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:
|
Testing for Brother-Sister Controlled Group |
|
Shareholder |
Acme
Co. |
Widget
Inc. |
Jones
& Co. |
Effective
Control |
|
J. Smith |
40% |
10% |
25% |
10% |
|
N. Williams |
30% |
60% |
20% |
20% |
|
R. Jones |
30% |
30% |
55% |
30% |
|
Total |
100% |
100% |
100% |
60% |
Controlling
Interest Test: |
100% ownership by same three individuals exceeds 80% required for
controlling interest test |
Effective
Control Test: |
60% identical ownership exceeds 50% required for effective control
test |
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:
- 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).
- 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.
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