By Jon Schultze and Barry Salkin
One of the less-discussed provisions of the recently enacted SECURE Act 2.0 makes two changes to the “family attribution” rules under Section 414 of the Internal Revenue Code (the “Code”). As described below, these technical rules apply when determining the ownership of entities for purposes of the nondiscrimination rules to which tax-qualified retirement plans are subject. The two changes will be beneficial to owners of closely held businesses, and will eliminate two traps for the unwary.
The Code, and IRS regulations under the Code, prohibit discrimination in favor of highly compensated employees in the availability and amount of benefits provided under a tax-qualified plan. To prevent circumvention of the nondiscrimination rules by the use of multiple entities, the Code treats certain legally separate entities as a single entity when applying the nondiscrimination rules. This is achieved by means of the controlled group and affiliated service group rules found in Section 414.
Whether or not entities are related under the controlled group and affiliated service group rules is based on ownership interests. For example, one of the ways in which a controlled group (and therefore a single employing entity) can exist is if five or fewer individuals own 80% or more of two entities and the same individuals own more than 50 % of the entities taking into account only their identical, or common, ownership in each entity. If A owns 100% of company X, and B owns 100 percent of company Y, there would be no controlled group because there is no common ownership of the two companies.
An individual can, however, have an indirect ownership interest in an entity if the ownership interest of a family member is treated as belonging to, or attributed to, the individual. If A and B are married to each other, the spousal attribution rule treats A’s ownership interest in company X as B’s and B’s ownership interest in company Y as A’s, making company X and company Y related entities for nondiscrimination testing purposes. As a result, if company X and company Y provide different benefits to their highly compensated employees and non-highly compensated employees, nondiscrimination testing can fail.
This can be a problem for spouses who own separate businesses. To address this, the existing regulations under Code Section 414 create an exception to spousal attribution if four conditions are satisfied:
- an individual has no direct ownership interest in their spouse’s business;
- the individual does not participate in the management of the other spouse’s business and is not a director, officer or employee of the spouse’s business;
- the business’s passive income (dividends, interest, rent, royalties, and annuities) is no more than 50% of its gross income; and
- the ownership in the business does not have any restrictions on the spouse’s disposition of the business that favor the individual, or the children of the individual and the spouse under the age of 21.
Before the enactment of SECURE Act 2.0, a minor child would be treated as owning the interests of his or her parents. As a result, separate businesses of two parents that otherwise satisfy the above exception to spousal attribution would be considered members of the same controlled group because ownership of the parents is attributed to the minor child.
To correct this situation, SECURE Act 2.0 changes the family attribution rules to allow disaggregation of the entities if the only common ownership is the indirect ownership of the entities by a child under the age of 21 due to the attribution of the parents’ ownership interests to the child.
Another trap for the unwary is that the first condition for the exception to spousal attribution (no direct ownership interest in the spouse’s business) cannot be satisfied in a community property state because each spouse is deemed to own one-half of the other person’s business. As a result, the controlled group determination for spouses each owning their own business in a community property state can be different from the controlled group determination for the identical business structure in a non-community property state. SECURE Act 2.0 eliminates this anomalous result by disregarding community property laws when determining ownership for purposes of controlled groups and affiliated service groups.
These two changes should provide greater flexibility in designing benefit plans of entities separately and wholly owned by spouses, starting in 2024. While these modifications to the controlled group and affiliated service group rules will affect a limited number of taxpayers, they provide a useful illustration of the complexities and potential traps for the unwary under the Code’s controlled group and affiliated service group rules. Additional attribution rules that were not changed by SECURE Act 2.0 continue to apply when determining controlled groups and affiliated service groups as well as when identifying highly compensated employees and key employees. Therefore, it is important to communicate ownership interests and family connections to plan administrators to avoid unintended consequences.