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)
Filename: 1247.html
Date Produced: 07/95

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

Background
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.

Issue
Does the arrangement set forth above achieve its desired goals?

Answer
The arrangement set forth above clearly does not work.

Discussion
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 treated:

-paragraphs (3), (4), (7), (16), (17), and (26) of section 401(a);

-Sections 408(k), 410, 411, 415, and 416; and

-Sections 79, 106, 117(d), 120, 125, 127, 129, 132, 274(j), 505, and 4980B.

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 plan loans.

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 plan loans.