What Are 401k Controlled Group Rules
The 401k controlled group rules are provisions in the Internal Revenue Code that govern the aggregation of companies with common ownership for the purpose of determining an employee’s eligibility to participate in a retirement plan. The general purpose of these rules is to prevent employers from gaining an unfair advantage by designing, amending, or terminating their plans in a manner that discriminates against certain employees of one company within a controlled group. Specifically, these rules are intended to prevent controlled group employers from taking advantage of certain benefits afforded under the Code . These benefits are, among others, the ability to contribute excess employer match and non-elective contributions without regard to code section 401(a)(26), 401(a)(4), 401(a)(17), 401(k)(3), 408(k)(6) and 408(p), the ability to use the top-heavy rules of one company within a controlled group to apply to all companies within a controlled group (to the detriment of favorably impacted employees), and the availability of unfettered access to Code section 420 Transfers to fund retiree health benefits when the controlled group consists of an employer that does not sponsor a qualified plan.
Recognizing a Controlled Group
A controlled group is a combination of two or more business entities (e.g., corporations, general partnerships, limited partnerships, limited liability companies, sole proprietorships, etc.) that are considered a single employer under the Internal Revenue Code for certain purposes.
The IRS regulations applicable to 401k plans define a controlled group as:
… two or more corporations that are all members of the same controlled group at any time during the current or the prior year under section 414(b). [or]
… two or more trades or businesses (whether or not incorporated) that are under common control pursuant to regulations prescribed by the Secretary through the aggregation rules of section 414(c)(1). [or]
… two or more trades or businesses that are under common control pursuant to regulations prescribed by the Secretary through the application of principles similar to those used in section 414(m). [or]
… two or more trades or businesses under common control pursuant to regulations prescribed by the Secretary through the application of principles similar to those used in section 414(o).
Common control may include:
(1) The parent-subsidiary group.
This exists where one or more corporations owns, directly or indirectly, at least 80% of the total voting power or value of the stock of another corporation and the two or more corporations "constitute a controlled group of corporations" as defined in Code section 1563(a).
Note that while controllers may own less than 80% of a subsidiary-producing entity, they will still fall under the control group if they own more than 50% of the controlled organization.
(2) The brother-sister group.
This exists when two or more corporations are each owned directly or indirectly by the same five or fewer individuals, estates, or trusts.
(3) Any trade or trades or businesses (whether incorporated or unincorporated) that are under common control pursuant to regulations prescribed by the Secretary of the Treasury.
In general, a controlled group of employers will:
(1) Satisfy minimum participation standards for ERISA-governed plans; and
(2) Be subject to the coverage and participation rules applicable to ERISA-governed plans.
Categories of Controlled Groups
The Internal Revenue Code and regulations identify various types of controlled groups, including parent-subsidiary, brother-sister, and combined controlled groups. This section briefly describes each type.
Parent-Subsidiary Controlled Group
A parent-subsidiary controlled group exists if the common parent corporation owns at least 80 percent of a subsidiary corporation’s stock (by vote or value). As a result, the parent corporation retains direct or indirect 80 percent or more ownership of the subsidiary corporation.
Example: P Inc. owns 80 percent of S Inc. stock, and therefore P Inc. and S Inc. are members of a parent-subsidiary controlled group. The 80 percent stock threshold is applied on a combined voting power/corporate charters/value basis for each class of corporation stock.
Parent-subsidiary controlled groups do not have to include all of their subsidiaries if not qualified.
Example: P Inc. owns 80 percent of S1 Inc. stock and 50 percent of S2 Inc. stock. P Inc. and S1 Inc. are members of a parent-subsidiary controlled group, but S2 Inc. is not, because S2 Inc. is not (as to P Inc.) owned at least 80 percent in terms of value or combined voting power/corporate charters.
Participant counts for parent-subsidiary controlled groups are made on the last day of each plan year.
Brother-Sister Controlled Group
A brother-sister controlled group exists when five or fewer owners own directly or indirectly at least 80 percent of each corporation’s stock (by vote or value), and there is a syntactical overlap between the two groups of owners.
Example: P and Q are individual shareholders. P and Q each own 50 percent of P Inc. stock and 60 percent of Q Inc. stock. Because P and Q together, directly or indirectly, own at least 80 percent of the P Inc. and Q Inc. stock, they can be members of a brother-sister controlled group.
