Category: Partnerships & LLCs
Subject: Affiliated Service Groups
Title: Effect of One Shareholder Establishing Qualified Medical and Retirement Plans
IRC Sections: 414(m); 105(h)
Filename: 1071.html
Date Produced: 8/97

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
PS is a partnership that renders dental services. PS is equally owned by three S corporations, S1, S2, and S3. The S corporations are wholly owned by three separate dentists. The sole activity of S1, S2, and S3 is providing dental services to PS.

The shareholder of S1 wants to set up a tax-qualified medical reimbursement plan for his S corporation. The plan would be self-insured. The shareholder also wants to put his wife on the payroll of S1 in order to have her covered under a qualified retirement plan set up by S1.

Issue
What are the tax ramification of the plan set forth above?

Answer
The medical reimbursement plan and the retirement plan set up by S1 would very likely fail to be tax qualified. In addition, existence of such plans could very easily cause the retirement plan of PS to be disqualified. If PS has a self-insured medical plan, the plan could also be disqualified. If PS has an insurance-funded medical plan, existence of the plan contemplated by S1 could cause a violation of the ERISA rules.

Discussion
IRC Section 414(m) provides a number of situations in which employees of multiple organizations must be considered employed by a single employer for purposes of various employee benefit rules (including SEP contributions). These rules are referred to as the affiliated service group rules.

The rules were enacted to prevent a common abuse in which highly-paid employees (typically owner-employees) would be employed by one company, and the lower-paid, rank-in-file workers would be employed by a separate company, controlled or somehow affiliated with the first. A generous retirement plan and other tax favored employee benefits would be established for the company employing the highly-paid employees, and a far less generous arrangement (or none at all) would be set up for the company employing the lower-paid employees.

I believe the situation set forth above easily fits under the variation of the affiliated service group described at Section 414(m)(2)(A): a service organization, in this case PS, and an organization which is a partner or shareholder in the first service organization and regularly performs services for the first service organization.

For purposes of the qualified retirement plan rules, S1, S2, S3, and PS would be considered one employer. As such, any separate retirement plan covering only the nominal employees of S1 would likely not be tax qualified resulting from failure to meet the coverage and anti-discrimination rules applicable to qualified retirement plans. Similarly, the employment of the wife of S1's shareholder could cause PS's plan to be disqualified for the same reason.

With respect to the medical reimbursement plan under Section 105, there are specific anti-discrimination rules set forth at Section 105(h) for self-insured medical plans. Section 105(h)(8) incorporates by reference the affiliated service group rules of Section 414(m). Presumably, these rules would be violated if all the employees of S1, S2, S3, and PS were taken into account.

If the medical reimbursement plan of S1 were funded by insurance instead of being a self-funded plan, I believe there would be no problem, at least from a tax perspective. To my knowledge, there is no tax rule that says an insurance-funded medical plan must be non-discriminatory. It is my understanding, however, that an insurance funded medical plan as described about could possibly violate the anti-discrimination rules of ERISA.

As I understand it, self-insured medical plans are not subject to ERISA; thus, there is a tax provision that prohibits discrimination. Since insurance funded plans are subject to ERISA, no tax discrimination rule is needed because ERISA makes such discrimination unlawful.

If the parties wish to pursue or further confirm the ERISA issue, then a qualified attorney should be engaged. I am neither licensed nor fully qualified to do so.