Looking at Controlled Groups – The Finer Points Sunday, April 28, 2013 Christian Hofstadter, JD, LLM, Employee Benefits

Counsel, Sutter Health

Janice M. Wegesin, CPC, EA, form5500help.com

Related Employers

• Types of related employers

• Controlled group

• Affiliated service group

• May be comprised of corporations, unincorporated businesses or any combination thereof.

• §414(b) is limited to controlled groups consisting only of corporations and further references §1563 for attribution rules. Otherwise see §414(c).

• §414(m), (n), and (o) defines affiliated service groups.

Consequences

• Controlled groups are treated as a single employer when applying

the qualified plan rules.

• General qualification under §401;

• Coverage under §410;

• Vesting under §411;

• Limits under §401(a)(17), §401(a)(30), and §415;

• Top-heavy rules under §416.

Types of Controlled Groups

• Parent-subsidiary controlled groups exist when one business (the

common parent) owns at least 80% of one or more other

businesses (the subsidiaries).

• May involve multiple tiers of subsidiaries that are owned at least

80% by a common parent or by subsidiaries in a higher tier.

• Examples that follow reference corporations, but the principles

apply regardless of the type of entity involved (partnership, LLC,

sole proprietorship, etc.)

Parent-Subsidiary Examples

• Corporation A owns 90% of Corporation B. Neither corporation

owns any interest in any other businesses. Corporations A and B

constitute a parent-subsidiary controlled group.

• Corporation A is the parent

• Corporation B is the subsidiary

• Corporation Z owns 90% of Corporation W; 100% of

Corporation X; and 88% of Corporation Y. Because Corporation

Z (parent) owns at least 80% of each company (the subsidiaries),

the controlled group consists of the four companies.

Multiple Layers

Company J owns

100 % of Company M

90% of Company R

80% of Company S

100% of Company H

90% of Company B

100 % of Company W

Complexities

Company J owns

100 % of Company M

60 % of Company W

• Corporations J and M are a

parent-subsidiary controlled

group.

• §415 looks at more than 50%

ownership test, so J, M, and W

are treated as a controlled group

solely for purposes of applying

§415 limits to the plans.

Foreign Parent or Subsidiary

• Sometimes US companies are owned by foreign parent.

• Employees at foreign parent usually not eligible for the US plan

• But controlled group may still exist

• Employees of foreign parent are usually excluded from coverage testing under non-resident alien exclusion.

• All US companies owned by foreign parent may be required to be aggregated under parent-subsidiary rules.

• Opposite is true if US company is parent and owns 80% of foreign company.

Brother-Sister Controlled Group

• Exists if five (5) or fewer common owners satisfy an

80% common control test and a 50% effective control

test.

• Common owner must be an individual, trust, or

estate.

• Businesses must satisfy both tests to be a brother-

sister group.

80% Common Control Test

• Test looks at the combined ownership of the common

owners in each business.

• Example: Russ and Scott are owners of Company RS.

Russ, Scott, and Harry are owners of Company RSH.

• Since Harry is not a common owner, he is not

considered in the test.

• Russ and Scott must have a combined ownership in

each business of at least 80% for the common

control test to be satisfied.

50% Effective Control Test

• Evaluates common ownership interests

• The same five (5) or fewer common owners taken into

account to satisfy the 80% common control test must

be used to apply the 50% effective ownership test.

• Identical ownership measured against lowest common

denominator for individual.

• If a person owns 25% of one company and 40% of

another company, the identical ownership is 25%.

Applying the 50% Test

• Facts:

• Russ owns 40% of Corporation RS, while Scott owns 60%.

• Russ owns 50% of Corporation RSH; Scott owns 30%; Harry

owns remaining 20%.

• Two persons – Russ and Scott – own at least 80% of both

businesses to satisfy the common control test.

• Russ and Scott also effectively control at least 50% of both

companies. Identical ownership for Russ is 40%; for Scott is

30%.

Applying the Tests

Different Results [50% but not 80%]

Different Results [80% but not 50%]

When is Determination Made?

• Two or more corporations are members of a controlled group any time such corporations meet the requirements of §1563(a).

