Coverage Testing When Spouses Each Own a Business

When determining potential coverage testing issues for a company’s retirement plan, it’s important to look at whether a business is part of a controlled group of businesses. Simply put, coverage testing is a mathematical test in which an employer must demonstrate that at least 70% of the employees who have met the plan’s eligibility criteria are receiving a benefit from the plan.  When two or more businesses are in a controlled group, employees from all companies in the controlled group that have met the eligibility requirements are combined to perform the 70% calculation.

Controlled groups fall into two main relationship scenarios: Brother-Sister Relationships and Parent-Subsidiary Relationships.  In a Parent-Subsidiary Relationship, one company owns at least 80% of another company.  In that case, employees from both companies will be combined for coverage testing.  In a Brother-Sister Relationship, five or fewer common owners satisfy a common ownership test across both companies.  In that case, the two companies are considered to be a controlled group and, again, employees from both companies will be combined for coverage testing. 

Although for some plan purposes (like determining Key employees and Highly Compensated Employees (HCEs)), family attribution rules require that an individual be treated as owning stock that is owned by his/her spouse, the attribution rules of Internal Revenue Code (IRC) Section 1563(e)(5), which are used to determine controlled groups, provide an exception to the attribution of stock from an individual to his/her spouse if these conditions are satisfied: 

  • Each spouse has no ownership in the other’s business;
  • Neither spouse is a director or employee or manager of the other’s business;
  • Not more than 50% of either business entity’s gross income was derived from royalties, rents, dividends, interest, and annuities; and
  • The spouse that owns the business can dispose of the stock at any time, without restrictions.

Suppose a husband and wife each own separate, unrelated businesses.  If the exceptions above are met, each individual will be considered to have sole ownership over their respective companies, without any attribution of ownership to the spouse.  In that case, the two businesses will NOT be in a controlled group and each company can sponsor its own retirement plan without having to take into consideration the employees of the spouse’s company for coverage testing purposes. 

However, when the spouses in question have a child under age 21, the exceptions above won’t matter because a controlled group will be deemed to exist due to the fact that the minor child is attributed stock in each company, creating a scenario in which there is now common ownership across both businesses.  This ownership attribution will remain until the child is no longer considered a minor.  If both companies are considered part of a controlled group because of the child’s ownership, it may be difficult to demonstrate compliance with the 70% coverage testing if only one company is providing retirement benefits to its employees.

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