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.