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Excerpted from Judith Wethall
Seyfarth Shaw LLP
November 2007
You are in charge of administering your company's 401(k) plan.
You are diligent and monitor every aspect of the plan. A wholly owned subsidiary
of the parent you work for enters into a joint venture with another
organization. The subsidiary will own 80 percent of the new entity. You only
hear about the transaction from a coworker in the lunchroom. When you ask about
it, you are told "Don't worry, it won't affect our benefits at all." Two years
later, the IRS audits your 401(k) plan. You are confident that all will go well
— that is, until the auditor notes that the joint venture sponsors a
401(k) plan that is in your controlled group of corporations.
What's the problem? If you are part of a controlled group of corporations, your
401(k) plan will be impacted (maybe adversely) by the other company's plans.
This article will discuss:
- How to determine whether you are part of a controlled group;
- The consequences of failing to comply with the controlled group rules; and
- The traps to look out for when you are administering a 401(k) plan that is
part of a controlled group.
Please note that although health and welfare plan issues, defined benefit plans,
and executive compensation matters are also impacted by the controlled group
rules, they are beyond the scope of this article.
Types of Controlled Groups
Federal law requires that employers within the same "controlled group" of
businesses be treated as a single employer for many employee benefit purposes.
The controlled group rules are very complex, and this article will only
summarize the general rules.
Generally, two or more businesses are considered a single employer for the
purpose of employee benefits issues if they are members of:
- A parent-subsidiary controlled group,
- A brother-sister controlled group,
- A management organization, or
- Some combination of the three.
Parent-Subsidiary Controlled Group. This type of controlled group exists
when a business (i.e., the parent) owns at least 80 percent of the
outstanding stock or profit interest of another entity (i.e., the
subsidiary). This is the simplest type of controlled group to ascertain.
Brother-Sister Controlled Group. This type of controlled group exists when:
1) the same five or fewer individuals, estates, or trusts own at least 80
percent of the stock or profit interest of two or more businesses; and 2) the
same five or fewer individuals own at least 50 percent of the businesses' stock
or profit interest (taking into account an owner's interest in one entity only
to the extent it does not exceed the owner's interest in the other entity).
Example
Jack and Jill are co-owners of two businesses. Jack owns 75 percent of one
business and 20 percent of another, while Jill owns 10 percent of the first
business and 60 percent of the other. As a general rule, there is no controlled
group under these circumstances. Although Jack and Jill together own at least 80
percent of both entities, they fail the 50 percent test in that Jack is deemed
to own just 20 percent of both businesses and Jill is deemed to own just 10
percent of both entities, for a total of only 30 percent.
Unfortunately, there are exceptions to the general rules that make the analysis
even more complicated. For example, some restricted stock is disregarded when
calculating ownership percentages.
Management Organization. Finally, a controlled group can be formed when the
entities have little or no common ownership, but one entity exists to service
the other entity. These are known as management organizations.
To determine if you are in a controlled group of corporations, you should
contact an employee benefits attorney.
Consequences of Failing to Comply with Controlled Group Rules
Both the Department of Labor (DOL) and the Internal Revenue Service (IRS)
scrutinize qualified retirement plans and corporate organizational charts to
determine whether controlled groups exist. If a plan fails to operate in
accordance with the controlled group rules, or operates as a controlled group
without meeting one of the requisite tests described above, the IRS can
disqualify the plan.
If a plan is disqualified, several adverse retroactive tax consequences flow,
including but not limited to:
- Disallowance of the deduction claimed by the sponsoring company;
- Inclusion of employer contributions in the gross income of participants
(IRS may limit to the highly compensated employees only);
- Inclusion of deferred compensation in the gross income of both highly
compensated and nonhighly compensated employees; and
- The subsequent amendment of all corporate, plan, and individual tax returns
for the disqualified plan years.
More common than disqualification is the IRS imposition of sanctions. In
addition to such sanctions, the plan sponsor may need to rerun costly
discrimination testing, locate and refund monies to participants, or make
corrective contributions to the plan.
