Solo 401K Eligibility: Are Parents and Children Related? Controlled Groups

I’ve got a pal who whose got a great gig going. It’s a “side-business” that nets him about $120K a year. Prime candidate for an Individual K. He’s got lots of discretionary income to invest and needs to reduce his current taxable income. At his job (read: W-2) he gets to invest his 401k in loaded mutual funds to which he’s been reducing his contributions as he increases his allocation to real-estate and other alternatives.

Sounds like a great candidate for a Checkbook Control Solo 401K! Between him and his spouse they could sock away tens of thousands of dollars in their Solo K and invest tax free in real estate (remember no UDFI on leveraged real-estate in a 401k!). BUT, NOT SO FAST. Here’s the catch, my buddy’s W-2 comes from his Dad’s company, which has several hundred people on payroll and the IRS has got a tool known as the Controlled Group Rules which result in ownership of businesses being attributed  to relatives for tax purposes. This could potentially make a child’s Qualified Retirement Plan – QRP – subject to anti-discrimination testing based on their  parent’s employees, making them ineligible for a Solo 401k – intended for an owner-only business, with no employees.

To resolve this matter, Congress provided a handy reference known as the Internal Revenue Code (IRC). The Internal Revenue Code defines  family relationships in several places…so we’ve got to interpret the conflicting definitions and determine which of those apply. (Hint: It depends…)

[If “con” is the opposite of “pro,” what is the opposite of “progress?”….answer at the end of the post:)]

IRC Definitions

If you were to randomly come across the following passages, you’d be forgiven for concluding that they’re not from the same source.

Passage A – IRC §267

The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants.

Note that family includes siblings, as well as all ancestors and descendants regardless of age.

Passage B – IRC §318

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.

Note that siblings are not included and that with regard to ancestors and descendants only parents, children, and grandchildren are included – again, regardless of age.

Passage C – IRC §1563

(A) Minor children: An individual shall be considered as owning stock owned, directly or indirectly, by or for his children who have not attained the age of 21 years, and, if the individual has not attained the age of 21 years, the stock owned, directly or indirectly, by or for his parents.
(B) Adult children and grandchildren: An individual who owns (within the meaning of subsection (d)(2), but without regard to this subparagraph) more than 50 percent of the total combined voting power of all classes of stock entitled to vote or more than 50 percent of the total value of shares of all classes of stock in a corporation shall be considered as owning the stock in such corporation owned, directly or indirectly, by or for his parents, grandparents, grandchildren, and children who have attained the age of 21 years.

Note that we’ve now got a distinction between “minor  children” and “adult children.” Whereas attribution between parents and minor children is unconditional, attribution between adult children and parents only takes place when the attributee owns more than 50% of the entity regarding  which the attribution is being applied.

Honestly, even though you haven’t randomly encountered these passages, your still forgiven for concluding they’re not from the same source.

So…which definition governs????

IRC §414 – Definitions and Special Rules deals with retirement plans and is where our question is addressed, so all we’ve got to do is read it. Simple as pie.

IRC §414(b) – Employees of Controlled Group of Corporations

Employees of Controlled Group of Corporations: For purposes of sections 401[Qualified pension, profit-sharing, and stock bonus plans], 408(k) [Simplified employee pension defined], 408(p) [Simple retirement accounts], 410 [Minimum participation standards], 411[Minimum vesting standards], 415 [Limitations on benefits and contribution under qualified plans], and 416 [Special rules for top-heavy plans], all employees of all corporations which are members of a controlled group of corporations (within the meaning of section 1563(a), determined without regard to section 1563(a)(4) and (e)(3)(C)) shall be treated as employed by a single employer.

If you’ve managed to follow all those references and gobbledygook you may have noticed that the code specifically applies the §1563 definition, but Congress couldn’t make it that straightforward…obviously.

IRC §414(m) – Employees of an Affiliated Service Group

Other Definitions: For purposes of this subsection— In determining ownership, the principles of section 318(a) shall apply.

So now we’ve got it…sometimes the §1563 definition applies and sometimes the §318 definition applies. More specifically, there are 2 types of groups targeted by the tax law, “controlled groups” and “affiliated service groups.” Under the controlled group rules §1563 is applied and under the affiliated service group rules §318 is applied.

Back to my Buddy

In my buddy’s case the affiliated service group rules don’t apply (that’s for another post) – and he’s over 21 years of age –  so the best move for him is to get himself an Individual K. He’ll reduce his current tax billput more away for retirementget tax free growth on his investments, and most importantly, he’ll get to invest as he chooses

[…the opposite of “progress” is “congress”]