Charlie Consultant is meeting with Vince to review the plan year end compliance testing and 5500 form for his computer company’s 401(k) plan. As they are saying their good-byes, Vince mentions that his vitamin company has been growing dramatically, and in a couple more years he may consider setting up a 401(k) plan for those employees. Charlie’s eyes get wide, his heart starts pounding and his mouth drops open in shock. “What vitamin company?” he asks.

Why is Charlie Consultant so concerned? If Vince’s two companies are determined to be a controlled group and the plan fails coverage testing, the plan may be in jeopardy of disqualification. It is irrelevant whether or not Vince’s companies have anything to do with one another. The issue is common ownership.

Qualified plans must cover a sufficient portion of a company’s non-highly compensated employees to satisfy the coverage testing requirements of IRC Section 410(b). Businesses that are considered to be under common control are required to treat the employees of all members of the group as if they were employed by a single employer for testing purposes. The implications of this single employer rule can be dramatic.

This newsletter will provide an overview of the controlled group rules, coverage testing and the implications of being under common control.

Controlled Groups

Many businesses are affiliated with other businesses, either because one company owns the other (“parent-subsidiary”) or because the same five or fewer people own a significant portion of both businesses (“brother-sister”). Parent-subsidiary companies and brother-sister companies are called “controlled groups.”

The controlled group rules apply not only to corporations but also to all forms of businesses including sole proprietorships, partnerships and limited liability companies.

Businesses that do not constitute a controlled group may still need to be treated as one employer, under the complex affiliated service group rules, if they are tied together in performing services for one another or for third parties.

Certain outstanding shares are disregarded in determining whether a controlled group exists, i.e., treasury stock and non-voting preferred shares.

Parent-Subsidiary Controlled Group

The parent-subsidiary rules generally are straightforward and easy to apply. A corporation is a subsidiary when at least 80% of its stock, measured by vote or value, is owned by another (parent) corporation.

Brother-Sister Controlled Group

Although the brother-sister rules can be as simple as Vince owning all of the stock of both Computer Company and Vitamin Company, in practice they are often complex to apply. There are two requirements which must be met in order to have a brother-sister controlled group:

• Controlling Interest: The same five or fewer individuals must own, directly or indirectly by attribution, 80% or more of the vote or value of the stock of each business. Only shareholders owning interests in each potential member of the group are counted–any shareholder who does not own stock in all of the companies being considered is ignored.
• Effective Control: The owners identified above must own more than 50% of the vote or value of each business, taking into account ownership of each person only to the extent identical for each company. The determination is made by adding together the lowest ownership percentage for each owner in the companies being tested.

The following example demonstrates the operation of the controlling interest and effective control rules:

Stock Attribution

In applying the brother-sister rules, constructive ownership rules provide that stock owned by one spouse is attributed to (treated as owned by) the other spouse, unless either:

• The two are divorced or legally separated, or
• The second spouse owns no direct interest in the stock (including community property interest); is not a director, fiduciary, or employee of the company and does not participate in the company’s management; less than half of the company’s income is from royalties, rents, dividends, interest and annuities; and the spouse’s stock is not subject to ownership restrictions running in favor of the first spouse or their under age 21 children.

Stock is also attributed from an individual’s under age 21 children to the individual. If the individual owns, or is deemed to own, more than 50% of the company, stock owned by the individual’s adult children, grandchildren, parents and grandparents is also attributed to the individual.

Because of this attribution rule, if a husband and wife each own 100% of a business and they have a child under age 21, the child is deemed to own both businesses. Therefore, a controlled group will exist even if there is no attribution between the parents.

Code Section 1563 stock attribution rules apply for controlled group purposes and are not the same as the Code Section 318 attribution rules used for determining key and highly compensated employees.

Mergers and Acquisitions

Special transition rules apply in the case of mergers and acquisitions. When one company buys all of the stock of another company, causing the two companies to become members of a controlled group, they may have one to two years before all the rules apply on an aggregated basis.

QSLOB Exception

The qualified separate line of business (“QSLOB”) rules are intended to enable companies to avoid the consequences of pension aggregation, even though members of a controlled group. These rules are rarely applicable to smaller businesses and are primarily utilized by larger companies that can bear the burdens and expenses of demonstrating satisfaction of the QSLOB rules.

