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

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1 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 Types of related employers Controlled group Affiliated service group Related Employers 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. 1

2 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.) 2

3 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 100 % of Company W 90% of Company R 80% of Company S 100% of Company H 90% of Company B 3

4 Complexities 100 % of Company M Company J owns 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. 4

5 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 brothersister 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. 5

6 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%. 6

7 Applying the Tests Different Results [50% but not 80%] 7

8 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 midperiod changes. 8

9 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. 9

10 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. 10

11 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. 11

12 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? 12

13 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 13

14 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 14

15 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. 15

16 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 16

17 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. 17

18 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 18

19 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. 19

20 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 brothersister controlled group) Any combination of the above 20

21 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? 21

22 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: 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 22

23 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. 23

24 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. 24