Rev. Rul. 68-303

Advice has been requested whether a partnership that enters into a contract to transfer its common-law employees to an unrelated corporation must consider those employees in determining whether its employees' profit-sharing plan meets the coverage requirements of section 401 of the Internal Revenue Code of 1954.

A partnership entered into a contract with an unrelated corporation pursuant to which the partnership agreed to transfer its common-law employees to the corporation and the corporation agreed to provide the services those employees had previously performed for the partnership. The employees continued to perform the same services they had performed for the partnership before the contract was made and continued to be supervised by the partners. However, the corporation maintained their payroll records, issued their pay checks, and provided all necessary insurance for them. The corporation received a fee equal to 110 percent of the aggregate salaries of the employees.

Section 401(a)(3) of the Code provides that a plan will not qualify under section 401 unless it benefits a sufficient number of employees to meet the percentage requirements set out therein or a classification of employees set up by the employer and found not to discriminate in favor of employees who are officers, shareholders, supervisors, or highly compensated. Section 401(d)(3) of the Code provides, in effect, that section 401(a)(3) is not applicable to a plan that covers an owner-employee, as defined in section 401(c)(3). Instead, section 401(d)(3) of the Code provides that such a plan will not qualify under section 401 unless it benefits each employee, other than an owner-employee, who has been a full-time employee of the trade or business for more than three years.

Section 1.401-11(d) of the Income Tax Regulations states that a self-employed individual, by reason of the contingent nature of his compensation, is considered to be a highly compensated employee and, thus, is a member of the group in whose favor discrimination is prohibited.

Regardless of whether the coverage provisions of section 401(a)(3) or 401(d)(3) of the Code are applicable, employment for pension, profit-sharing and stock bonus plan purposes means the same, generally, as employment for other purposes, including coverage for social security or similar public programs. See Rev. Rul. 60-379, C.B. 1960-2, 156. A contractual arrangement will not be determinative of the employer-employee relationship where the realities of the situation contradict the terms of the contract. For example, in the case of Roy Bartels, et al. v. Birmingham , 332 U.S. 126 (1947), Ct. D. 1689, C.B. 1947-2, 174, the Supreme Court of the United States held that where a contractual provision contradicts all the other facts and circumstances in the case bearing upon a determination of the true relationship between the various parties involved for employment tax purposes, the contractual provision is not conclusive of the relationship. That case required a determination whether certain orchestra members were employees of the orchestra leader or of various proprietors of dance halls. The Court stated, in effect, that when the facts demonstrate that the orchestra leader is liable for the tax, the Government cannot treat the formal contractual agreements of the leader and proprietors as a basis for collecting the tax from the proprietors.

In the instant case the determination whether the partnership or the corporation is the employer is governed by the usual common-law rules applicable in determining the employer-employee relationship. The guides for applying such rules are found in section 31.3121(d)-1(c) of the Employment Tax Regulations. Before the partnership and the corporation entered into the contract, the partnership was the employer under the usual common-law rules. After the contract was entered into, the employees performed the same services for the partnership under the continuing control and supervision of the partnership. The only change, from the viewpoint of the employees, was the source of the pay checks. The contract in no way changed the realities of the situation.

Accordingly, the employees subject to the agreement in the instant case must be considered in determining whether the partnership's profit-sharing plan meets the coverage requirements of section 401 of the Code.