• Unfortunately, changes often occur during plan year, not just at beginning/end.

• Previously unrelated companies become part of a controlled group

• Related companies fall out of controlled group status

• When changes occur during the year, qualification requirements must be reviewed taking into account mid-period changes.

What is Ownership?

• Ownership is identified based upon type of entity.

• Ownership in a corporation is in the form of stock.

• Partners have a capital and/or profits interest.

• LLC / LLPs have membership interests.

• Sole proprietors own 100% of their businesses.

• Ownership in a trust or estate is measured as an actuarial interest.

Voting Power vs. Value

• Stock ownership is measured on the basis of voting power or

value.

• When the percentage looks at voting power, only classes of

stock entitled to vote are considered.

• If percentage is based upon value, all classes of stock are

considered.

• 80% parent-subsidiary threshold is measured either by 80% of

the value of the subsidiary’s stock or 80% of the voting power.

• Similar application for corporations involved in brother-sister

test.

• Mix and match value and voting power for brother-sister

common control and effective control tests.

§1563 Attribution Rules

• Directly written to apply to corporations and refer to stock

ownership.

• The same principles apply to other entity types.

• Family attribution

• Attribution between spouses: yours is mine; mine is yours.

• Legally separated or divorced spouses do not experience

attribution.

• Another exception looks at individual direct ownership

and status as employee, director, or management.

• But community property rules in some states may

override this exception.

Family Attribution [continued]

• Between parents and minor children: any interest held by a minor (child under the age of 21) is attributed to the parent.

• Goes both ways (child to parent; parent to child).

• Legally adopted children treated as child under this rule.

• Limited attribution from / to adult children (age 21 or older): no attribution unless the stock holding is more than 50% of direct ownership or in combination with other attribution.

• Example: mother owns 60% of stock, while adult son and daughter each own 20% of the stock. Children are not attributed mother’s stock because each owns less than 50%; mother is attributed children’s stock because she owns more than 50% interest on her own.

Adult Children and Attribution

• Is this a controlled group or brother-sister group?

• Suppose Mother owns 60% of Corporation A; Son owns

20%; Daughter owns 20%.

• Son owns 80% of Corporation B; Daughter owns other 20%

of Corporation B.

• No. Mother is treated as owning 100% of Corporation A but has

no interest in Corporation B. There is only 40% common

control and only 40% effective control under the brother-sister

rules.

• Note that if spousal or minor child attribution gets parent

above 50%, it could lead to attribution from adult children.

Attribution To / From Grandparents

• Regardless of age of grandchild, an individual who owns

more than 50% of a business is treated as owning the

interest in that business that is owned by the individual’s

grandchildren or grandparents.

• No double attribution in family attribution.

• Any ownership by attribution is not further

attributed to someone else.

• No attribution between siblings.

Attribution under §1563

• Between spouses (unless exception applies)

• From parent to minor child (under age 21)

• From minor child to parent

• From adult child (21 or older) to parent only if parent owns directly or by other attribution more than 50% of company

• From parent to adult child only if child owns directly or by other attribution more than 50% of company

• From grandchild at any age to grandparent only if grandparent owns directly or by other attribution more than 50% of company

• From grandparent to grandchild at any age only if grandchild owns directly or by other attribution more than 50% of company

• NO attribution between siblings.

• NO double attribution.

Attribution and Same-Sex Marriage

• Is there attribution between same-sex spouses who are

legally married under state law?

• No. The Defense of Marriage Act (DOMA) defines

marriage as a marriage between one man and one

woman. Federal law supersedes state law in this

regard.

• On the other hand, when children of same-sex

marriages are owners, does this potentially result in

attribution to the same-sex spouses?

