How to Attribute Family Ownership When 401(k) Plan Testing

It’s impossible to complete annual 401(k) plan testing accurately without a clear understanding of the plan sponsor’s ownership structure. This information is used to determine the company’s controlled or affiliated service group status as well as the Highly Compensated Employee (HCE) and key employee status of plan participants. To make these determinations properly, certain “family attribution” rules must be applied correctly. These IRS rules exist to thwart ownership structures that would otherwise permit a 401(k) plan to discriminate in favor of business owners.

The family attribution rules applicable to 401(k) plan testing generally fall under two sections of the Internal Revenue Code (IRC) - Sections 1563 and 318. If you’re a business owner, I recommend you understand both rules. This knowledge can help ensure you give your 401(k) provider the company ownership information they need to accurately complete plan testing.

Ownership Attribution Basics

Attribution is the concept of treating a person as owning an interest in a business that is not actually owned by that person. For purposes of 401(k) plan testing, attribution involves adding the ownership interest of certain family members to the direct ownership of an individual. For example, if a husband and wife each own 40% of a company, both spouses would be treated as owning 80% of that company (40% direct + 40% attributed).

The IRC section 1563 attribution rules apply to controlled group determinations while IRC section 318 apply for other testing purposes. These rules are written in terms of stock ownership, but the same principles also apply to unincorporated companies.

“Double attribution” – or multiple tiers of attribution - is not permitted under either rule. Once an individual is attributed ownership from a family member, that interest can not be attributed again from the individual to another family member.  For example, if a daughter is attributed her father’s ownership interest in a company, her spouse can’t be attributed her attributed ownership.

The IRC section 1563 Rules

The IRC section 1563 family attribution rules apply when determining whether or not a company is part of a controlled group. A controlled group is defined as two or more companies with common ownership. When 401(k) coverage testing, all members of a controlled group are considered a single employer. That means all employees of the controlled group must be tested together to confirm a nondiscriminatory group of employees is covered. The controlled group rules exist so business owners can’t subdivide their company into separate companies - one employing HCEs and the other employing non-HCEs – to discriminate in favor of HCEs.

Omitting a controlled group member from a 401(k) coverage test can be a costly mistake should the issue trigger a test failure. Correcting a failed test usually involves retroactively covering the employees of the omitted company. Since the new participants can’t retroactively make salary deferrals, non-HCEs must receive a Qualified Nonelective Contribution (QNEC) to correct their “missed deferral opportunity.” They must also receive any missed employer contributions.

Summary of the 1563 rules:

The IRC section 318 Rules

The IRC section 318 rules are more straightforward. They apply when determining:

• Highly Compensated Employee (HCE) status for nondiscrimination testing
• Key employee status for top heavy testing
• Affiliated service group (ASG) status for coverage testing – like controlled groups, ASGs are considered a single employer

Failing to correctly apply the 318 rules can lead to false 401(k) test results and/or discriminatory contribution allocations. These issues can be expensive to fix if they are found in later years, or worse, during an IRS audit.

Summary of the 318 rules:

Staying Out of Trouble is Easy with the Right Help!

401(k) plans offer valuable benefits to employers and employees alike. To access these benefits, however, a 401(k) plan must meet IRS plan qualification requirements. One major requirement is not discriminating in favor of HCEs. A 401(k) plan meets this requirement by passing annual IRS-mandated testing.

An experienced 401(k) provider can complete this testing in their sleep. That said, to accurately complete these tests, the provider will need company ownership information from the plan sponsor. If you’re responsible for providing this information, you must give them the family information they’ll need to properly apply the 401(k) attribution rules. In general, this information is easy to understand with some basic education.