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Retirement Planning

Considering an Employee Stock Ownership Plan (ESOP) as a Form of Succession? Beware of Potential IRS Scrutiny

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By Chris J. Roe, CPA, PFS

Employee Stock Ownership Plans (ESOPs) offer an excellent succession strategy for businesses. These plans not only enable employees to share in the company’s growth and financial rewards, but they also furnish immediate tax advantages for the departing owner and continued tax benefits for the business itself.

What is an Employee Stock Ownership Plan (ESOP)? 

An ESOP operates as a qualified retirement plan, subject to Employee Retirement Income Security Act (ERISA) regulations. It functions similarly to a 401(k) plan and eventually becomes the company’s owner following a sale.

The transaction’s structure is straightforward: the current owner sells their shares to the ESOP in exchange for cash and a promissory note that is paid over time. To finance the initial cash payment, both the company and the ESOP secure loans from a bank. Over time, as the business generates profit, these are used to repay the original shareholders and the bank.

Common Misconceptions about ESOPs

Despite its seeming simplicity, several misconceptions about ESOPs persist. Here are a few of them: 

You will receive a lower sale price compared to selling to a third-party buyer. While this may be the case when dealing with strategic buyers or private equity firms, those with businesses difficult to sell may find ESOPs a more favorable option. Additionally, given the tax benefits of ESOPs, your after-tax proceeds may be significantly more.

You’ll lose control of the business, which will be managed by many shareholders having a say in operations. In reality, your employees, who are indirect owners via the ESOP, do not have voting rights concerning the business’s day-to-day activities. Governance falls to the ESOP Trustee and the appointed board of directors, a board the outgoing owner can lead if they wish. This arrangement ensures the former owner maintains control over operations until they decide it’s time to retire.

You’ll miss out on future growth of the business if you sell to an ESOP. While it’s true selling your stake means you won’t reap all the rewards of the business’s expansion, you can mitigate this by negotiating for warrants as part of your deal. These warrants can give you a stake in the business’s future growth, essentially providing a “second bite at the apple,” typically within a 7 to 10-year timeframe.

You won’t benefit from the tax deferral options you heard are available to C Corporation shareholders if you’re an S Corporation. In certain instances, if C corporation shareholders sell their stock to an ESOP and reinvest 100% of the sale price in qualified securities (basically US stocks and bonds), the capital gain realized will be deferred until a security bought with the proceeds is sold. This benefit does not currently exist when selling S corporation stock. Nonetheless, with adequate planning, you may convert from an S Corporation to a C Corporation before the sale to take advantage of tax deferrals. Additionally, there may be strategies that allow you to switch back to S corporation status, enabling you to defer taxes on income related to the ESOP shares until employees start receiving distributions. Be aware, the IRS has a keen eye for scrutinizing any transaction where corporate reorganizations are done solely for tax benefits. 

ESOP ownership and covering the debt to former owners and banks will hamper growth. Contrary to this belief, if the ESOP owns a substantial portion of the S Corporation, the company could experience roughly a 30% boost in annual after-tax cash flow, given that ESOPs are not tax-liable entities. While at first the ESOP needs to use its cash to pay down debt, after approximately five years, the ESOP can use the funds—otherwise owed to federal and state governments—to invest in its business operations or strategic acquisitions. In other words, it can grow even faster.

Four Benefits of ESOPs

So, why should a company consider adopting an ESOP? Here are four compelling reasons: 

  1. Tax-Advantaged Exit Strategy with Continued Control: The ESOP offers a unique way for current owners to sell their shares tax-efficiently while allowing them to remain in control of the business, should they desire to do so.
  2. Employee Participation in Economic Rewards: By enabling current and future employees to have an ownership stake in the company, the ESOP allows them to participate in the business’s financial success.
  3. Unparalleled Employee Incentive: The ESOP is one of the most effective ways to incentivize and reward employees. They create a sense of ownership and commitment, increasing productivity and job satisfaction.
  4. Investment Diversification: While the primary purpose of an ESOP is to invest in the company’s stock, it also offers the flexibility to diversify its investment portfolio over time, providing an added layer of financial security for the employees.

IRS Scrutiny of ESOP Tax Strategies

Given the substantial tax advantages of ESOPs, it’s not surprising that many advisors advocate for these benefits, sometimes pushing the boundaries of tax law. When tax strategies are marketed and ultimately abused, the IRS takes notice. 

