Category: Compensation & Employee Benefits;
Deductions & Credits
Subject: Employee Leasing
Title: Employee Leasing to Achieve C Corporation Employee Benefits
for Non-C Corporation Employers
IRC Sections: 414(n), 401(a), 408(k)
Date Produced: 07/95
Copyright 1998, The Tax Resource Group. All rights reserved.
Telephone 800-578-3498. Internet: www.taxresourcegroup.com
It has been suggested that the owners of a non-C corporation business
(a partnership, an S corporation, or an LLC) can avail themselves
of certain tax deductible employee benefits which have heretofore
been available only to the employees of C corporations. The following
benefits have been mentioned:
-ability to borrow from a qualified retirement plan; and
-ability to fully deduct employee fringe benefits (health
insurance, group term life insurance, etc.) paid on behalf of
the owners of such businesses.
In order to achieve the foregoing result, the non-C corporation
taxpayer (in this case and LLC) will establish a captive, C corporation,
employee leasing organization to employ all LLC employees and
owners. Because the leasing organization is a C corporation and
the legal employer, it can establish a qualified plan of the type
available to C corporations and can pay deductible employee fringe
benefits available to C corporation employees. The fees paid by
the LLC to the leasing organization should be fully deductible.
Does the arrangement set forth above achieve its desired goals?
The arrangement set forth above clearly does not work.
Section 414(n) provides that the compensation paid by an employee
leasing firm will for purposes of certain employee benefit rules
be considered paid by the taxpayer to whom the services of those
employees are provided. The following employee benefits are so
-paragraphs (3), (4), (7), (16), (17), and (26) of section
-Sections 408(k), 410, 411, 415, and 416; and
-Sections 79, 106, 117(d), 120, 125, 127, 129, 132, 274(j), 505,
The items listed in the first two lines of references above
cover most of the major qualification and operating rules for
qualified retirement plans: the minimum participation rules, the
anti-discrimination rules, the minimum vesting standards, the
maximum benefit and contribution rules, the maximum compensation
limits, the additional participation requirements, the SEP rules,
and the top-heavy rules. The items in the third line of references
include the major tax-free employee non-retirement benefits: group
term life insurance benefits, employer-provided accident and health
insurance, tuition assistance, group legal services, cafeteria
plans, educational assistance programs, dependent case assistance
programs, the general rules controlling includibility of fringe
benefits, employee achievement programs, VEBA plans, and the excise
tax for failure to comply with the COBRA rules.
Included within the clear reach of Section 414(n) is all the
non-retirement employee benefits targeted by the arrangement described
above. Accordingly, if Section 414(n) applies, the LLC in this
case will be considered the provider of those benefits with the
result that no deduction will be allowed for amounts attributable
to the owners of the business.
The rules which allow borrowing from C corporation qualified
plans are not directly included within the reach of Section 414(n).
More about this below.
Section 414(n)(2) provides the definition of what employee
leasing arrangements fall under the jurisdiction of Section 414(n).
For purposes of paragraph (1), the term "leased employee"
means any person who is not an employee of the recipient and who
provides services to the recipient if--
such services are provided pursuant to an agreement between
the recipient and any other person (in this subsection referred
to as the "leasing organization");
such person has performed such services for the recipient (or
for the recipient and related persons) on a substantially full-time
basis for a period of at least 1 year; and
such services are of a type historically performed, in the
business field of the recipient, by employees.
It seems to me that all the requirements set forth above are clearly
met by the taxpayers in this situation with the possible exception
of the last one which deals with services of a type historically
provided by employees. In this case, the owners are the issue,
not the rank-and-file employees. However, Proposed Regulation
1.414(o)-1(b) provides that a leased owner is treated as a leased
employee for purposes of Section 414(n).
Section 414(n)(5) contains some safe harbor rules which the
taxpayers in this case do not appear to meet. These safe harbor
rules mitigate the effect of Section 414(n) on the qualified plan
rules only, not the non-retirement employee benefits. Accordingly,
even if the taxpayers in this case could somehow fit under the
safe harbor rules of Section 414(n)(5), there would be no escaping
the effect of Section 414(n) with respect to items such as employer
provided health coverage, etc.
Section 72(p) allows qualified plan participants to borrow
from the plan under certain carefully controlled conditions. Section
72(p)(1)(A) prohibits any borrowing if the plan covers one or
more self employed individuals. Under Section 72(p), loans made
by plans covering self employed individuals are treated as distributions.
Similar rules at Sections 4975 treat plan loans to self employed
individuals as a prohibited transaction.
Section 72(p) is not included on the list of provisions within
the ambit of Section 414(n); however, Section 72(p)(2)(D) provides
that the rules of Section 414(b), (c), and (m) apply in determining
whether any plan loan is subject to the distribution rule. Section
414(m) provides the affiliated service group rules which cause
two or more separate legal entities to be considered a single
employer. Since Section 72(p) prohibits loans by any plan covering
one or more self employed persons, treating the taxpayer LLC and
the employee leasing organization as a single employer would create
a plan covering self employed individuals and thereby prohibit
The affiliated service group rules are applicable if 10% or
more of a service organization is owned by highly compensated
employees of an entity to which the service organization provides
most of its services. Section 414(m). The same interests own 100%
of both the taxpayer LLC and the employee leasing operation. Virtually
the entire business of the employee leasing operation consists
of performing services for the taxpayer LLC. Accordingly, it appears
the affiliated service group rules apply in this case thus prohibiting