If you’re not sure exactly what is a 401k controlled group, this article will help you determine if you’re businesses are in one.
In what seems like an ever-shrinking talent pool, being an employer that matches 401k contributions by your employees gives you an easier time attracting and keeping top talent.
However, keeping track of 401k plans if you have more than one business or have significant ownership rights in more than one business may be tough and demanding.
Even so, if the related businesses pass one of four ownership tests by the IRS, you can offer all your employees across the different companies the same 401k plan under a controlled group.
This article will explain what a control group 401k is and the laws governing it.
What exactly is a 401k Controlled Group?
A 401(k) controlled group is a collection of companies with shared ownership that fall under the IRS’s definition of controlled groups and are therefore allowed and required by law to serve all its employees under one 401(k) plan.
The IRS defines controlled groups as two or more trades, corporations, and/or businesses with specific relationships.
401(k) plans must serve each employee of all controlled group members to pass the coverage test every year.
Disregarding a member can result in failing the coverage test and costly IRS penalties including being disqualified for the plan are possible when controlled group rules are broken for years.
The controlled group laws are designed to deter unscrupulous business owners from dividing their firm into different companies with some hiring highly compensated employees (HCEs) and the others hiring non-highly compensated employees (NHCEs) – in a scheme geared toward providing a hefty retirement plan to the HCEs and a poor plan to the NHCEs.
Controlled Group Rules
The controlled group relationship exists between two or more companies under these circumstances as stipulated in the Revenue Act of 1964:
1. Parent-Subsidiary Relationship
Under this relationship, one or more owned corporations are linked through the ownership of stock with a common parent corporation owning at least 80% of another corporation.
Think of it like this: You own 100% of Corporation X, and Corporation X owns 90% of Corporation Y. In this case you can get a 401(k) plan through Corporation X or Y which would serve employees in both corporations.
2. Brother-Sister Relationship
A controlled group has a brother-sister relationship if it is a group of at least two corporations with these characteristics:
- Has five or fewer owners in common who own at least an 80% controlling interest of each company.
- Has five or fewer owners in common who have more than 50% of the stock of each corporation.
To fulfill the first requirement, the common owners need to own over 80% of all the businesses in the group. To fulfill the second requirement, the same common owners must own more than 50% of each corporation.
3. Family Attribution
Family attribution occurs when a person is treated as having an interest in a business when it is actually owned by a close family member.
For instance, over 50% ownership of a business by a parent can be attributed to the child and the same kind of ownership by a child can be attributed to the parent.
However, attribution does not apply for married couples unless there is direct ownership or clear participatory roles in the company.
Similarly, spousal attribution does not apply if over half of the company’s gross income is held up in inactive investments.
4. Affiliated Services
This rule was established to deter business owners from starting a service-based company as an affiliate of a principal business.
Service businesses, according to the IRS, are those that offer health, legal, engineering, architecture, accounting, actuarial science, performing arts, consulting, and insurance services.
To put it another way, if a company provides services to the principal company and a partner or service relationship exists, the two companies can be considered as part of a controlled group.
401k Plan Coverage Testing
401(k) plans are required to go through comprehensive IRS testing annually as proof they don’t favor Highly-Compensated Employees (HCEs).
One of the tests they go through is the coverage test which is done to ensure a 401(k) plan covers the right number of Non-Highly Compensated Employees (NHCEs).
It’s important to understand the basics that run coverage testing to avoid omitting information that can result in inaccuracies.
While your 401(k) provider completes this test for you, it’s your job to furnish them with the information needed for the test. An omission takes years to discover and too much damage will have been done by that time necessitating costly failed test corrections.
As a rule of thumb, where a 401(k) plan covers 100% of eligible employees, it will pass coverage testing instantly.
However, if your corporation is part of a controlled group, it’s easy to fail the coverage test.
In this respect, all companies in the 401k control group need to be tested together by applying the ratio percentage test (RPT)
A plan will pass the RPT if the percentage of NHCEs benefiting under the plan is at least 70% of the HCEs benefiting under the plan.
Correcting a Failed Coverage Test
To fix a failed coverage test, you can adopt a corrective amendment up to 9 and a half months after the end of the plan when the failed test took place.
However, since it’s impossible to retroactively make employee contributions in a new year, you can make a qualified nonelective contribution (QNEC) to the new NHCEs to fix their missed deferral opportunity while you make any missed contributions to the new NHCEs.
If you miss to make the corrections within the 9 and a half month period, the IRS considers it a demographic failure. A demographic failure can only be corrected through IRS’ Voluntary Compliance Program (VCP).
The Bottom Line
401k controlled group rules were created to guard employees and ensure business owners don’t set up their own retirement plan by establishing a different business without offering their employees plan benefits.
These regulations are complex and far-reaching. If you are a business owner with two or more business entities that you control or are directly associated with and are contemplating getting a 401(k) plan, it is best to consult a tax professional or a 401(k) third-party firm to help you navigate these rules effectively and safely.
If you need help understanding if you’re business is within a controlled group, schedule a plan discussion with us or take 30 seconds to find which plan is best for your company with The Retirement Plan Evaluator.