Coverage Testing

Qualified retirement plans are required to benefit a nondiscriminatory group of employees. A minimum percentage of non-highly compensated employees (NHCEs) must benefit when compared to the percentage of highly compensated employees (HCEs) who are benefiting.

If the employer sponsoring the plan is a member of a controlled group, all employees of the other companies in the controlled group must be considered when performing coverage testing. If two companies are members of a controlled group, it still may be possible for the companies to maintain separate plans or have separate benefit structures within the same plan, such as different matching contribution rates in a 401(k) plan or different levels of profit sharing contributions.

If most of a controlled group’s HCEs are in one company, then it is not surprising that pension law ordinarily will restrict that company from having a pension plan more generous than that covering employees of the other controlled group members. Conversely, two similarly sized controlled group members, with HCEs and rank and file evenly divided between them, should be able to have disparate plans, or only one of them have a plan.

Highly Compensated Employees

An employee of any member of the controlled group who falls into either of the following two categories is an HCE:

1. A more than 5% owner at any time during the current plan year or preceding plan year (Section 318 stock attribution rules apply which treat an individual as owning stock owned by his spouse, children, grandchildren or parents).
2. An employee who had compensation (including compensation from all members of the controlled group) in excess of the indexed limit for the preceding plan year ($90,000 for 2003).

Ratio Percentage Test

The ratio percentage test compares how many of the company’s HCEs are benefiting to how many of the NHCEs are benefiting. As long as the percentage of NHCEs covered is at least 70% of the percentage of HCEs covered, the plan will pass the coverage test. Separate tests are performed for each type of contribution, i.e., 401(k) deferrals, matching, profit sharing contributions.

Participants are treated as benefiting when they receive a contribution or accrue a benefit under the plan. In a 401(k) plan, employees are considered to be benefiting if they are eligible to make 401(k) deferrals and receive matching contributions, even if they do not actually make deferrals.

Example: Vince has a controlled group since he owns 100% of both Computer Company and Vitamin Company. Charlie Consultant quickly gets employee information from Vince so he can perform a coverage test including Vitamin Company employees who are not covered by the Computer Company 401(k) plan. Computer Company has 39 eligible NHCEs who are all benefiting, and Vitamin Company has 16 NHCEs.

Since Vince is the only HCE and he is participating in the plan, 100% of the HCEs are benefiting. Combining both companies, there are 55 NHCEs and 39, or 70.91%, of the NHCEs are benefiting. The test is passed since the percentage of NHCEs benefiting exceeds 70% of the percentage of HCEs benefiting. Charlie breathes a sigh of relief.

Average Benefits Test

If the ratio percentage test is failed, the plan may be tested under the much more complicated average benefits test. Generally, the average benefit percentage for NHCEs must equal or exceed 70% of the average benefit percentage of HCEs.

Other Plan Rules

In addition to the coverage rules, members of a controlled group are aggregated and treated as one employer for purposes of:

Maximum Annual Benefits: Amounts credited to all plans are combined to determine if the maximum annual limits have been exceeded.

Compensation: Compensation from all companies is aggregated and capped at the maximum annual limit.

Service: Hours of service with all members of the controlled group are considered for eligibility and vesting purposes. An employee who transfers to another company in the controlled group is not considered to be separated from service and will not be eligible to receive a distribution from the old employer’s plan. Depending upon his service with the old employer, he may be immediately eligible for the new employer’s plan and be 100% vested.

Top Heavy Testing: All plans must be combined for testing purposes if a key employee is a participant. If the combined plans are top heavy, top heavy minimum contributions and vesting will be required for all plans.

Plan Loans: Loans from all plans in the controlled group are aggregated for purposes of the $50,000 IRS maximum loan limit.

Conclusion

Often the analysis of whether two or more companies are controlled group members is complex, and the pension consequences of aggregation can be dramatic, even exposing plans to disqualification. It is, therefore, important for business owners to be aware of the controlled group and coverage rules and to disclose to their retirement plan professional any and all ownership interests.

This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.