Traps in Administering Plans
Administering a 401(k) that is part of a controlled group can be more
complicated than administering one that is not. In general, other plans and
employees in the controlled group must be taken into consideration in
administering the plan.
Nondiscrimination Testing. All employees in a controlled group must be
included when performing nondiscrimination testing for a qualified plan or
plans. Testing is accomplished by comparing the groups of highly and nonhighly
compensated employees covered by the plan against the total groups of highly and
nonhighly compensated employees within the entire controlled group.
The genesis of this requirement was a concern that a controlled group could
organize itself so that its highly compensated employees reside in one
corporation (which has the more generous plan) and nonhighly compensated
employees reside in another corporation (which has the less generous plan). To
prevent this, the IRS has devised very rigid nondiscrimination testing that
applies across the controlled group of companies. For example, the controlled
group rules apply to nondiscrimination coverage testing, ADP/ACP benefits
testing, 401(a)(4) benefits, rights and features testing, and top heavy testing.
Because members of a controlled group are considered a single employer for
qualified plan purposes, the issue of whether to aggregate separate 401(k) plans
for ADP/ACP testing purposes often arises in a controlled group situation.
Generally, whether to aggregate or test separately depends on whether the plans
can pass the coverage test individually or need to be aggregated in order to
pass.
Finally, as of January 1, 2006, all members of a controlled group must apply the
same testing criteria for the nondiscrimination tests. For example, if one plan
defines its highly compensated employees as those who are in the top 20 percent
based on compensation, all the plans required to be aggregated must apply the
same criteria. This is also true for the look-back rule (allowing plans with
fiscal plan years to elect to compute data on a calendar year basis), and
prior/current year testing (the period used to measure compensation for purposes
of the nondiscrimination tests).
Catch-up Contributions. If a plan sponsored by a member of a controlled
group provides for catch-up contributions (where participants over age 50 may
make additional salary deferrals to the plan), every member of the controlled
group must offer catch-up contributions if they sponsor a 401(k) plan. There are
some limited exceptions for union plans.
Intra-Company Transfers. Employees transferring from one entity to another
within the controlled group must be treated as working for a single employer for
401(k) purposes. This means that when the employee terminates participation in
one 401(k) plan and begins participation in a 401(k) plan maintained by an
entity within the controlled group, the employee may not be allowed to:
- Get a distribution from the first 401(k) plan or roll over any account
balance from the first plan into the new employer's 401(k) plan; or
- Secure a loan from the second plan if he or she has reached the maximum
loan amount under the first plan.
Similarly, all plan limits will need to carry over with the participant into the
new plan. Unlike a termination of employment and subsequent employment with an
unrelated employer, the related employer must take into account any amounts
already deferred by the transferred employee under the first plan, as well as
any compensation and employer contributions. Additionally, the second plan must
recognize service for eligibility and vesting of any employee within a
controlled group of corporations.
Determination Letter Filings. The IRS has revised its procedures for plan
sponsors to apply for a favorable determination letter. The required periods for
submitting such an application are based on the plan sponsor's federal
identification number (FEIN) for individually designed plans. A plan may elect
to have its cycle determined by the FEIN of the parent if the sponsor of the
plan is a member of a controlled group of corporations. If this option is
elected, then all members of the controlled group must file under the same
cycle.
Bottom Line
As summarized herein, controlled group issues are far-reaching and complex. It
is imperative that plan sponsors identify controlled groups and then operate
their 401(k) plans in compliance with the controlled group rules.
Judith Wethall is an associate in the Chicago office of Seyfarth Shaw LLP. She
may be contacted at jwethall@seyfarth.com.
Copyright © 2007 M. Lee Smith Publishers LLC. This article is an excerpt from Benefits and Compensation Law Alert (ISSN 1526-7967). Benefits and Compensation Law Alert is designed to provide accurate and authoritative information in regard to the subject matter covered. It is published with the understanding that neither the author(s) nor its publisher is engaged in rendering legal, accounting, or other professional services through its pages. If legal advice or other expert assistance is required, the services of a competent professional should be sought. (From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a committee of Publishers and Associations.)
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