What if a somewhat arcane area of tax law had potentially serious ramifications for attorneys and other tax advisors across a broad range of practices, but was not consistently identified and planned for in actual practice? That is an accurate description of the rules surrounding “controlled group” status between two or more businesses, which I have seen arise in business formation/transactions, estate planning, employment and family law settings. The purpose of this overview is to briefly survey controlled group rules for non-ERISA practitioners, so that they can become aware of the potential complications that controlled group rules can create.
- Why Do Controlled Groups Matter?
The main reason they matter is because the IRS treats separate businesses within a controlled group as a single employer for almost all retirement and health benefit plan purposes. In fact, annual reporting for retirement plans (and for health and welfare plans with 100 or more participants) requires a statement under penalty of perjury as to whether the employer is part of a controlled group. Therefore controlled groups are most frequently a concern where business entities have employees and particularly when they sponsor benefit plans, whether retirement/401(k), or health and welfare plans. Note, however, that creation of a business entity that has no employees can still create a controlled group issue when it acts as a conduit to link ownership of two or more other entities that do have employees.
Being part of a controlled group does not always mean that all employees of the member companies have to participate in the same benefit plan (although it can sometimes mean that). However it generally means that separately maintained retirement plans have to perform nondiscrimination testing as if they were combined, which not infrequently means that one or more of the plans will fail nondiscrimination testing. This is an event that usually requires the employer sponsoring the plan to add more money to the plan on behalf of some of the additional counted employees, or to pay penalty taxes in relation to same. Similar complications can arise in Section 125 cafeteria or “flexible benefit plans,” and for self-insured group health plans, which are subject to nondiscrimination requirements under Code § 105(h). Nondiscrimination rules are meant to apply to insured group health plans under the Affordable Care Act (“ACA”), so additional complications could arise in that context when and if the rules are enforced by the IRS, following publication of regulatory guidance.
Controlled group status can also mean that several small employers together comprise an “applicable large employer” subject to the ACA “pay or play rules,” and related annual IRS reporting duties. Small employer exceptions under other laws, including COBRA and the Medicare Secondary Payer Act, reference controlled group status when determining eligibility for the exception.
- How Do I Identify a Controlled Group?
Determining controlled group status requires synthesizing regulations and other guidance across multiple Internal Revenue Code (“Code”) provisions and therefore is a task for a specialized ERISA or tax practitioner. What follows are very simplified definitions aimed at helping advisors outside that specialized area flag potential controlled group issues for further analysis.
Strictly speaking, the term “controlled group” refers to shared ownership of two or more corporations, but this article uses the term generically as it is the more familiar term. “Ownership” in this context means possession of the voting power or value of corporate stock (or a combination thereof). Shared ownership among other types of business entities is described as “a group of trades or businesses under ‘common control.’” Ownership in this context refers to ownership of a capital or profits interest in a partnership or LLC taxed as a partnership. Controlled groups can also arise in relation to tax-exempt entities, for instance if they own 80% or more of a for-profit entity, or even between two tax-exempt entities where there is substantial overlap of board membership or board control.
Complex interest exclusion rules mean that not all ownership interests are counted towards common control; exclusion may turn on the nature of the interest held (e.g., treasury or non-voting preferred stock) or on the party holding the ownership interest (e.g, the trust of a tax-qualified retirement plan).
The two main sub-types of controlled group are: parent-subsidiary, and “brother-sister,” although a combination of the two may also exist. A parent-subsidiary controlled group exists when one business owns 80% or more of another business, or where there is a chain of such ownership relationships. As that is a fairly straightforward test, I will focus on the lesser known, but more prevalent, brother-sister type of controlled group.
A brother-sister controlled group exists when the same five or fewer individuals, trusts, or estates (the “brother-sister” group) have a “controlling interest” in, and “effective control” of, two or more businesses.
- A controlling interest exists when the brother-sister group members own, or are deemed to own under rules of attribution, at least 80% of each of the businesses in question.
- Effective control exists when the brother-sister group owns or is deemed to own greater than 50% of the businesses in question, looking only at each member’s “lowest common denominator” ownership interest. (So, a group member that owed 20% of one business and 40% of another business would be credited only with 20% in the effective control test.)
- In order to pass the 80% test, you must use the interests of the same five or fewer persons (or trusts or estates) used for purposes of the greater than 50% test. See US v. Vogel Fertilizer, 455 US 16 (1982). Put otherwise, the two tests consider only owners with a greater-than-zero interest in each of the businesses under consideration. If, under this rule, you disregard shares adding up to more than 20% of a business, the 80% test won’t be met and that business generally won’t form part of the controlled group. (Although the remaining businesses may do so.)
The controlled group attribution rules are quite complex and can only be touched on here. Very generally speaking, an ownership interest may be attributed from a business entity to the entity’s owner, from trusts to trust beneficiaries (and to grantors of “grantor” trusts as defined under Code § 671-678), and among family members. Stock options can also create attributed ownership under some circumstances. The attribution rules can have surprising consequences. For instance, a couple, each with his or her wholly-owned corporation, will be a controlled group if they have a child under age 21 together, regardless of their marital status, because the minor child is attributed with 100% of each parent’s interests under Code §1563(e)(6)(A). Community property rights may also give rise to controlled group status. Careful pre-marital planning may be necessary to prevent unintended controlled group status among businesses owned separately by the partners to the marriage.
This is the first part of a two-part discussion that was first published as an article in the Santa Barbara Lawyer Magazine for October 2017. The second half will address a variation of these rules that are specific to businesses formed by doctors, dentists, accountants, and other service providers.