In a pointed move, the IRS has zeroed in on ESOP transactions. In News Release IR 2023-144 released on August 8, 2023, the IRS begins by saying:

As part of an expanded focus on ensuring high-income taxpayers pay what they owe, the Internal Revenue Service today warned businesses and tax professionals to be alert to a range of compliance issues that can be associated with Employee Stock Ownership Plans (ESOPs).

“The IRS is focusing on this transaction as part of the effort to ensure our tax laws are applied fairly and high-income filers pay the taxes they owe,” IRS Commissioner Danny Werfel said. “This means spotting aggressive tax claims as they emerge and warning taxpayers. Businesses and individual taxpayers should seek advice from an independent and trusted tax professional instead of promoters focused on marketing questionable transactions that could lead to bigger trouble.”

Werfel noted the IRS is working to ensure high-income filers pay the taxes they owe. Prior to the Inflation Reduction Act, more than a decade of budget cuts prevented the IRS from keeping pace with the increasingly complicated set of tools that the wealthiest taxpayers may use to hide their income and evade paying their share.

“The IRS is now taking swift and aggressive action to close this gap,” Werfel said. “Part of that includes alerting higher-income taxpayers and businesses to compliance issues and aggressive schemes involving complex or questionable transactions, including those involving ESOPs.” [ “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023]

The news release highlighted various concerns, such as valuation of the stock, allocation of shares to a disqualified person, and prohibited loans within the ESOP structure. 

In particular, the IRS drew attention to certain arrangements involving S Corporations that raised concerns. The agency viewed these strategies as potentially abusive, as they directed taxable business profits into the ESOP to avoid taxes while simultaneously lending those funds to shareholders tax-free to meet their cash flow needs. 

…[T]he IRS has seen promoted arrangements using ESOPs that are potentially abusive. For instance, the IRS has seen schemes where a business creates a “management” S corporation whose stock is wholly owned by an ESOP for the sole purpose of diverting taxable business income to the ESOP. The S corporation purports to provide loans to the business owners in the amount of the business income to avoid taxation of that income. The IRS disagrees with how taxpayers interpret this transaction and emphasizes these purported loans should be taxable income to the business owners. These transactions also impact whether the ESOP satisfies several tax law requirements which could result in the management company losing its S corporation status. [ “IRS cautions plan sponsors to be alert to compliance issues associated with ESOPs,” News Release IR-2023-144, August 9, 2023]

As the News Release stated, the IRS is looking to educate taxpayers regarding the risks associated with ESOP strategies while also carrying out appropriate investigations. 

At Rx Wealth, we always caution clients about deals that sound too good to be true usually are. ESOPs, in our opinion, can offer significant advantages to business owners if implemented properly. Those considering an ESOP should seek qualified professionals for advice rather than strategy promoters.

If you’re exploring options for business succession and are interested in learning more about ESOPs, schedule your complimentary consultation here. We’ll give you the straight talk on ESOPS and explain how you can use them properly to benefit you, your family, and your employees.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The Numbers to Know to Maximize Your 2023 Retirement Contributions

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By Chris J. Roe, CPA, PFS

The inflation we saw in 2022, along with the steps the Fed has taken to curb it, has put a strain on everyone’s wallets. But a silver lining we can look forward to in 2023 is higher contribution limits for our retirement accounts. 

The IRS recently released 2023’s contribution limits, so you can begin incorporating the changes in your financial plan to make the most of your savings opportunities. Here’s a rundown of the updated figures.

Employer-Sponsored Plans

401(a), 401(k), and 403(b) Employee and Total Contribution Limits

The employee contribution limit for 401(a), 401(k), and 403(b) retirement plans is $22,500 in 2023. If you are over 50 years of age, you can contribute an additional $7,500, an increase of $1,000 over 2022. Thus, total contributions for individuals over age 50 are $30,000.

For 2023, all employee/employer contributions will increase to $66,000, and for individuals over age 50, $73,500.

If you are lucky to participate in both a 401(a) and 403(b) plan, a maximum of $66,000 can go into each plan—a nice tax loophole.

The 401(a) compensation limit (the amount of earned income that can be used to calculate retirement account contributions) will increase to $330,000 in 2023. 

