Moving Employees Between Entities: Tax Implications & Best Practices
Understanding how to transfer employees between entities under common ownership while staying compliant with tax laws.
Why Moving Employees Between Entities Isn’t Taxable
Many businesses transition employees between entities to streamline HR, payroll, and benefits administration. Under the Internal Revenue Code (IRC), such transfers are generally not taxable, provided they meet certain conditions.
Legitimate Business Purpose
- Streamlining payroll and HR management.
- Implementing a Management Services Organization (MSO).
- Managing deferred compensation plans effectively.
- Enhancing business efficiency and compliance.
Utilizing an MSO Structure
When an MSO is used for centralized functions like payroll and HR, the transition is tax-free if IRS guidelines are followed.
Key IRS Compliance Rules
To avoid IRS scrutiny, businesses must ensure:
- Arm’s-Length Agreements: Documented service agreements with proper pricing.
- No Disguised Compensation: Employee pay remains consistent.
- Ownership Consistency: Entities remain under common control.
- Control Group Compliance: Meeting IRS definitions of control groups.
Key IRC Sections for Compliance
Businesses should adhere to the following IRS tax codes when moving employees between entities:
Example: Moving Employees Between Entities
Scenario: An S corporation transfers employees to a C corporation under common ownership. The C corporation operates as an MSO and leases employees back.
Outcome:
- Ownership remains consistent, avoiding taxable events.
- Payments to the MSO qualify as deductible business expenses.
- Deferred compensation complies with §409A regulations.
Best Practices for Compliance
- Ensure Reasonable Compensation: Salaries must reflect market rates.
- Document Business Purpose: Clearly state reasons for the transfer.
- Formalize Agreements: Use legally binding service contracts.
- Verify Payroll Compliance: Adhere to IRC §3401 payroll tax rules.
Conclusion
Businesses that properly document and structure employee transfers under common ownership can remain compliant while avoiding IRS penalties. Implementing an MSO structure can enhance efficiency, streamline payroll, and provide tax advantages.
