Is there any common ownership between your company and another employer? Does your company have an exclusive service relationship with another employer? If the answer is yes to either, the group of entities may be Related Employers under the Internal Revenue Code, with consequences that ripple across compliance matters for the affected employee benefit plans.
“Related Employers” generally refers to a number of possible entity groupings under the Internal Revenue Code, including such combinations as Controlled Groups and Affiliated Service Groups.
What’s at Stake
The process for determining Related Employer status can be complex, but first let’s consider why anyone should care about it. What’s at stake if entities are (or are not) Related Employers?
In a nutshell, Related Employers are treated, for qualified plan purposes, as though they were a single employer (let’s call this a “Group”). For example, nondiscrimination testing and coverage requirements of a plan sponsored by any entity within a Group must consider the employees of the entire Group. It is easy to see how serious compliance failures might ensue when uninformed Related Employers administer their plans without due consideration of all Group employees. Equally serious problems can arise in the opposite scenario, when unrelated employers, assuming incorrectly that they are related, improperly combine their employee populations for plan participation and compliance purposes.
Note that Related Employer status is of particular relevance under the Affordable Care Act, which requires that employees of all related entities be included in calculating the number of Full-Time Equivalent Employees.
Caveat: This high-level introduction to the topic simplifies some of the defining concepts for the sake of clarity. Expert legal advice is recommended for any real-life situations requiring a Related Employer analysis.
Common Ways that Groups Can Arise
What circumstances make two or more employers a Group? In general, it involves a certain level of common ownership between two or more companies (a Controlled Group, which for purposes of this discussion includes controlled groups of corporations as well as trades or businesses under common control), or common ownership plus a particular level of service activity by or between two or more entities (an Affiliated Service Group).
Any kind of employer or business entity may be included in a Group under the applicable law, including sole proprietorships, corporations, and pass-through entities; accordingly, this article makes no distinction among entity forms and uses the generic terms “employer,” “entity,” and “company” interchangeably.
While the analysis for any specific set of companies will depend entirely on the particular ownership structure and business activities of the entities, read on to learn about some common ways that Related Employer Groups can arise.
Controlled Groups – Examples of Less Obvious Groups
There is a familiar rule-of-thumb in the benefits world for spotting Controlled Group status, i.e., a parent company is in a Controlled Group with any subsidiary owned at least 80% by the parent. However, the Code defines the word “own” also to include several forms of indirect ownership. Furthermore, there are ways for otherwise unrelated entities to be linked in a Group by common owners in a so-called Brother-Sister Controlled Group.
These rules create a number of Controlled Groups that may not necessarily be immediately recognizable to a plan administrator, illustrated by the following examples:
- Marital Attribution. Under the Code’s marital attribution rules, a married person may be deemed to own a spouse’s interest in an entity. For example, a solo law firm, owned by a husband and employing a paralegal and a legal secretary, is in a Controlled Group with his wife’s small medical practice if she owns more than half of that practice. Accordingly, for annual testing, reporting, and possibly for eligibility purposes as well, the medical practice’s benefit plans must take into account the law firm’s employees, and vice versa. Note, however, since the enactment of SECURE 2.0, this presumption of attributed ownership between married individuals may be overcome through a four-part test establishing the non-involvement of one spouse in the other spouse’s business.
- Corporate Subsidiaries Related through their Parent. A corporate parent with multiple operating subsidiaries may comprise a Controlled Group regardless of whether the parent has any employees. Subsidiary plan sponsors that are unaware of the entire set of entities within the parent’s ownership structure should confirm the existence of any Brother-Sister Controlled Groups to ensure that all employee populations are properly included in annual plan compliance activities.
- Ownership Shared by Individuals Can Create a Controlled Group. A Controlled Group of entities exists if 5 or fewer individuals, trusts or estates share sufficient ownership and control of the entities, as determined by two mathematical tests described in the regulations. It may be helpful in spotting this potential group to keep in mind that (i) all entity ownership interests must be recharacterized at the level of an individual, trust or estate, often by reference to various types of legal attribution, and (ii) the outcome of the analysis can be affected by even a small shift in entity ownership in the future.
An accurate understanding of the Controlled Group rules can give employers the opportunity to avoid Controlled Group status by strategically arranging their ownership structure, if feasible. Alternatively, certain large employers may qualify to formally avoid the treatment of the Group as a single-employer for retirement plan purposes, by filing a Qualified Separate Line of Business statement.
Your ERISA counsel is a key partner as you clarify your understanding of whatever your Controlled Group status may be, and as you grapple with the consequences of that status.
Affiliated Service Groups are (usually) about ownership and company operations.