457(b) Contribution Limit

The 457(b) contribution limit for 2023 is $22,500. These plans have unique catch-up contribution rules, so consult with your plan administrator if you want to put more in yours.

Employer-Sponsored Plan Contribution Limits

Individual Plans

Traditional & Roth IRA Contribution Limits

For 2023, the IRA contribution limit will increase to $6,500 ($7,500 if age 50 or older).

The IRA deductibility phaseout for those with a retirement plan at work is:  

  • For single taxpayers: $73,000-$83,000
  • For married filing jointly taxpayers: $116,000-$136,000
  • For taxpayers not participating in a plan but with a spouse who is: $218,000 to $228,000

Roth IRA contributions are available to single taxpayers with a modified adjusted gross income (MAGI) between $138,000-$153,000 and married filing jointly taxpayers between $218,000-$228,000. If your MAGI exceeds these limits, you will need to contribute indirectly via a backdoor Roth Ira. 

Traditional & Roth IRA Contribution Limits

Self-Employed or Small Business Plans

SEP IRA Contribution Limit

SEP contribution limits increase to the lesser of 25% of employee’s compensation, or $66,000 for 2023. SEP IRAs do not have an over-age-50 catch-up contribution. If you are looking to contribute over $66,000 and are over 50, you should consider alternative retirement plans. 

SIMPLE IRA & SIMPLE 401(k) Contribution Limits

The SIMPLE IRA and SIMPLE 401(k) contribution limits will increase to $15,500. Taxpayers over age 50 can contribute an additional $3,500, for a total of $19,000 for this group.

Defined Benefit Plans

The defined benefit plan limit will increase to the lesser of 100% of your average compensation for the highest three consecutive years or $265,000.

Self-Employed or Small Business Plans

Medical Benefit Plans

Health Savings Account (HSA) Contribution Limit 

In Revenue Procedure 2022-24, the IRS confirmed that for 2023, the health savings account (HSA) contribution will increase to $3,850 for single people and $7,750 for families. If you are over age 55, you can contribute an extra $1,000. 

HSAs are an underutilized strategy for long-term wealth building that allows taxpayers to receive a tax deduction upfront, tax-deferred growth, and tax-free withdrawals in the future when medical expenses are incurred. This year’s increase is generous, so take advantage of it to the fullest.

Flexible Spending Accounts (FSA) Contribution Limit

For 2023, you can contribute $3,050 to a flexible spending account (FSA), an increase of $200 over 2022. 

Medical Benefit Plans

It is important to know the contribution limits for your retirement accounts and consult with a financial advisor or tax advisor, like Rx Wealth,  to make the most of your savings opportunities. By taking advantage of the contribution limits and planning carefully, you can ensure that you are making the most of your retirement savings and working towards a financially secure future.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Open Q&A for Physicians & Healthcare Professionals

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Chris recently hosted an “Ask Me Anything” open Q&A webinar for physicians and healthcare professionals. In it, he answered questions that participants brought to the meeting, such as:

  • Should I contribute to my Roth 403(b) or should I contribute to a tax-deductible 403(b)?
  • What should I be doing from a tax planning perspective if I am simply employed by a hospital?
  • How do I know how much I need to save for retirement?
  • Given that this has been a rough year, what should I be doing with my investment portfolio and how can I combat inflation?

Watch the recording here:



Is Your IRA Creditor Protected?

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By Chris J. Roe, CPA, PFS

Physicians, like anyone else, commonly get personal and business loans. As part of getting a loan, a promissory note and security agreement are usually included and signed with little review or thought. Unfortunately, in signing these documents, it’s possible for your IRA assets to be inadvertently pledged as part of the transaction.

The ruling in the Florida case, Kearney Construction Company, LLC v. Travelers Casualty and Surety Company of America, held that a debtor’s personal IRA, which is normally protected from creditors, was no longer protected because it was pledged when the IRA owner signed a blanket security agreement granting the lender a security interest in all the debtor’s accounts. Mr. Kearney had executed a promissory note and signed the blanket statement before filing for bankruptcy.

The UCC-1, a standard security agreement lenders file to record their security interest in assets, had generic blanket collateral language and granted the lender a security interest in “all assets and rights of the pledgor.” Because of this, the court says it was enough to grant a valid security interest in an IRA.

