If you’re considering moving employees between entities under common ownership—such as transitioning employees from an S corporation to a C corporation or implementing a Management Services Organization (MSO)—understanding the tax implications is crucial. Many businesses use this approach to streamline HR, payroll, and benefits administration. Thankfully, such transitions are generally **not taxable**, provided they meet specific conditions and follow the **Internal Revenue Code (IRC)**.
This article explores why employee transfers under common ownership or an MSO are not taxable, how to stay compliant, and the key IRC sections you need to consider.
Why Moving Employees Between Entities Isn’t Taxable
- **Legitimate Business Purpose**
The transfer should serve a valid business purpose, such as:
– Streamlining payroll, HR, or employee benefits.
– Centralizing management through an MSO structure.
– Administering **deferred compensation plans**, such as non-qualified stock options or executive bonuses.
– Enhancing operational efficiency and reducing administrative burden.
By ensuring a legitimate business purpose, businesses demonstrate the transaction is not structured for tax avoidance.
- **Using an MSO Structure**
When an **MSO (Management Services Organization)** is used to centralize functions like payroll, HR, or employee leasing, the restructuring is not taxable as long as the MSO arrangement follows IRS rules and the relevant IRC sections. The MSO acts as a service provider, leasing employees back to the operational entities. The payments made to the MSO are treated as **ordinary business expenses** under IRC §162.
- **Arm’s-Length Agreement**
A formal **Master Services Agreement (MSA)** should document the arrangement, including:
– Terms for leasing employees back to the original entity.
– Arm’s-length pricing for services provided by the MSO or related entity.
This ensures the transaction avoids any appearance of disguised compensation.
- **No Disguised Compensation**
To avoid IRS scrutiny, ensure that:
– Employee pay and benefits remain consistent before and after the transition.
– No additional or hidden compensation is tied to the movement of employees.
- **Ownership Consistency**
Both entities must share **common ownership**, meaning there is no change in control. This ensures the movement is not treated as a taxable sale or exchange of assets.
- **Control Group Rules**
Even if entities are not subsidiaries, they can qualify under **IRS control group rules**:
– **Parent-Subsidiary Group**: One entity owns at least **80%** of another.
– **Brother-Sister Group**: Five or fewer individuals collectively own at least **80% combined control** and more than **50% effective control** across entities.
This ensures that separate legal entities, like S and C corporations, can qualify as being under common ownership without being direct subsidiaries.
- **Employees as Intellectual Property (IP)**
Employees are not considered taxable property. Their value lies in the services they provide. Moving them between entities or into an MSO does not create a taxable event.
Key IRC Sections to Ensure Compliance
**[IRC §351: Transfer of Property to a Corporation](https://www.law.cornell.edu/uscode/text/26/351)**: Allows tax-free transfers of property, including service arrangements, to corporations under common control.
**[IRC §409A: Non-Qualified Deferred Compensation Plans](https://www.law.cornell.edu/uscode/text/26/409A)**: Governs deferred compensation arrangements and ensures strict compliance.
**[IRC §482: Allocation of Income and Deductions Among Related Entities](https://www.law.cornell.edu/uscode/text/26/482)**: Ensures payments between entities or to an MSO reflect market rates.
**[IRC §162: Ordinary and Necessary Business Expenses](https://www.law.cornell.edu/uscode/text/26/162)**: Payments to the MSO or related entity are deductible as ordinary business expenses.
**[IRC §83: Property Transferred in Connection with Performance of Services](https://www.law.cornell.edu/uscode/text/26/83)**: Confirms no taxable property (e.g., stock options) is transferred during restructuring.
**[IRC §414(b) and §414(c): Control Group Rules](https://www.law.cornell.edu/uscode/text/26/414)**: Defines control groups and ensures entities under common ownership are treated as a single employer.
**[IRC §3401 and §3101: Payroll and Employment Taxes](https://www.law.cornell.edu/uscode/text/26/3401)**: Confirms compliance with payroll tax and FICA requirements under the new structure.
**[IRC §269A: Personal Service Corporations (PSCs)](https://www.law.cornell.edu/uscode/text/26/269A)**: Ensures proper income characterization for PSCs.
Practical Example
Scenario:
An S corporation transitions its employees to a C corporation under common ownership. The C corporation, structured as an MSO, provides payroll, HR, and deferred compensation plan management services. Employees are leased back to the S corporation under a documented MSA.
Business Purpose: The restructuring improves efficiency, centralizes HR functions, and manages deferred compensation under a compliant MSO structure.
Tax Treatment:
– No taxable event occurs because ownership remains consistent, and the MSO complies with relevant IRC sections.
– Payments to the MSO are deductible as ordinary business expenses under §162.
– Deferred compensation remains compliant with §409A.
Risks and Best Practices
- **Ensure Reasonable Compensation**
Owner and employee compensation must remain reasonable and defensible under IRS scrutiny.
2. **Document the Business Purpose**
Clearly outline the reasons for restructuring, such as centralized HR, payroll, or deferred compensation.
3. **Formalize Agreements**
Use an MSA to document terms, pricing, and services provided by the MSO or related entity.
4. **Review Payroll Compliance**
Verify payroll tax compliance under IRC §3401 and related sections.
Conclusion
Businesses that follow the appropriate guidelines and leverage MSOs or common ownership arrangements can avoid triggering taxable events. Proper documentation, adherence to arm’s-length pricing, and compliance with IRC sections ensure smooth transitions while aligning with legitimate business objectives.
Optimize Your Business Tax Strategy
Looking to structure employee transitions or implement an MSO? **Guardian Tax Consultants** can help you navigate the complexities of payroll, HR, and deferred compensation while staying compliant with tax regulations. Contact us today for a personalized consultation.
