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Who's the Employer?

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

Directors As Managers

(Posted May 5, 2001)

Question 97: Able and Baker own 50% of three corporations. The first is a C corporation which has as its sole source of income the payment of management fees from the other two corporations (which are both S corporations). The two shareholders receive directors fees from the C corporation and they are officers of that corporation. Can they establish "SIMPLE" plans individually using this self-employment income without covering any other employees?

Answer: Let's start with the notion that the three corporations are obviously a controlled group (and likely are a management function affiliated service group as well). Nonetheless, their separate unincorporated businesses as directors of the C Corp is technically not part of the controlled group.

So the real question is whether each of those Schedule C businesses is in a management function group with the C Corporation. Put another way, is the principal business purpose of the Schedule C business that of providing management functions for the C Corp? If so, then the bottom line is that a SIMPLE plan would have to cover employees from all the businesses.

The issue of whether directors provide management functions is addressed at Q 13:16 of my book, Who's the Employer?.

Do corporate directors provide management functions?

At first glance, it would surely appear they do. What do directors do other than manage? However, the Committee Reports accompanying IRC �414(m)(5) take a different approach:

"The conferees intend that the provision is to apply only where the management functions performed by one person for another are functions historically performed by employees, including partners or sole proprietors in the case of unincorporated trades and businesses."

Because directors, as such, are not employees (see Q 2:35), logically it would follow from the Committee Report that directors are not performing management functions for purposes of IRC �414(m)(5). The withdrawn proposed regulations incorporated this rule, but covered inside directors under a separate (also withdrawn) provision in IRC �414(o). A director who is a 5% owner of the corporation would still be treated as a leased owner under what remains of the proposed �414(o) regulations. (See Chapter 15.)

Rev. Proc. 2000-6, in listing the requirements for a determination letter on management function group status, specifically asks "whether or not it is unusual for such management functions to be performed by employees of organizations in the employer's business field in the United States" This confirms that the IRS is using the Conference Report in issuing letters.

However, at some professional meetings, IRS representatives have taken the opposite approach, saying directors are providing management functions. Given the confusion on this issue, the author recommends that directors wishing to set up a plan for the director's fee request a determination letter on their ASG status. This is particularly true of "inside" directors, directors who are also officers, who seem particularly vulnerable.

In your situation, I think they would be particularly vulnerable to an IRS challenge. But let's suppose for a moment that you decided that no director is providing a management function and so a management function group doesn't exist. Does that end the question? Not in this case.

The two shareholders have several functions in the corporation, if I am correctly reading between the lines of your question. They are directors, officers, and managers of the S Corporations. In other words, they most all of the work of the C Corporation, some of it clearly in the capacity of an employee. It is only their work as a director that would qualify as a separate business. They could not set up a SIMPLE plan with regard to their compensation as corporate officers or for doing the work of the corporation.

If I were an auditor, I would look very carefully at the total payments to the shareholders and compare how much is allocated to each service. Particularly with regard to the directors fees, if I found that they exceeded a reasonable fee for what they actually did as directors (and face it -- in a two man corporation, the directors as such don't do much) I would either reallocate it as compensation for employee services, or (if I were really feeling frisky) treat it as a nondeductible dividend. Either way, it could blow your SIMPLE contribution out of the water.

Bottom line: it ain't that easy to get around covering your employees.

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.