Is your company owned by another company, does your company own other companies, or do the owners of your company own other companies?
If so, you may be part of a controlled group of related entities. Under IRS rules, all related entities that are part of a controlled group must be treated as a single entity for the purposes of employee benefits. It’s important to understand whether or not your company is part of a related group.
In this article, we explain the types of “controlled group” relationships and how those relationships may affect your 401(k) plan. You can also refer to the attached brochure at the bottom of the article for more information on related groups.
Controlled Groups: What They Are and Why It Matters
There are three principal types of controlled groups: parent/child groups, brother/sister groups, and combined groups.
A parent company owns 80% or more of another company. Child companies are those in which another company holds an ownership interest of 80% or more.
An owner of the parent company is considered to be an owner of the child company in the same percentage as the owner’s holdings in the parent entity. A company can be both a parent and a child company, and it’s possible to string together multiple parent and child companies. For example, if Company A owns 85% of Company B, and Company B owns 85% of Company C, then A is the parent of B and C, B is the parent of C and the child of A, and C is the child of A and B. All three companies are considered to be related entities and would be considered to be part of a controlled group
A Brother/Sister group exists when the same five or fewer individuals own more than 80% of two or more companies that they also have common control of (which would mean that a 50% or more of the ownership interest is held in an identical manner). See the example below, in which Alan, Bob, Carrie, and Debra are unrelated persons:
Example 1: Company A and Company B are brother/sister entities. Alan, Bob, Carrie, and Debra together own 80% or more of both companies, and more than 50% of the ownership of the two companies is identical because you consider the smallest amount owned in both entities to get the identical ownership, and Alan holds 25% in both companies; Bob holds 20% in both companies; Carrie holds at least 20% in both companies; and Debra holds at least 20% in both companies. Together these five or fewer individuals own 90%, which is more than 80% of both entities, and they have 85% identical ownership in both entities, which is more than 50%.
Example 2: Company C is not a related entity to Company A or Company B. While more than 50% of the holdings are identical to Company A and Company B, Alan, Bob, Carrie, and Debra don’t collectively own more than 80% of Company C. Remember, you need both 80% common ownership and 50% identical ownership to have a brother/sister controlled group.
Example 3: Company D is not a related entity. Though Alan, Bob, Carrie, and Debra collectively own 95% of Company D and thus meet the control requirement, they don’t meet the identical ownership requirement. Alan owns at least 5% of companies A, B, and D. Bob owns at least 5% of companies A, B, and D. Carrie owns at least 20% of companies A and D and at least 25% of B and D. Debra owns at least 25% of company A and D and at least 20% of B and D. Collectively, the identical ownership between A and D and B and D is only 45%, less than the 50% threshold.
A simplified diagram:
A combined group exists when three or more companies are connected through a combination of parent/child and brother/sister groupings. Each organization must be either part of a parent/child or brother/sister group, and one organization is both a parent and a brother/sister group. You might think of this as an uncle/nephew relationship. In the diagram below, Companies A, B, and C are a combined group.
A Note On Partnerships
Partnerships are treated almost identically to corporations, with an interest in the profits or capital of that partnership being treated as an ownership interest. For example, a parent of a partnership has an 80% interest in the profits or capital of that partnership. In a partnership, however, the partnership’s ownership interest is attributed proportionally to any partner who has an interest of 5% or more in either the profits or the capital of the partnership. The 50% or more ownership interest requirement for corporations does not apply to partnerships.
Additionally, under IRS rules, a partnership is considered part of a company’s controlled group only if the partnership is engaged in a trade or business. For example, the partnership has an intent to make profit, and is regularly providing goods or services with continuity.
Why These Relationships Matter
Prior to these rules, employers would often try to avoid paying benefits by grouping otherwise eligible employees into separate entities. The IRS is giving a tax benefit for offering benefits and thus wants to prevent situations in which a plan sponsor avoids compliance testing and allocates employee benefits in an unequal manner. To prevent employers from granting unequal benefits, the IRS requires that certain related companies be subject to annual compliance testing as a single employer. For these related entities, annual testing, including minimum participation and coverage, average deferral and average contribution along with Top Heavy testing which looks at balances must be performed at a related entity group level.
In certain circumstances, larger employers with distinct divisions operating in different industries and having more than 50 employees will be qualified as separate lines of business, which can be evaluated independently, despite having overlapping ownership. For example, a conglomerate like General Electric might operate multiple distinct divisions that maintain separate retirement plans.
What Happens if My Company Is Part of a Controlled Group?
If your company is in a controlled group with another business (as parent/child, sister/brother, or a combined group), compliance testing will be conducted at the group level as though the related entities were one entity. Guideline, or any other organization that is performing testing for companies in the controlled group, will need employee data, including each employee's salary, age, and contribution amounts, as well as year-end contribution balance, for each company in the controlled group.
Whether your plan passes compliance testing will depend in part on the coverage and participation of employees in related companies. This creates challenges if one company in the group offers a more generous 401(k) plan than another, has higher participation rates, or even just has a different ratio of highly compensated and non-highly compensated employees. If any tests don’t pass, plan corrections will need to be made.
Best Practices For Setting Up 401(k) Benefits For A Controlled Group
When setting up a plan for companies in a controlled group, there are choices you can make at the outset that will make compliance testing easier and more successful.
First, each company in the controlled group may wish to offer a 401(k) plan with similar terms to the others—if some companies have 401(k) plans while others do not, coverage testing problems are likely to occur, as some employees will be covered by a 401(k) while others will not be. One way to ensure comparable coverage across the controlled group, is for each related entity to adopt the identical plan(s).
Second, related companies are factored into your plan’s annual compliance testing. For this reason, Guideline requires you to disclose you and your family’s ownership interests in other businesses. Your company must be able to obtain the required information and transmit it to Guideline at year end, for Guideline to use as part of compliance testing.
Third, we strongly encourage you to consider a Safe Harbor plan for your company and related companies. Using a Safe Harbor plan exempts the plan from some of the most problematic compliance tests, thus increasing the likelihood of plan compliance.
Now that you know about controlled groups, you can determine if your company is part of a controlled group and report related companies to Guideline so we can help ensure your plan complies with IRS requirements. If you believe that related companies may not have been included in compliance testing for the prior year, please notify Guideline immediately.