in proposed form for an eternity now (since '07), and since then they've taken root as the primary basis for Section 125 guidance in many areas.  Without them it's a sea of gray interpretations of the statute, which really would just be a guessing game.

Even the IRS constantly points to the proposed cafeteria plan regs as controlling in other forms of guidance like Chief Counsel Memoranda (example: https://www.irs.gov/pub/irs-wd/202317020.pdf) and Information Letters (example: https://www.irs.gov/pub/irs-wd/16-0048.pdf).

Plus the IRS itself has told us we can rely on the proposed regs in the preamble--

https://www.govinfo.gov/content/pkg/FR-2007-08-06/pdf/E7-14827.pdf

As noted in this preamble, taxpayers may rely on the new proposed regulations for guidance pending the issuance of final regulations.

...

Proposed Effective Date

With the exceptions noted in the ‘‘Effect on other documents’’ section of this preamble and under the ‘‘Debit cards’’ section of the preamble, it is proposed that these regulations apply for plan years beginning on or after January 1, 2009. Taxpayers may rely on these regulations for guidance pending the issuance of final regulations.

 

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Thank you for sharing your helpful observations.

(While the example I described is not an interpretation I would advise, I can see how some lawyers might.)

Another curiosity: Is an analysis of whether a nonowner employee is deemed self-employed different if the employer is a partnership (or a limited-liability company treated as a partnership for Federal income tax purposes)? Is there anything in the Internal Revenue Code, or in the proposed § 125 rules, that treats a parent as a deemed partner or otherwise a self-employed individual because the parent’s adult child is a partner?

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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I don't read those attribution rules applying in any context other than a more than 2% owner of an S Corp.  The cross reference to §1372/§318 attribution only explicitly applies in the S Corp shareholder definition section.

So I would interpret those rules to permit cafeteria plan eligibility for family members of a partner or other type of (non-S Corp) self-employed individual.

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