Retirement Plan Family Attribution Rules - What You Don't Know Can Hurt You
The outdated family attribution rules are hindering the ability of small businesses to adopt new plans and expand participant coverage. It’s time for a change.
There once was an actuary who owned his own actuarial firm, had 15 employees, and sponsored a cash balance DB plan combined with a 401(k) profit sharing plan.
One day while at the grocery store, he ran into his ex-girlfriend from college. She told him that she was now a successful business owner with 150 employees—and revealed that he was the father of her minor child! After the shock wore off, the actuary realized that he was unknowingly the member of a controlled group. His retirement plans had likely been failing coverage for many years, and he was going to have to file a VCP application with the IRS.
The Code Section 1563 family attribution rules are used in the controlled group provisions
established as part of the Revenue Act of 1964. According to an IRS study guide, those provisions “were initially issued as part of a tax reform package intended to encourage small businesses, which operated in the corporate form. Over time some medium and large businesses
began taking advantage of the lower tax rates afforded small businesses by organizing their structure into multiple corporate forms.”
In 1974, ERISA added Code Sections 414(b) and (c). After their addition, all employees of commonly
controlled corporations, trades or businesses had to be treated as employees of a single employer. When enacted, these code provisions used the statutory definition of controlled groups found in Code Section 1563(a), which includes the ownership tests that we are now required to use to
determine if a controlled group exists.
Generally speaking, the family attribution rules under Section 1563 required that if two spouses each have ownership in their own individual businesses, their businesses must be considered a single employer for retirement plan purposes when testing the plan for coverage and non- discrimination unless they can meet four exceptions:
The individual does not have direct ownership in the spouse’s business;
The individual is not a director or employee, and does not participate in the management of the spouse’s business;
No more than 50% of the gross income of the spouse’s business for a taxable year is derived from passive investments (e.g., royalties and rents); and
The spouse’s ownership interest is not subject to disposition restrictions running in favor of the individual or the minor children of the individual and the spouse (e.g., the business owner cannot be required to offer a right of first refusal to his or her spouse or their children before selling the business to a third party).
However, Section 1563 also states that even if two individuals can meet the exceptions above or are not even married, if they have a child together under the age of 21 or live in a community property state, they are still considered a single employer for retirement plan benefits and testing.
The results of the Section 1563 family attribution rules required to be used under Section 414, as
illustrated in the story above, are outdated and illogical in the current economic environment. They were enacted long before most households had two working parents. Today, it is more likely that both parents in a household work, and the number of women-owned businesses has
increased dramatically. Therefore, it is more likely that both spouses own their own companies and they could potentially meet the non-involvement exception.
Assuming that the individuals either are not spouses or if they are they can avoid being considered
a controlled group of entities by qualifying under the non-involvement exception, should they have to be considered a single employer for retirement benefits simply because they have a child under the age of 21? Take it a step further: If the spouses have divorced and have nothing to do with one another besides having a child together who is under the age of 21, why should they still be considered a single employer?
The rules get even more complicated and illogical when you consider the impact of state community property laws. If the spouses start their businesses while living in a non-community property state and then move to a community property state, they are suddenly considered a controlled group when they weren’t before. And even if they move back to a non-community
property state, they are still considered a controlled group.
The application of these outdated rules is currently affecting the retirement plan industry and hindering the ability of small businesses to adopt new plans and expand participant coverage.
For example, a TPA business owner tells the story of a physician client she took over. His wife owned a gym and they had four kids under 21. They had never covered the gym employees, and no one had ever asked them about owning other companies. If the plan had been failing coverage
in prior years when considering the gym employees, the plan would have to go through the IRS VCP
program and the doctor and his wife would probably have to either make retroactive contributions to retain the plan’s qualified status or retroactively disqualify the plan and pay the taxes and penalties.
Another colleague tells the story of a client who got married to someone with a child from a previous relationship. However, the client could not adopt the child because that would have created a controlled group.
Then there is the situation where one spouse has a very lucrative business and wants to sponsor a cash balance plan for their business but isn’t able to because their spouse’s less profitable business can’t afford the contributions that would be required. This kind of situation is created solely
because a minor child is involved.
A LEGISLATIVE FIX MAY BE IN THE WORKS
In late April, a bill was introduced in the U.S. House that seeks to correct the archaic and unfair family attribution rules. The bipartisan “Family Attribution Modernization Act” is championed by the American Retirement Association.
The bill seeks to correct tax laws that automatically consider spouses in nine community property states to own 50% of all property obtained during the marriage thereby creating a controlled group of businesses where both spouses own their own business. It also seeks to address the attribution of shares from parent to minor spouse and back to parent, as is the case in the example in the
A similar provision is included in the broader “Securing a Strong Retirement Act” (a.k.a. “SECURE 2.0”) legislation also pending in the House.
While we believe in the need to protect plan participants from potential abuses that can occur
when individuals own multiple companies or spouses own multiple companies, we also feel that the two issues addressed in this article need to addressed and updated for the current reality because of the number of people who own small businesses and the increase in the number of women-owned businesses. If these two attribution rules are corrected, we believe that the family
attribution rules would be far more equitable and would encourage more business owners to adopt retirement plans and increase participant coverage.
By Shannon Edwards & Linda Chadbourne
Originally posted in ©2021, American Society of Pension Professionals & Actuaries (ASPPA) Summer 2021 issue of Plan Consultant magazine.