Contrast with Attribution Under §318

• Used in identifying HCEs and Key Employees

• Summary of attribution rules (if one is a direct owner) -

• Between spouses

• From parent to child (including adopted children)

• From child to parent

• From grandchild to grandparent

• NO double attribution

• NO attribution from grandparent to grandchild

• NO attribution between siblings

Excluded Stock Ownership

• Stock excluded from the controlled group analysis:

• Treasury stock

• Nonvoting preferred stock

• Additional exclusions apply to both parent-subsidiary and

brother-sister controlled groups if certain conditions are met:

• Ownership held by a deferred compensation plan

• Restricted stock held by an employee

• Certain stock owned by a tax-exempt (§501) organization

• Exclusions applying only to parent-subsidiary controlled groups

if certain conditions are met:

• Certain ownership interests in a subsidiary that are held by

a principal owner, officer, partner, or fiduciary of a parent

Nonvoting Preferred Stock

• Preferred stock is “stock which is limited and preferred

as to dividends”

• Example:

• Charlie owns 100% of Company A.

• Charlie owns 100% of the nonvoting preferred stock of

Company B (totaling 90% of Company B’s value).

• Charlie’s best friend, Angel, owns 100% of Company B’s

common stock (totaling 10% of Company B’s value).

• Angel also owns 100% of Company C.

Nonvoting Preferred Stock

• Is the preferred stock truly nonvoting?

• Preferred stock may not be considered nonvoting if:

• Preferred stockholders may vote for any member

of the board of directors

• Preferred stockholders could have a right to vote

in the future if a certain event occurs

• Preferred stockholders have the option to convert

their preferred shares into common stock

Restricted Stock

• If an employee of a company owns stock in that

company which is subject to a condition that runs in

favor of the company or one of its “common owners,”

that stock is excluded if the condition substantially

restricts the employee’s right to dispose of the stock

• This exclusion only applies if five or fewer

individuals, estates, or trusts own or are deemed to

own at least 50% of the company in question.

Restricted Stock Example

• Stacy owns 100% of Company A and 75% of Company

B.

• Rupert, an employee of Company B, owns 10% of

Company B stock but it is subject to a right of first

refusal in favor of Stacy.

• The remaining 15% is owned by an unrelated investor.

• Therefore, the stock Rupert owns is excluded from the

equation, and Stacy’s ownership in Company B equals 75/90

or 83.3%.

• Company A and Company B are a controlled group.

Interest Held By Certain Individuals

• Ownership in a subsidiary by a principal owner, officer,

partner, or fiduciary of the parent is excluded.

• “Officer” includes president, vice presidents, general

manager, treasurer, secretary, comptroller, etc.

• A “principal stockholder” is someone who owns, or

is deemed to own via attribution, at least 5% of the

parent’s stock (voting power or value)

• This exclusion only applies if the parent owns at least

50% of the subsidiary

Interest Held By Certain Individuals

• EXAMPLE: Susan is the CEO of Company X. Susan owns

25% of Company Y, and Company X owns the remaining 75%

of Company Y.

• Since Susan is an officer of Company X, her stock in

Company Y is excluded.

• Company X is treated as owning 100% of Company Y.

• Company X and Company Y are a controlled group.

• At first glance this does not look like a controlled group.

• It is important to keep track of each owner’s position with the

companies being analyzed

Attribution from Stock Options

• In general, an individual who has an option to buy stock

is deemed to own the stock covered by that option

under the attributions rules.

• Example:

• Jake is a 100% owner of Company A.

• He owns 75% of Company B, and the remaining

25% is owned by Jake’s unrelated assistant, Harry.

• As part of the agreement that governs Harry’s 25%

share, Jake may purchase all of Harry’s share in

Company B at any time.

Stock Option Agreements

• Rule also could apply to agreements between companies.

• Example:

• Company A owns 40% of Company B.

• Through a contract entered into between the

companies, Company A has a right to purchase up to

an additional 50% of Company B’s shares.

• Through the stock option rules, Company A is

deemed to own 90% of Company B.

• Company A and Company B are a controlled

group.

“Traditional” Stock Options

• What if there are options to buy stock directly from the

company? Alternative views:

• Stock that could be purchased directly from a

company should be treated as treasury stock, and is

therefore excludable from the analysis.

• Stock under those options are attributed to the

person who acquires or holds the option.

• Is there a correct answer?

Determining Partnership/LLC Ownership

• When determining the ownership in a partnership or

LLC that is taxed as a partnership, both the profits

interest and capital interest of the partners must be

reviewed

• It is common for a person’s profits interest to be

different from his or her capital interest

Determining Partnership/LLC Ownership

• It is common for partners to have different percentages

for their profits and capital interests.