A brother-sister controlled group does not have to include all members.
Example: P is the sole stockholder of P Inc. and owns 100 percent of Q Inc. stock. P Inc. and Q Inc. are members of a brother-sister controlled group. R is a 10 percent employee owner of P Inc. Also, P owns 8 percent of W Inc. stock. P Inc. and W Inc. are not members of a brother-sister controlled group, even though P owns at least 80 percent of both corporations.
Participant counts for brother-sister controlled groups are made on each controlled group member as of the last day of the month that contains the last day of the plan year.
Combined Control Group
A combined control group exists when the following test is satisfied: (1) parent-subsidiary: each corporation in the group is a common parent corporation or subsidiary; and (2) total ownership: the common parent or one or more of its shareholders own at least 80 percent of each corporation’s stock (by vote or value).
Example: C Inc. owns 80 percent of the stock of S1 Inc. and S2 Inc., and S1 Inc. owns 80 percent of the stock of S2 Inc. Because C Inc. owns at least 80 percent of the stock of each of the three corporations, the three corporations together constitute a combined controlled group under this definition.
Examples
C Inc. – Parent Inc.: owns 100 percent of the voting stock of S Inc.
S1 Inc. – Syndicator: 80 percent owner of each of S2 Inc., S3 Inc., S4 Inc., S5 Inc., and S6 Inc.
Brothers P and Q are the sole shareholders of P Inc. and Q Inc., each owning 80 percent of P1, 70 percent of P2, 75 percent of Q1, 80 percent of Q2, and 60 percent of W1, respectively.
A group of corporations is a combined controlled group if group members are in the following arrangement:
Example: If P and Q each own 80 percent of S1 Inc., P owns 50 percent of S2 Inc., and P and Q each own 40 percent of S3 Inc, P, Q, and S1 make up a combined controlled group.
Controlled Group Compliance Obligations
Complex compliance requirements are required of a company participating in a controlled group under the 401k plan. Among other rules, the sponsor will have to pass compliance testing for its 401k plan as if the plans of the other companies in the controlled group were part of its own plan. This means that the sponsor may well fail compliance testing, even while the combined successful testing of all related plans shows that the plan is successful. The entire controlled group plan has to be tested as if there is a single plan covering all employees, assuming all employees participate in the plan covering all employees. And since the multiple employer plan has to have the same form and terms for everyone, this may entail changes such as changing an employee from being 100% vested to being 20% vested. These changes would make sense only if the participation of the related employers was also altered to create similar success.
A company participating in a controlled group can be exposed to liability for failure of a plan maintained by another member of the controlled group. Each employer who participates in the plan is jointly and severally liable under the statute for any failure to comply with the law. This will require very close coordination of choice of vendors and plan administration for all of the plans in the controlled group to avoid plan operational failures or issues with vendors.
Nondiscrimination testing must occur on an aggregated basis for all members of the controlled group. All employees must be included in testing performed on the controlled group as a whole. For nondiscrimination testing purposes, aggregating plans means combining the data from all employees of all employers in the controlled group. Certain tests and comparability requirements must be satisfied, and these tests are typically the section 401(a)(4) ADP and ACP tests and 410(b) minimum coverage test. The combined plans can also fail the average benefit percentage test under section 401(a)(4). A controlled group can also affect retirement age. Multiple employers can use a single plan, but they must do so in a manner as to not cause discrimination against non-highly compensated employees. The non-discrimination testing imposed on plans with a controlled group will translate into operational challenges for the sponsor.
All participants must be counted and considered in applying the 40 percent rule under regulation 1.401(a)(4) – the group may not have a group that consists of greater than 40 percent of highly compensated to non-highly compensated employees. This rule continues to apply as long as the plan covers at least 20 percent of all employees of the controlled group.
Controlled Group Non-Compliance Issues and Repercussions
The risks of violating the controlled group rules are significant. One of the effects of violating the controlled group rules is that all affiliated entities (not just the ones that are part of the decision-making chain) are subject to the same contribution, coverage, and nondiscrimination testing requirements. In some cases, the result could be that employees of non-compliant entities lose out on retirement savings, or worse, that employees of companies with perfectly good operating results have to help fund the retirement benefits of employees at a less profitable company.