Since giving a security interest in an IRA is considered a prohibited transaction for tax purposes, the result is disastrous on two fronts. One, a pledged IRA is deemed immediately terminated, and a taxable distribution occurs; and two, the IRA loses its tax-exempt status and is no longer qualified as a creditor-exempt asset under Florida law.

While many believe this case was wrongfully decided and the Florida legislature is actively trying to fix it, we need to be aware of this decision in planning any current and future financing transactions. A few simple moves and awareness can prevent you from being in a bad situation like Mr. Kearney.

To avoid this situation, any pledge agreement signed going forward should be clear that retirement accounts and other creditor-protected assets are not pledged. The next question becomes, where does this leave debtors who executed blanket pledges in the past?

This now leaves physicians in Florida and perhaps other states who have signed these blanket pledge statements (which includes anyone who has a mortgage, credit card, or other loans) in a state of flux, questioning if their IRAs have lost their tax-exempt status and are no longer creditor protected.

So, what can be done to correct the past? Here are a few untested suggestions:

  • Renegotiate the security agreement with the lender to provide clarity. This should be done with great care.
  • Refinance the debt and negotiate a new security pledge agreement to provide clarity on the IRA and other creditor-protected assets.
  • Rollover your existing IRA to an ERISA-Sponsored Plan (i.e., 401(K)) 
  • Set up a new IRA and roll over the existing IRA. It is unclear how the new IRA is treated from a creditor protection standpoint since funded with a possibly tainted IRA. 
  • Use your IRA to purchase creditor-protected assets. 
  • Do a Roth conversion.
  • Do a lifestyle withdrawal from your IRA. This will allow you to place new earned income into other creditor-protected vehicles.

Before implementing any strategy, please consult an attorney or tax advisor. While we wait to see if legislation fixes the issue, any security agreement should be closely reviewed by legal counsel and provide for language to exclude any tax-advantaged assets. Going forward, pledging assets should be done with great care. If not, you may end up losing your IRA and incurring a large tax bill.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The situations or opinions mentioned in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing. 

Benefits of Becoming an Independent Contract Physician

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By Chris J. Roe, CPA, PFS

Considering an independent contract physician position can be scary. After all, as an independent contractor, you’ll be solely responsible for paying your taxes, the cost of medical malpractice insurance, and maintaining health and other benefits.

It’s natural to fear the unknown, but before you choose to remain a W-2 employee simply because it seems easier and more comfortable, educate yourself on the advantages and disadvantages of transitioning to an independent contractor role.

Employee vs Independent Contractor – What’s the Difference?

When you’re a big healthcare employee, your pay is a salary, and earnings are reported on tax form W-2. Income taxes tend to be fairly straightforward since your employer withholds all federal, state, and local income taxes (if applicable) along with your portion of FICA and Medicare tax. Employers also cover their portions of the FICA and Medicare tax.

Plus, your employer usually offers a nice a la carte menu of benefits like health, group life, and disability insurance. Employers also might cover the costs of certain business expenses like professional licensing and medical malpractice insurance. For these reasons, being an employee is easy. 

However, everything has a downside. First, your take-home pay, on an after-tax basis, might be significantly lower when working as an employee versus contracting as an independent physician. Secondly, you’re stuck with employer-provided benefits, whether or not the options are good. For example, your employer may only match a small percentage of your 401K contribution. Plus, you’re unable to deduct any employee business expenses incurred but not reimbursed on your tax return, as a result of 2018 tax changes. Employee business expenses may include travel, books, meals, office supplies, or vehicles. Conversely, independent contract physicians can deduct a plethora of expenses, giving them a definite tax advantage.

As an independent contract physician, your pay is reported on Form 1099-NEC. The company paying you does not withhold taxes, so you receive the gross pay agreed upon in your contract. So, taxes are more complicated and require quarterly estimated tax payments. Additionally, you’ll be responsible for paying self-employment taxes. You’ll also need to seek out your own health care coverage as well as disability, life, and medical malpractice insurance. That said, you’ll be able to deduct certain business expenses like vehicles, business meals, business travel, continuing education, and office expenses against your gross income.

As an independent contract physician, you’ll file a Schedule C on your income tax return after receiving the Form 1099-NEC. However, you may decide to operate your practice through an S-Corporation or other business entity, which will make your tax filings more complex but potentially offer additional tax advantages. Note that Congress recently put forth proposed legislation to curtail S-Corporation benefits so you’ll need to explore this option further. 

