Hidden Figures: Why It’s Important for Plan Sponsors to Identify Controlled Groups

The identification and treatment of controlled groups often proves to be an enormous challenge for owners of multiple business entities. The rules for determining whether a controlled group exists are complex, requiring employers and plan administrators to ask the right questions, carefully analyze the responses, and adapt employee benefit plans as needed when a controlled group exists. These rules apply regardless of the types of entity — C corporations, S corporations, LLCs, partnerships, sole proprietorships, and tax-exempt entities — that are under common control. This article focuses on stock corporations. 

An inaccurate controlled group determination can create unnecessary expense for the employer. Additionally, because controlled group status impacts all facets of plan compliance and administration, and must be disclosed annually on Form 5500, assessments should be performed when any changes in ownership structure occur. 

We offer the following insights to help demystify controlled groups based on the business relationships among a group of fictional, interrelated companies. 

A Cautionary Tale for Plan Administrators and Employers

To illustrate the complexities and nuances of a controlled group, we will take a look at the following fictional scenario. 

For more than 25 years, a family has owned and operated several businesses, starting with a children’s clothing company (Company Alpha, the parent company). Following their initial success, the family launched additional enterprises, including a clothing manufacturing facility, a luxury hotel and spa, and two restaurants (collectively referred to as Companies Beta, Kappa, Delta, and Epsilon). Various family members shared ownership of each venture and also worked at the businesses.

Each organization sponsored a separate employee benefit plan that was offered to qualified employees of that particular business. Plan provisions varied widely in several key areas, including the amount of the employer match for retirement plans and the types and levels of health insurance offered. Company Alpha’s employee benefit plan was the most generous. The business owners and their plan administrator attempted to comply with all ERISA and tax rules but overlooked one critical component: controlled group status. 

An IRS audit of the parent company (Company Alpha) revealed the interconnecting business relationships. The IRS determined that a controlled group existed. In addition to assessing fines, the IRS required that all employees of the businesses that made up the controlled group be retroactively included in the plan that had offered the most benefits and highest employer retirement fund matches covering the previous years.

What could the business owners and plan administrators have done differently?

Review Business Relationships with a Knowledgeable Advisor

As ownership and working arrangements shift, business relationships can quickly become complicated for tax and employee benefit plan purposes. Determining controlled group status becomes more challenging, especially given the complexity of business relationships. The following tests are statutory requirements that determine whether a controlled group has formed or not: 

• Parent-Subsidiary Controlled Group Test:  A controlled group would exist when one company (the parent) owns at least 80% of a subsidiary. For example, Company Alpha in our story owns 85% of Company Epsilon, which means that Companies Alpha and Epsilon are a controlled group for purposes of their employee benefit plans. 
• Brother-Sister Controlled Group Test:  This test involves two prongs: 

1. Five or fewer individuals must own at least an 80% of each company; and 
2. The same people must own at least 50% of all companies in the potential controlled group. 
   
   

In our cautionary tale, four individuals own 89% of Companies Alpha, Beta, and Epsilon, and they also own 60% of Companies Kappa and Delta. 

• Combined Group Test: This test, in effect, builds on the prior two situations. A controlled group generally consists of two or more businesses that meet the following conditions:
  • The companies all have either a parent-subsidiary or brother-sister controlled group arrangement; and
  • At least one company is a common member in two of the companies.
    
    

In our controlled group simulation, Companies Alpha and Epsilon have a parent-subsidiary relationship, and Companies Beta and Epsilon have a brother-sister controlled group arrangement. Companies Alpha, Beta, and Epsilon could be considered a combined group.

If the entities are not part of a controlled group, then employers and plan administrators must also consider affiliated service group status. 

As noted above, an affiliated service group relates more to services than ownership structure, although some level of ownership or control may exist. None of our test companies are service organizations and none provide management services to the others, so it is unlikely that an affiliated service group exists. But if they shared management services or had other relationships, they might be an affiliated service group. It is advisable to do a baseline analysis of the affiliated service groups whenever in doubt.

Determining controlled and affiliated service group status is not a “quick question.” Therefore, when asked to check a few boxes on a form, it is important to correctly connect the dots among business entities. Complicated rules apply to employee benefit plans, and careful analysis should be an ongoing process undertaken by companies, their plan administrators, and third-party advisors who possess thorough knowledge of the subject. 

Ask the Right Questions — Then Ask Again

Employers and plan administrators should watch for controlled group status during annual reviews. It is also crucial to review employee benefit plans when family and business circumstances change, something that can occur from year to year or even from month to month. Third-party administrators, accountants, and other providers may ask some crucial questions every year, including:

• Have any business relationships changed? In our example, Companies Alpha, Beta, and Epsilon formed a brother-sister controlled group. However, Company Epsilon was sold off midway through the fiscal year, which may mean that Company Epsilon is no longer part of the controlled group, even though the controlled group continues to exist for the other entities. 
• Have there been changes to the ownership structure? Ownership percentages may be affected by marriage, divorce, or inheritance. For example, when two married owners of Company B file for divorce, plan administrators should review any potential effects on the balance of ownership and voting power, especially in light of family attribution rules. 
• Have the stock ownership attribution rules been considered? Family attribution and other stock ownership attribution rules apply and are often missed by those who are not familiar with these complex rules. For example, the entity organizational chart might show who owns what percentage of each entity but might miss the “constructive ownership” rules that deem certain individuals to own stock that is actually owned by others.
• Is the management structure the same as last year? This type of change may or may not affect affiliated service group status but should still trigger a review of that status. 
• Have ownership percentages been adjusted or altered? In our example, Companies Alpha and Beta originally were owned 50-50 by a husband and wife. But the owners gifted small percentages of ownership in Company Beta to their three children as each of them reached age 18. 
  
  

Keeping business information up to date is crucial for employee benefit plan administrators. They are tasked with plan document design and implementation, as well as compliance testing, but can only work with the data they are given. Employers must be aware that failing to recognize a controlled group can be costly in the form of fines, penalties, and retroactive retirement plan contributions to formerly ineligible employees.

Accurate Controlled Group Determination Is Critical

Determining whether a controlled or affiliated service group situation exists is a task that some employers might ignore, since it is confusing and complex, in the hope that it never becomes an issue. However, government regulators expect plan sponsors to understand these rules and ensure their plans comply with regulations, so pleading ignorance is not an acceptable excuse to the Department of Labor or the IRS. 

For plan sponsors, determining whether their companies are part of a controlled group is not a do-it-yourself project. Navigating complex rules while also factoring in the unique nuances of a group of related businesses is not easy; the determination can have serious implications for both the employee benefit plan and the business. Providers and third-party consultants with expertise in this area can offer a holistic, comprehensive analysis. Keep in mind that these rules apply to both retirement plans and health and welfare benefit plans.

Learn more about how to avoid the consequences of having the wrong controlled or affiliated service group status. Our Global Employer Services and Employee Benefit Plan Audits teams help guide clients as they administer their employee benefit plans. We can analyze the client’s current plan documents, offer recommendations for consideration, and then help them achieve their objectives.