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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

79.9% Isn't 80%; But Wait-- There's More!

(Posted March 31, 2005)

Question 274: A guy owns 100% of a construction company: "LargeCo." Then he forms another company (an "S" corporation for tax purposes) named "SmallCo," which leases equipmnent and real estate to LargeCo. He owns 79.9% of SmallCo; the other 20.1% is owned by an unrelated party. Now SmallCo installs a qualified plan that covers only SmallCo employees. Does the plan have to cover the employees of LargeCo?

Answer: Are the two companies a controlled group for qualified plan purposes? No. 79.9% common ownership is not 80% common ownership.

Of course, if I were an auditor, I'd poke around really hard to make sure the 20.1% was truly independent. Is that owner free to vote as he pleases? Really free? Is there an option (actual or implied)? What did the other owner pay for the stock (or was it a gift)? I'd look VERY closely. But, if it's real, there isn't a controlled group.

Are the two an ASG? No. Neither an equipment leasing firm nor a construction company would be a service organization.

So, can SmallCo set up a plan and disregard the employees of LargeCo? Absolutely, yes, based on the facts you've given me.

But is that the end of the story? Nope. I'd bet SmallCo has one employee, the Guy, right? And so it's setting up a plan to cover the Guy for his SmallCo compensation. Tell me what the Guy does for this equipment leasing company to earn his compensation. Once every five years, maybe, he signs a lease. Boy, that's deserving of a big salary isn't it? NOT.

Why is that important? If his salary is more than "reasonable compensation," then it isn't compensation. It's a disguised dividend. And dividends aren't the basis for 404 deduction limits or 415 annual addition limits.

Nice try, though.

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.