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When two or more companies comprise a controlled group, they are considered a single employer for 401(k) plan purposes. The controlled group rules exist to keep business owners from circumventing the 401(k) nondiscrimination rules by splitting a business into multiple entities. Overlooking a controlled group member can lead to a failed coverage test. Steep IRS penalties - including plan disqualification - are possible when this happens. A basic understanding of the controlled group rules can help employers avoid this trouble.
In general, the controlled group rules are straightforward. However, they can get complicated fast when common ownership involves stock, trusts or estates. A qualified ERISA attorney may be required to make an accurate determination when this is the case.
When do companies represent a controlled group?
Two or more companies represent a controlled group when either a “parent-subsidiary” or “brother-sister” relationship exists:
- A parent-subsidiary relationship exists when one company owns 80% or more the other company
- A brother-sister relationship exists when two thresholds are met:
- Common Ownership - the same 5 or fewer individuals own 80% of more of each company; and
- Identical Ownership - the common owners have identical ownership of more than 50%.
Example of a brother-sister controlled group:
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Explanation: Companies A and B have 3 common owners - Brad, Steve and Eric. John and Rick are disregarded from the brother-sister test because they don’t have ownership in both companies. Brad, Steve and Eric meet the common ownership test because they own >=80% of Companies A and B. They also meet the identical ownership test because their identical ownership is >50%.
Don't forget the family attribution rules
"Attribution" is the concept of treating a person as owning an interest in a business that is not actually owned by that person. The IRC section 1563 family attribution rules apply to controlled group determinations. Under these rules, the ownership interest of certain family members is added to the direct ownership of an individual. For example, if a husband and wife each have a 40% ownership stake in a company, each spouse would be considered to own 80% (40% direct + 40% attributed) of the company for controlled group purposes.
Below is a summary of the controlled group family attribution rules:
| Family Member | Attribution Rule |
| Spouse |
Is generally attributed their spouse's ownership unless all of the conditions listed in §1563(e)(5) are satisfied |
| Parent |
Is always attributed the ownership of a minor child (under age 21)
Is attributed the ownership of an adult child (21 or older) only if the parent owns (directly or by other attribution) more than 50% of the company |
| Siblings | Are never attributed the ownership of other siblings |
| Children |
A minor child is always attributed the ownership of a parent
An adult child is attributed a parent's ownership only if the adult child owns (directly or by other attribution) more than 50% of the company. |
| Grandparent |
Is attributed a grandchild's ownership (regardless of age) only if the grandparent owns (directly or by other attribution) more than 50% of the company. |
| Grandchild |
A grandchild (regardless of age) is attributed a grandparent's ownership only if the grandchild owns (directly or by other attribution) more than 50% of the company. |
How is coverage testing passed?
To pass coverage testing, a 401(k) plan must satisfy either the ratio percentage or the average benefit test each year. The ratio percentage test is most commonly used. To pass this test, the following calculation must equal or exceed 70%:
(eligible NHCEs benefitting from the plan / eligible NHCEs employed by controlled group) / (eligible HCEs benefitting from the plan / eligible HCEs employed by controlled group) => 70%
Definitions:
- Eligible – employees (including leased employees) who have satisfied the plan’s eligibility requirements.
- HCE – any employee with > 5% ownership in any employer of controlled group or income in excess of the HCE threshold during the prior year)
- NHCE – any employee who is not an HCE
Not knowing your controlled group status can be a costly mistake
To correct a failed coverage test, the employer may adopt a corrective amendment, up to 9½ months following the close of the plan year in which the failure occurred, to retroactively expand plan coverage. However, since the new participants can’t retroactively make employee contributions, a qualified nonelective contribution (QNEC) must be made to the new NHCEs to correct their missed deferral opportunity. Any missed employer contributions must also be made to the new NHCEs.
When a coverage failure is not corrected within 9½ months, it’s considered a demographic failure by the IRS. Demographic failures can only be corrected using the IRS’ Voluntary Compliance Program (VCP). When a VCP correction is necessary, employer fines can apply.
Not correcting a demographic failure can result in plan disqualification if the issue is uncovered by the IRS during an audit.
Bottom line – it can be costly to correct a failed coverage test due to a blown controlled group determination. A new determination should be made each year that nondiscrimination testing is completed and during any changes in company ownership. If you are unsure about your company’s controlled group status, consult your 401(k) provider or legal counsel.