In addition to the deductions already mentioned, self-employed health insurance, 401K contributions, and half of your self-employment taxes are also deductible. While being self-employed might entail some up-front hassles, you may realize higher after-tax income in the long run. Remember, increasing income is generally never the easiest path to take.

Benefits of Independence

One key benefit of being an independent contract physician is simply the word “independent.” When you oversee your own destiny, the freedom to design the benefits and retirement plans that work best for you and your family exists. When an employer provides benefits, you’re limited to their offer because it’s usually part of the entire compensation package and is cheaper than declining and paying for your own benefits on an after-tax basis. As an independent contract physician, you don’t have to settle for inferior benefits.

Medical Malpractice Insurance Cost

One of the biggest concerns when contemplating an independent contractor route is the medical malpractice insurance cost. In our experience, though, the increased compensation realized more than covers the after-tax cost of medical malpractice insurance and other benefits. Most companies that contract with independent physicians have negotiated preferred third-party arrangements to provide medical malpractice insurance and other benefits at favorable rates.

Health Insurance Cost

Another fear we hear is health insurance costs a lot more. While your health insurance costs will likely be greater than within a large group plan, remember the following: 1) You now have the ability to choose the right plan for you and your family, 2) You have the ability to choose a high deductible plan and make tax-deductible contributions to an HSA, and 3) You can deduct your health insurance premium on a pre-tax basis. As an independent contract physician, you’ll have the flexibility and control to design your own benefit plan, including its cost.

Cost of Other Benefits

Finally, many doctors share their fear that other benefits, such as group disability and life insurance, will cost more or be unobtainable. For physicians with certain pre-existing medical conditions, that might be true. However, if you’re relatively healthy, these insurances tend to be more cost-effective over the long run when purchased independently. Since you own and control your insurance choices, you won’t need to worry about losing benefits should you choose to switch your contract to another company.

Business Perks of Independence

Again, one of the main perks of owning your business and contracting with a company is the control you have. You decide what benefits to purchase and when to terminate the ones you do not need, what retirement plans to implement and how much to contribute, what the best business structure is for your operation, plus how and who you should hire in your business. There is a lot of value to control!

There are tax perks, too. You can choose your retirement plan and contribute the maximum contribution if you so choose. This is a big advantage – as an employee, you’re subject to how much your employer wants to contribute. Plus, you can have multiple retirement plans, such as a 401K, and a defined benefit plan allowing for larger annual contributions than if you were an employee. And certain expenses paid for with after-tax dollars are now deductible on a pre-tax basis.

Did you know that if you have a child over the age of 14, you can employ them in your practice?  If you employ your child, you can deduct their wages and related costs from your taxes, too. Depending on your business structure, you may or may not need to pay payroll taxes. In most instances, your children will pay little or no income taxes on their wages. Generally, the benefit works out to saving about 20-30% per year in taxes. For example, if you pay your child $12,000 and your net savings is 30%, you will save about $3,600 in income taxes. 

Additionally, your child is eligible to contribute the earnings to a Roth IRA, which allows them to get a jump on retirement savings. That said, the greatest benefit is the ability to teach your child work ethic and responsibility. 

While this article provides an overview of factors to consider when making the leap from employee to independent contract physician, you’ll need to think through your personal situation and prepare a unique comparison. 

At Rx Wealth Advisors, we specialize in advice and consultation to Physicians exploring independence. We can assist in preparing an analysis that will help you make an educated decision. Feel free to reach out to us for a second opinion. Call us at 412-227-9007 or email croe@rxwealthadvisors.com.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Practice-Owning Physicians: Beware of This Retirement Tax Trap

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By Chris J. Roe, CPA, PFS

As a practice-owning physician, one way to save on taxes is to implement a retirement plan. As a financial professional, I have given this advice hundreds of times to business-owning professionals.

However, if you’re not aware of it and don’t plan for it, there is a tax trap looming that can cost you, as a practice-owning physician, a lot of time, headaches, and money. 