A typical plan administrator who becomes aware of a possible Affiliated Service Group (“ASG”) issue may quickly find themselves outside their accustomed area of expertise. Compared with Controlled Group analyses, which turn on direct or attributed entity ownership, an ASG analysis requires ownership information plus details about the nature, timing, and value of particular business activities.
Note once more that this brief description is not intended to cover all of the technical complexities of ASG determinations, but is intended to help a plan administrator spot the issues for further investigation.
Traditional ASGs are comprised of two or more entities with at least some common ownership and that either (i) coordinate regularly in the provision of services to third parties, or (ii) that, within the group, receive/provide services “of a type that are historically performed by employees in the industry.” An additional category of ASGs is the so-called “management function” ASG, not requiring any cross ownership and comprised of a person or entity performing management functions and its primary client.
In addition to these broad standards regarding service activities (which are unburdened by elaborate technical detail, for the sake of clarity), an ASG analysis may also extend to other business facts, as needed, to gauge the significance of the relevant service activities to the subject entities, particularly as a source of revenue.
Let’s look at an example of a traditional ASG: A doctor owns 100% of her practice and 49% of a laboratory to which she refers virtually all of her lab work. The level of shared ownership and control between the entities is insufficient for there to be a Controlled Group. However, depending on certain other factors, such as the relative value of the doctor’s referrals to the laboratory, there may be an ASG here, due to the cross ownership combined with the coordination between the entities in the provision of services to third parties.
In fact, an ASG analysis often turns on a granular level of business detail. Variables such as the activities performed by certain employees, the timing and value of business activities, gross and net company revenues, and direct and indirect control of the company, may all play key roles in the determination of whether there is an ASG.
Groups of Three or More Employers May Exist
In the event multiple entities are in the picture, a Related Employer analysis must consider every possible pair of entities until all two-employer Groups are identified. To further complicate the matter, common ownership and the relevant service arrangements may create Controlled Groups and Affiliated Service Groups comprised of three or more entities. Combinations of CG and ASG may even exist, depending on the particular business circumstances.
A Spin-Off May (or May Not) Effectively Break-Up an Existing Group
Because of the minimum ownership levels required for Controlled Group status, company owners within a Controlled Group may deliberately alter ownership structures in an attempt to break up the Group to avoid the expense of covering the larger group of employees in an affected benefits plan. This strategy could work, but if any common ownership remains, the employers must take care not to carry on business relationships with one another in such a way to create an Affiliated Service Group. Affected employers must be aware that any common ownership, no matter how small, combined with certain service arrangements between entities, may confer Affiliated Service Group status.
Take the example of a Controlled Group of five dental practices (the “Dental Group”), jointly owned by a handful of partners, and happily sponsoring a rich cash balance plan for its employees. The partners decide to economize operations by moving its internal “back-office” administration into a new entity, Dental Admin Co, to be owned only in very small percentages by the Dental Group partners. Dental Admin Co will be staffed by its own employees, will operate in its own space, and will be majority owned by an unrelated third party; clearly it is not a Controlled Group member with Dental Group. But, Is Dental Group off the hook from covering the employees of Dental Admin Co?
The answer is a resounding maybe. Notice that some common ownership remains between the practice and the administration company. Furthermore, the services provided to Dental Group by Dental Admin Co are of a kind “historically performed” by employees of a dental practice. It seems likely that Dental Admin Co and Dental Group will indeed be an ASG. As a result, rather than removing the obligation for the cash balance plan to cover the administrative employees, the Dental Group’s re-organization has merely created a new ASG comprised of the Dental Group Controlled Group and the Dental Admin Co.
The Disappearance of a Controlled Group
With little or no notice, a subsidiary employer may find itself outside of a Controlled Group, as the result of a stock dilution or some other transaction reducing the Parent company’s ownership. This may create compliance hassles not only for affected retirement plans, which must re-structure formally to recognize the new arrangement, but also for health and welfare benefits, which can experience serious disruption as a result of this change. Fortunately for retirement plans, the applicable regulations afford a little time to the affected employers to address the effects of a change in Group status, but there is no such transition period for health and welfare plans. It is important to remain up to date on shifts in Parent ownership.
The public policy behind the Related Employer rules is to prevent the unfair exclusion of rank-and-file employees from participation in their employers’ benefit plans. The IRS’ enforcement attitude in a plan audit is likely to be consistent with this policy, that is to say, an IRS examiner may scrutinize Related Employer status quite closely. For this reason and for the quality of plan compliance generally, employers should take care to identify any Related Employer Groups they are in and to design the affected employee benefit plans accordingly.