Nondiscrimination and Nondiscrimination Testing

Under pre-SECURE 2.0 law, two spouses who each have ownership interest in separate businesses often ran into problems trying to pass nondiscrimination testing due to the family attribution rules.  This often limited the flexibility of businesses offering retirement benefits solely due to state community property laws or the existence of minor children—and unintended consequence.  SECURE 2.0 created two important exceptions that can now help closely held business owners offer retirement plans without running afoul of the IRS.<br /> <br /> The government prohibits business owners from establishing retirement plans that primarily benefit highly compensated employees (HCEs) while excluding other less highly compensated individuals.  To prevent businesses from using multiple entities to provide benefits primarily to HCEs and pass the anti-discrimination tests, the law treats certain related entities as a single entity for nondiscrimination testing purposes.<br /> <br /> These “controlled group” rules evaluate the ownership structure of related entities.  If enough common ownership exists, the entities are deemed to be a single business for retirement plan testing purposes.  Similarly, when applying the law, individuals may be deemed to own business interests owned by certain family members—including spouses and minor children.<br /> <br /> Under pre-SECURE 2.0 law, one spouse was always deemed to own the business interests that were owned by their spouse unless a spousal exception applied.<br /> <br /> Under IRC Section 414, the spousal exception applies if all of the following are true: (1) the spouse has no direct interest in their spouse’s business, (2) the spouse does not participate in management of their spouse’s business, and is not a director, officer or employee of that business, (3) no more than 50% of that business’ income is passive (meaning derived from rents, royalties, dividends, interest and annuities), and (4) the spouse’s ownership interests are not subject to restrictions on the spouse’s ability to dispose of them that favor the other spouse or their minor children.<br /> <br /> Ignoring the attribution rules can expose the sponsoring business to steep penalties and potential disqualification.<br /> <br /> Couples who live in community property states were previously unable to qualify for the spousal exception.  In community property states, each spouse is deemed to own 50% of their spouse’s assets acquired during the marriage.  SECURE 2.0 overrides and disregards community property laws for purposes of the Section 414 spousal exception.<br /> <br /> Example: Assume David and Judy are a married couple residing in Texas, a community property state.  During the marriage, each spouse established their own separate business (each owning 100% of the interests in their respective business).  The two businesses are completely unrelated.  However, under pre-SECURE 2.0 law, David was treated as owning 50% of Judy’s business and vice versa under Texas law.  The couple was unable to qualify for the spousal exception because they could not satisfy the “no direct interest” requirement.<br /> <br /> Post-SECURE 2.0, no controlled group is deemed to exist because Texas’ community property laws are disregarded.  Beginning in 2024, David and Judy can each establish individual retirement plans for their business.  Each plan can be structured to pass the nondiscrimination testing rules considering only the individual company’s employees.<br /> <br /> Under pre-SECURE 2.0 law, minor children (under age 21) were treated as though they owned 100% of their parents’ business assets when determining whether a controlled group existed.  Therefore, if two individuals each owned separate businesses, a child in common would be deemed to own 100% of each parent’s business.  That’s true regardless of whether the two parents were ever married.<br /> <br /> Considering the example above, assume David and Judy had a seven-year-old child, Meredith.  Pre-SECURE 2.0, Meredith was deemed to own 100% of David’s business and 100% of Judy’s business.  David and Judy were unable to qualify for the Section 414 spousal exception solely because of Meredith’s existence.<br /> <br /> SECURE 2.0 changed the rules to disaggregate ownership of two businesses where common ownership was based solely on the existence of a minor child.