Question 36: I have an LLC that is owned by five S corporations. Each S Corporation is 100 percent owned by a doctor. Each doctor draws the maximum salary of $160,000 through the S corporation. The employees all are paid through the LLC. We have designed a cross-tested profit sharing plan giving each doctor $30,000 and the employees 3 percent of compensation. The LLC and each S corporation will adopt the plan. Are the S corporation deductions limited to 15 percent of compensation?
If the deductions follow the compensation, then the doctors could not deduct the full $30,000, but would instead be limited to 15 percent of $24,000. Or may we look at the 15 percent limit for the affiliated service group as a whole?
Answer: The doctors would be far better off eliminating the S corporations.
As you guessed, each business included in an affiliated service group calculates its 404 deduction limit separately. (By contrast, with a controlled group, there is a single limit for the entire group; thus, the doctors could deduct $30,000.)
Q 13:25 of my book Who's the Employer? explains the matter in more detail:
How are the IRC §404 deduction limits applied to ASG members that jointly sponsor plans with other ASG members or cover their employees?
It depends on the situation. There are three categories of plans and sponsors with two alternative results:
- If the ASG members sponsoring the plan are also part of a controlled group or a common control group (under IRC §414(b) or (c)), then the deduction rules of those sections apply. (Treas. Reg. 1.414(m)-3(c)(2).) In the case of a controlled group, that means that the IRC §404 limits are applied on an aggregate basis (Q 10:28). It probably means the same in the case of a common control group, although potentially, common control groups fall in one of the categories below (Q 12:7).
- If the plan was established after 1988, then each employer computes its IRC §404(a) deduction limit separately. (IRC §413(c)(6)(A).)
- Otherwise (i.e., in the case of a plan established before 1989) all participants are deemed employed by a single employer and a single IRC §404(a) limit is shared between the group members. However, if the employer elects under IRC §413(c)(4)(B) to have the IRC §412 funding requirements computed separately (see Q 13:25), then each employer has a separate IRC §404(a) deduction limit. (IRC §413(c)(6)(B).)
Let us try to simplify this. If the plan sponsors are also part of a controlled group (and probably, if they are under common control) there is a single limit shared by everyone. If the plan was adopted before 1989 and the employer has not made the IRC §413(c)(4)(B) election, then there is also a single limit shared by everyone. Otherwise, each employer computes its IRC §404(a) deduction limit separately.
The provisions of IRC §413(c)(4) are available to an ASG member who sponsors a plan in which the employees of another member of the ASG participate, whether or not that employer cosponsors the plan. Having said that, the concerns raised about a controlled group member making and deducting contributions for the employees of other group members would apply to this situation. It is doubtful that such a contribution would be an ordinary and necessary business expense under IRC §162. (See Q 10:17.)
A few examples should make the implications of this plain, or at the very least plainer:
Controlled group. In 1996, Dr. Jones, Inc. was in an ASG with JJ Clinic, a partnership. Jones Inc. employed Dr. Jones and the Clinic employed the staff. Jones, Inc. and the Clinic jointly maintained a cross-tested profit-sharing plan. Under the plan, Dr. Jones had a compensation of $200,000 (only $150,00 could be counted under IRC §401(a)(17)) and received an allocation of $30,000. The staff members collectively had a compensation of $100,000 and received an allocation of $3,000. The two entities were not only part of an ASG, they were also part of a controlled group. Therefore, they have a single IRC §404(a) deduction limit of $37,500 (15% x [$150,000 + $100,000]). Since that exceeded the $33,000 contributed ($30,000 by Jones' corporation and $3,000 by the Clinic), the entire contribution is deductible.
Old Plan, Two Sponsors. Assume the same facts as the prior example, except the parties are not in a controlled group. They are just in an ASG. Assume further than the plan was established in 1987, and neither organization makes the IRC §413(c)(4)(B) election. The deduction limit is handled the same way as the prior example.
Old Plan, One Sponsor. Assume the same facts as the previous example, except that the Clinic does not sponsor the plan or make a contribution. The limit is nonetheless computed on a combined basis as though it had sponsored the plan, because of the proposed regulations. Thus, the IRC §404(a) limit is $37,500 and it does not preclude Jones, Inc. from deducting the full $33,000. However, IRC §162 might limit the deduction to $30,000 on the grounds that it is not an ordinary and necessary business expense to make contributions for the employees of other employers. If the issue arose under audit, Jones may wish to argue that it was necessary. Given that the Clinic is not sponsoring the plan, the only way Jones, Inc. can provide retirement benefits for its own employees is to cover at least some of the employees of JJ. Hence the contribution for those employees is necessary.
New Plan. Same facts as the previous example, except the plan was adopted in 1990. Each employer has its own IRC §404(a) limit. The limit for Jones, Inc. is $22,500 ($150,000 x 15%), and $10,500 ($33,000 - $22,500) is not deductible.
Same facts as the Old Plan, Two Sponsors example, except the plan was adopted in 1990. Each employer has its own IRC §404(a) limit. The limit for Jones, Inc. is $22,500. The limit for the Clinic is $15,000 ($100,000 x 15%). JJ can deduct its entire $3,000 contribution, but $7,500 ($30,000 - $22,500) of the corporation§s contribution is not deductible.
In both of the last two examples, the ASG members as a whole are worse off because they have separate entities. Practitioners should advise their clients in such situations to consider merging the various entities so as to arrive at a single IRC §404 limit.
Some practitioners have read the proposed IRC §414(m) regulations and come to a different conclusion about their effect than what is set forth above. Unfortunately, the regulations are out of date. When they were written in 1983, they correctly reflected the law at that time, which treated all cosponsors of a multiple employer plan (and hence ASG members) as a single employer for purposes of computing their IRC §404 limit on deductions. The proposed regulations read, in pertinent part:
If a plan maintained by a member of an affiliated service group covers an individual who is not an employee of that member, but who is an employee of another member of that affiliated service group, the plan will be considered to be maintained by the member that does employ that individual. Thus, the plan will be considered to be maintained by more than one employer for purposes of section 413(c). . .(6) (relating to deductions). Therefore, a member of an affiliated service group may deduct contributions on behalf of individuals who are not employees of that member, if the individuals are employed by another member of that affiliated service group.
Notice that the last sentence, beginning with "Therefore," explains the consequences of a plan being treated as maintained by more than one employer. That explaination was correct given the wording of IRC §413(c)(6) as it existed at the time.
However, several years after the proposal was written, IRC §413(c)(6) was amended to read as it does today. Hence, notwithstanding the regulations, if a plan sponsored by an ASG member was adopted after 1988, each employer computes its IRC §404 deduction limit separately.