Out of Control: The Tax Code s Controlled Group Rules Leave Many Plans (Unwittingly) Out of Compliance

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1 Out of Control: The Tax Code s Controlled Group Rules Leave Many Plans (Unwittingly) Out of Compliance August 2013 Lockton Companies When is a single employer not really a single employer? When it s a member of a controlled group of businesses. Who cares? You should, if you sponsor an employee benefit plan. Why? Because what you don t know about the controlled group rules or who is in your corporate family tree can send chaos rippling through the entire enterprise. EDWARD C. FENSHOLT, J.D. Senior Vice President Director of Compliance Services Lockton Benefit Group efensholt@lockton.com Federal law requires that employers within the same controlled group of businesses be treated as a single employer for many employee benefit purposes, including discrimination testing. Many executives particularly those of small, closely held employers don t know their employers are members of a controlled group. A distant holding company, venture capitalist, or group of individuals or trusts might own the employer, leaving the executives wholly unaware about who else nests in the corporate tree. Ignorance here is not bliss. Retirement plan sponsors submit applications to the IRS and annual filings to the Department of Labor, making representations under penalty of perjury regarding the sponsors membership (or lack thereof) in a controlled group. Federal auditors scrutinize plans to determine whether a controlled group issue exists... and may impose drastic penalties where a plan fails key requirements after applying the controlled group rules. Let s quickly review those rules and explore where they pose nasty problems. L O C K T O N C O M P A N I E S

2 The Controlled Group Rules The controlled group rules are complex, so we only summarize them here. Basically, two or more corporations, trades or businesses (including partnerships and proprietorships) are considered a single employer if they re members of a parent-subsidiary controlled group, brother-sister controlled group, or both. Generally, a parent-subsidiary (or vertical) controlled group exists where a corporation, trade or business owns at least 80 percent of the outstanding stock or profits interest of another business (in a tax-exempt entity; the test essentially is whether one organization may appoint and remove at least 80 percent of the directors or trustees of the tax-exempt entity). A brother-sister (or horizontal) controlled group exists where the same five or fewer individuals, estates or trusts own at least 80 percent of the stock or profits interest of two or more businesses. In addition, however, these owners must possess at least 50 percent of the organizations stock or profits interest, taking into account an ownership interest in one business only to the extent it does not exceed the individual s, estate s or trust s ownership in the other. For example, if John owns 75 percent of one business and 20 percent of another, while Paula owns 10 percent of the first business and 60 percent of the other, as a general rule, there is no controlled group. Although together they own at least 80 percent of both businesses, they fail the 50 percent test because John is deemed to own just 20 percent of both businesses, and Paula is deemed to own just 10 percent of both, for a total of 30 percent. But it s not quite that simple. Complex rules provide that some restricted stock is disregarded. In a venture capital situation, this means that key employees who own almost all the stock of a company might actually own very little for controlled group purposes the true ownership may lie elsewhere if their stock is restricted. In addition, some individuals may be deemed to own the interests held by certain family members. Consequently, it s very easy for a controlled group to exist without its members knowing it. 2

3 Where Does It Matter? The controlled group rules have key implications for many employee benefit programs: Retirement Plans All employees in the controlled group generally must be included when performing nondiscrimination testing under Code sections 410(b) (pertaining to discrimination in eligibility and participation), 401(a) (4) (benefits, rights and features), and 401(k) and (m) (employee and matching contributions) for a qualified plan. However, see the section below, titled Work-Arounds, for a discussion of an exception offered by the Tax Code s qualified separate lines of business rules. A 401(k) plan may not have a catch-up feature for employees age 50 and older unless all 401(k) plans in the controlled group have such a feature. Service with all members of a controlled group is taken into account for eligibility and vesting service calculations. Distributions permitted only upon employment termination may not be made where an employee moves from one company to another, and the two employers are members of the same controlled group. Controlled group members can be liable for pension obligations of another member who terminates an underfunded pension plan. In addition, controlled group members may be liable for another member s withdrawal liability when the other member withdraws from a multiemployer pension fund. When applying the limits on the amount of loans from qualified plans, all plans in the controlled group are treated as a single plan. In certain cases, benefits earned by an employee under multiple plans in the same controlled group are deemed to be earned under a single plan for purposes of applying the Code section 415 benefit limitations (for this purpose, the 80 percent ownership tests are reduced to 50 percent). Top-heavy testing is done on a controlled group basis. Defined benefit plan sponsors may be required to report, to the Pension Benefit Guarantee Corporation, material changes (such as bankruptcies) occurring within the controlled group. 401(k) plans might not be allowed to make distributions upon plan termination if there are other defined contribution plans in the controlled group. Welfare Plans COBRA applies to employers with at least 20 fulltime employees (or their part-time equivalents). In determining the number of employees, all members of the controlled group are considered. Self-insured healthcare plans and cafeteria plans (including flexible spending accounts) are subject to discrimination-testing rules that require consideration of all controlled group members. 3