The penalties for certain violations include being liable for excise taxes, penalties and disqualification of the plan. Well-meaning companies should not think that they leave too little room for ambiguity to risk a penalty, and should assume there will be enough coordination to avoid a plan disqualification. These penalties and disqualification largely enforce the contribution tests that were designed to ensure that the plan is a retirement and not a tax evasion benefit , protecting the retirement security for employees. For example, one of the tests is whether the plan covers a sufficiently representative group of lower-paid and higher-paid employees. Many of the rules are similar to the nondiscrimination standards that apply to health care plans.
If the controlled group does not comply with the requirements of the pension laws as they apply to the plan (including the minimum participation, minimum vesting, minimum funding, maximum payment, maximum accumulation, nondiscrimination, and required minimum distribution rules), it is liable for the excise taxes imposed on any violation (with respect to the plan) under section 4972, 4975, or 4980F of the tax code to the extent of its proportionate share of the contributions, benefits, or other amounts which caused such violation.
Managing a Controlled Group Compliance Program
The first step toward compliance with the controlled group rules is making sure you understand what they are and determine whether you are subject to them. Form 5500 filings will almost always trigger an employer to take a closer look at its plan coverage, especially when those plans are sponsored by entities owned or controlled with others. Whether it’s by virtue of full or partial ownership, the lines between related entities and their employee benefit plans can be very difficult to tease apart. Further, all eyes are on employers’ Plan 5500 filings, as governmental agencies, auditors, plaintiff’s willing to bring employer stock claims, and plan fiduciaries continue to examine those filings closely.
If you know – or think you may have – more than one plan that is subject to the controlled group rules, it is very important for you to keep a record of these companies and the determination of whether each company is part of your controlled group. This record should be maintained, and updated, on a regular basis. Given the sometimes complex factors at play on any given year, supporting documentation should also be maintained (for example, contracts, corporate structures and agreements relating to more than 50% ownership) so as to be immediately accessible if challenged in an audit. You should also consider engaging external counsel, or seek general professional advice if you believe your controlled group may constitute a "large" group (i.e., what would be considered a parent-subsidiary group) and, therefore, may warrant additional scrutiny.
Evolution and Emerging Directions for 401k Controlled Group Rules
As part of the Tax Cuts and Jobs Act of December 2017, which is the Tax Reform legislation, the definition of which entities are "eligible employers" to participate in defined contribution plans (such as 401k plans) was expanded. The general rule had been that to qualify as an eligible employer, the employer needed to have been in existence and employed one or more employees (other than certain owners) on or prior to December 31, 2016. That rule was expanded to also include the following types of entities that: 1.) Exist on or after January 1, 2017; and 2.) Are part of a controlled group, which control group is comprised of a group of entities under common control that meet the requirements of the controlled group test under Internal Revenue Code (IRC) §414(c).
This change basically enables many more small employers (especially groups of businesses with multiple entities) to create 401k plans for their employees.
Furthermore, this change isn’t subject to the usual exclusions from retroactive effect, so, as a result, any new 401k plan adopted by or on behalf of an eligible entity after December 31, 2016, is treated as being adopted as of January 1, 2017, and meets the eligibility criteria to be a qualified plan under IRC §401(k).
In addition, the IRS provided guidance earlier this year that, among other things, discussed the availability of certain changes to 401k plans during a period where there was a change in controlled group status. For example , the IRS indicated in 2017 that, if there is an ownership change such that businesses that were previously unrelated become part of the same controlled group during the 401k plan year, and certain other conditions are satisfied, then that new controlled group can potentially change the plan terms. This could mean that, if certain plan design changes need to occur, the new controlled group (or it’s third party administrator), may have more planning/implementation options.
Practical Tip: Notwithstanding the above positive changes, there are other rules (including the complex controlled group rules) that still require attention and analysis in the 401k context. As an example, the answer to the question of whether two or more commonly controlled businesses (i.e., businesses that are under common control pursuant to the controlled group rules) can have separate 401k plans requires thorough analysis of all such businesses. However, if certain controlled group conditions are met, the controlled group could change how employee contributions are "aggregated," and, as a result, can enable the controlled group to: 1.) most easily comply with the contribution acceleration rules (which require a reviewing of all 401k plans); or 2.) selectively accelerate certain 401k plans (which would otherwise have been subject to the "contribution acceleration rules").