Rx Wealth recently consulted on a physician practice’s retirement plan and ran into a major retirement plan issue many physician business owners overlook. In one specific case, a physician and their spouse each had separate businesses and were greater than 80% owners. Each business provided a 401(k) plan for their separate employees. Because the physician and their spouse had a minor child, their separate business ownership is attributed to the minor child, creating common ownership amongst the two businesses, known as a “controlled group.” Therefore, the separate 401(k) plans need to be treated as one plan for tax compliance testing. Moreover, the two plans we reviewed provided different benefit levels for employees, adding the potential for the plans to be disqualified for tax purposes.

Before getting too concerned, know Congress understood situations will exist where each spouse owns a distinctly separate, unrelated business. Congress thus designed rules to avoid your business being considered owned by your spouse and vice versa. If you meet an exception, your retirement plans will not be treated as one plan across the businesses. The exception exists when the following are true:

  • Each spouse owns no actual ownership in the other’s business;
  • Neither spouse is an employee, director, or participates in management;
  • The company does not derive earnings from passive sources, such as royalties, rents, dividends, interest, or annuities; and
  • No restrictions exist on either spouse’s ability to sell shares in their respective business that are favorable to the other spouse or minor child.

For example, If Dr. Smith owns a practice and Attorney Smith owns a law firm, and neither is involved in any way with the other’s practice, there is considered no controlled group; each retirement plan will be considered separate. However, if Dr. & Mrs. Smith live in a community property state, the spouses have a community property ownership in one another’s business. Thus, they have actual ownership, not attributed ownership. 

However, if you and your spouse have a minor child,  Congress failed to create an exception similar to a spousal exception for your minor child to be excluded as an owner of either you and your spouse’s business through family attribution. This is the retirement tax trap for the unwary.  When you have a minor child, a controlled group may be created unknowingly.

What is a Controlled Group?

Congress set forth rules to determine if businesses are part of the same group for the purposes of applying retirement plan rules. We tax people affectionately refer to these rules as the “controlled group rules.” (1)

A controlled group is created when two or more businesses connected through common ownership have the same five or fewer individuals that own at least 80% of the stock of the corporations. Family attribution applies, so stock owned by a parent, grandparent, child, or spouse is often deemed owned by another related person. For instance, stock you own in your business is also deemed to be owned by your minor child.

Under the controlled group rules, two or more employers related through common ownership are deemed a single employer for retirement plan testing purposes. These rules often require controlled group members to cover their employees with the same 401(k) plan in order to pass annual compliance testing. 

Why Evaluate Plans for a Controlled Group?

When evaluating retirement plans for tax compliance, a determination needs to be made if the two businesses are considered part of a controlled group. If a controlled group exists, the plans must be evaluated as one plan to ensure compliance with the tax law. 

Should a plan fail its compliance testing, the IRS may disqualify the plan. It is imperative to make an accurate controlled group determination and cover the proper employees with the proper benefits.

These rules exist to prevent physicians and business owners from splitting their business into two companies and enriching themselves with generous retirement plans while providing employees in a second business with either less generous or no retirement plan. 

Controlled group rules are generally straightforward. A 401(k) provider, along with your financial advisor and attorney, can assist in determining controlled group status. The issue arises typically inadvertently because of a failure to provide necessary information to the 401(k) provider about the two businesses. 

So, what happens if you inadvertently fall into this tax trap? Well, no worries. The IRS is not looking to disqualify plans for mistakes as long as they are remedied. The IRS  puts forth several avenues to fix mistakes.

A Path to Fixing Retirement Plan Non-Compliance

The IRS lays out two paths to fix a plan failure. 

First, an employer can adopt a corrective amendment up to 9.5 months following the close of the plan year in which the failure occurred in order to expand plan coverage retroactively. However, since new 401(k) plan participants cannot retroactively contribute, the business must make up the employee contributions and any employer contributions the business should have made for all plan participants.

Should the mistake not be discovered within 9.5 months, a second path is available. On this path, the employer must go through the IRS’s Voluntary Compliance Program. When a Voluntary Compliance Program correction is necessary, though, employer fines can apply.

Not correcting a failure can result in plan disqualification should an IRS audit uncover the issue.

What This Means For You

It can be costly not to understand the rules regarding controlled groups and retirement plans. While mistakes are fixable, ensure testing is done each year. Further, alert your 401(k) provider if your spouse owns a business. And if you are a little overwhelmed or think you may have an issue with a retirement plan, please reach out to us for a complimentary call.

(1) See Internal Revenue Code Section 1563.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.