4 Medicare secondary payer rules provide some exceptions for employers with small numbers of employees (exceptions under which Medicare becomes primary where it would otherwise be secondary). But in calculating whether an employer qualifies for the exceptions, all employees in the controlled group must be considered. Where an employer terminates a plan, or is sold off by its private equity group owner, COBRA liability for displaced employees might linger on the seller s side of the fence, where a group plan exists anywhere in the controlled group. When one member of a controlled group makes contributions to the health savings accounts of eligible employees, all members of the controlled group might be required to do the same. The 2010 health reform law applies nondiscrimination requirements to fully insured medical plans, and (beginning in 2015) imposes a play or pay coverage mandate upon employers with 50 or more full-time equivalent employees who fail to offer coverage to substantially all full-time employees. The nondiscrimination rules and the determination of whether an employer is subject to the play or pay mandate apply on a controlled group basis. Trouble Spots A flashpoint for controlled group problems is a corporate acquisition. Owners of several companies may acquire others, with no thought to the impact the new company s demographics will have on the plans already existing in the controlled group. Happily, for the most important purposes (e.g., the coverage discrimination testing rules for qualified retirement plans), the plans get a free pass through the end of the plan year following the year of the acquisition. COBRA violations occur frequently. A company may shut down, and the employer fails to provide COBRA coverage to the affected employees because the employer ceases to exist. But COBRA requires that if a group health plan exists anywhere in the controlled group, such a plan must provide the COBRA coverage. Failure to do so can trigger huge penalties on the surviving controlled group members. Other acquisition-related issues arise when two companies behave as though they are members of a controlled group, when they are not. For example, perhaps Company A and Company B are both 50 percent joint venture owners of Company C, and Company A puts Company C employees on Company A s self-insured health plan. Because Company A and Company C are not members of the same controlled group, the plan becomes a self-insured multiple employer welfare arrangement, or MEWA. Self-insured MEWAs are illegal in nearly all states, and surrender protection from state law that non-mewas typically enjoy. 4

5 Federal auditors scrutinize plans to determine whether a controlled group issue exists... and may impose drastic penalties where a plan fails key requirements after applying the controlled group rules. Work-Arounds Complex rules in the Tax Code may supply a solution in some contexts. The Code s Qualified Separate Line of Business or QSLOB rules permit retirement plans in a controlled group to be tested on something other than an aggregated basis, in certain circumstances. Again, the rules are complicated and should be utilized only after consultation with legal counsel. Other complex rules, called the Affiliated Service Group rules, allow certain organizations that service other organizations to be treated as members of the other organizations controlled groups. Employers looking to utilize the Affiliated Service Group rules should also speak with legal counsel. Private equity funds have argued that they are not subject to the Tax Code s controlled group rules with respect to their portfolio companies because the funds don t carry on a trade or business, a term that is central to the definition of a controlled group. While it s not clear whether that argument is a winner, the Pension Benefit Guaranty Corporation has opined that it s not, as has a federal appeals court. If other federal authorities rule similarly, the health reform law could pose significant challenges to private equity funds because of the risks associated with discrimination testing, and the application of the play or pay mandate. MEWAs created by joint venture situations may be defused by having one joint venture partner hire the joint venture s employees and lease them to the joint venture. Alternatively, the joint venture partner might choose to buy group insurance to cover it and the joint venture s employees; insured MEWAs pose fewer issues than self-insured MEWAs. Knowledge is the Key There s no broad-based solution to a controlled group issue. The key is to first understand whether you re a member of a controlled group. If so, you can then begin to accurately apply the various tests and requirements that apply to your plans. If you discover a problem, your remedy may differ from case to case, but at least you ll be attacking the issue from a position of knowledge rather than ignorance. 5

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