• Schedule K-1 reflects a partner’s beginning and

ending profits and capital interests, but these

amounts could fluctuate throughout the year.

• Review all applicable partnership agreements and

amendments.

Attribution from Trusts

• Beneficiaries of a trust are generally deemed to own their pro

rata interest of stock held by a trust if they have a 5% or greater

interest in the trust.

• Calculating a beneficiary’s interest may be very complicated,

requiring actuarial calculations and the use of certain tax

tables.

• In the case of “grantor trusts,” the grantor of the trust is

deemed to be the owner of the entire interest that is held by

the trust

• Beneficiaries of such trusts are deemed to own their

actuarial interest of the ownership of the trust.

Attribution from Trusts

• In general, all trusts have a grantor, and the grantor:

• Retains power over the trust’s administration; and

• Typically keeps control over the property held by the trust

• For example, a grantor trust generally exists when a trust

is revocable, the grantor has retained an income interest in

the trust, or some other right that the grantor possesses

regarding the trust

• In the case of non-grantor trusts, the grantor has given up all

rights pertaining to the principal assets of the trust (and only the

trustee may revoke or terminate the trust)

• The only way to be certain that a trust is a grantor trust for

controlled group purposes is to review the trust agreement

Stock Owned by a Tax-Exempt Organization

• Stock owned by a §501 organization (that is not the parent) is

excluded if the organization is controlled, directly or indirectly, by

any one or more of the following:

• The parent (in the case of a parent-subsidiary group)

• The corporation in question

• An officer of the parent (or the corporation in the case of a

brother-sister controlled group)

• An individual, estate, or trust which is a principal stockholder

of the parent (or of the corporation in the case of a brother-

sister controlled group)

• Any combination of the above

Tax-Exempt Organizations

• If at least 80% of the directors or trustees of one

organization are either representatives of, or directly or

indirectly controlled by, the other organization, a

controlled group exists between the organizations.

• A “representative” of an organization could be a trustee,

director, agent, or employee.

Issues with Foreign Companies

• When a foreign entity is part of a controlled group, only

nonresident aliens with no US source income may be

excluded.

• US source income is income that is earned by a

nonresident alien for services performed in the

United States; however, note there are certain

exceptions, such as income that is subject to a tax

treaty.

• May US citizens who are employees of foreign

controlled group members participate in the US plan?

Definition of Nonresident Alien

• An individual is a nonresident alien if he/she is not a

U.S. citizen and not a resident alien.

• A resident alien is an individual who either:

• Has been lawfully admitted to the U.S. as a

permanent resident (e.g., a green card holder);

• Satisfied the “substantial presence test” [IRS Publication

519 for more information: http://www.irs.gov/pub/irs-pdf/p519.pdf];

or

• Elects to be treated as a resident alien for tax

purposes

Tips for Effective Data Collection

• Start with the big picture:

• Does the plan sponsor have any ownership in

another entity?

• If the plan sponsor is privately held or a partnership,

do the owners/partners have any amount of

ownership in any other entities.

• Don’t forget to inquire about treasury stock and

nonvoting preferred stock

Tips for Effective Data Collection

• Educate your clients

• Try not to overwhelm your client with too many

questions at once.

• One of the greatest challenges may be obtaining

ownership information regarding a client’s spouse,

children, or other relatives.

Drill Down

• The plan sponsor indicates it has ownership in another

entity, ascertain the ownership percentage.

• A client advises that the parent (or owners) owns

less than 80% of the subsidiary, clarify that the client

understands that there are multiple layers to

determining ownership.

• A follow-up question could determine whether

Company B has more than one class of common stock,

etc.

Know Your Limits!

• If a client does not want to disclose all ownership

information, require them to engage an attorney to

perform the controlled group analysis.

• May a plan sponsor simply treat an entity as part of the

controlled group (whether or not it truly should be

included)?

• Consider including a disclaimer in your annual data

request stating that your client is ultimately responsible

for determining its controlled group/affiliated service

group status.