You probably already know that you need to plan for the ESOP repurchase liability – the cost of buying back shares from terminated ESOP participants. But, you may not understand exactly what that liability is and what the ESOP fiduciary’s role is in that process. This article explains repurchase liability planning from the ESOP fiduciary’s perspective – the pitfalls to watch out for and what the company can do to protect the ESOP fiduciaries (including the corporate directors and officers).
What Is A Controlled Group?
There are three types:
- Parent-Subsidiary Controlled Group. The simplest form of a parent-subsidiary controlled group consists of one business (the parent) that owns at least 80% of another business (the subsidiary). Ownership can be direct or indirect through the operation of the attribution rules (discussed below). A series or “chain” of businesses can also make up a parent-subsidiary controlled group where at least 80% of a subsidiary is owned by one or more of the other organizations and the common parent owns at least 80% of one or more other businesses.
- Brother-Sister Controlled Group. The simplest form of a brother-sister controlled group is where one individual owns at least 80% of two or more businesses. Here again, ownership can be direct or by attribution. The more owners who are involved in the various businesses, the more difficult the analysis becomes. Ultimately, the rule requires that there be no more than five owners (individuals, estates or trusts) who collectively own (i) at least 80% of each business and (ii) more than 50% of each business taking into account each person’s ownership interest only to the extent that it is identical with respect to each business (i.e., an owner’s lowest ownership percentage is used for this aspect of the rule). A person’s ownership is not taken into account unless the person owns an interest in each entity to be aggregated.
- Combined Controlled Group. A combined controlled group consists of three or more businesses where each is a member of either a parent-subsidiary controlled group or a brother-sister controlled group, and at least one business is both (i) the common parent of a parent-subsidiary controlled group and (ii) a member of a brother-sister controlled group.
How did SMALLCO and SMALL Vineyards get caught in the controlled group trap? Let’s examine the ownership of SMALLCO and SMALL Vineyards:
|Owner||SMALLCO||SMALL Vineyards||Identical Interests|
Because A, B and C collectively own (i) at least 80% of each business and (ii) more than 50% of each business (to the extent that their ownership interests are identical in each), SMALLCO and SMALL Vineyards constitute a brother-sister controlled group. If A owned only 25% of SMALL Vineyards and D owned 25%, no controlled group would exist because, taken together, A, B and C would own only 75% of SMALL Vineyards. D’s ownership in SMALLCO and SMALL Vineyards is not taken into account because D is not an owner of SMALLCO.
Note that it isn’t relevant under the controlled group rules whether different businesses are organized to avoid any employee benefit plan requirements or whether or not they have anything to do with one another (other than common ownership). The key is common ownership. The fact that some entities are foreign businesses also isn’t relevant. For example, if two U.S. corporations are wholly owned by a Japanese parent corporation, the two U.S. corporations are members of a controlled group even if they have no business dealings with one another or are in completely different businesses or locations. (However, read about the ability to divide a controlled group into separate lines of business (or “SLOBs”) for certain employee benefit plan purposes.)
How Do The Ownership Attribution Rules Work?
The controlled group rules take into account not only the ownership interests owned directly, but ownership interests attributed from one owner to another according to a number of ownership attribution rules. For example:
- Options Ownership of an option is treated as outright ownership.
- Partnership. A 5% or more partner is treated as owning the partner’s proportionate share of the partnership’s interests in other businesses.
- Estates/Trusts. A 5% or more beneficiary of an estate or trust is treated as owning the beneficiary’s proportionate share of the estate/trust’s business interests.
- Corporations. A 5% or more shareholder of a corporation is treated as owning the shareholder’s proportionate share of the corporation’s interests in other businesses.
- Minor Children A parent is treated as owning the interests owned by the parent’s minor children (and each such child is treated as owning his or her parents’ interests).
- Adult Children, Parents and Grandparents. An individual who owns more than 50% of a business is treated as owning the interests owned by the individual’s parents, grandparents, grandchildren, and children who have reached age 21.
- Spouse. An individual is treated as owning his or her spouse’s interest in a business. If each of the following criteria is satisfied, however, the non-owner spouse will not be treated as owning an interest in the owner spouse’s business for a particular taxable year:
- The non-owner spouse cannot own any interest in the owner spouse’s business directly at any time during the year.
- The non-owner spouse cannot be a director, fiduciary or an employee of the other spouse’s business and cannot participate in the management of the business at any time during the year.
- No more than 50% of the business’ gross income for the year can be derived from royalties, rents, dividends, interest, and annuities.
- The owner spouse’s interest in the business is not, at any time during the year, subject to conditions that (i) substantially restrict or limit the owner spouse’s right to dispose of such interest and (ii) run in favor of the non-owner spouse or the non-owner spouse’s minor children.
Families who live in community property states (e.g., California) should beware of the impact of community property laws on this exception to the spouse attribution rule. If a business is classified as community property, the IRS could take the position that the first or fourth criterion has not been satisfied because the non-owner spouse has a one-half community interest in the business. It can be argued that such an interpretation places taxpayers in community property states at a disadvantage relative to the rest of the nation and that such an interpretation is contrary to the spirit of the rule. Although the IRS has applied the community property laws to the controlled group rules in at least one non-benefit plan case, we have found no such cases that have addressed this exception with respect to employee benefit plan matters (although the IRS has taken this position in audit and VCP situations).
Are Any Interests Excluded?
Some interests are treated as not outstanding for purposes of the controlled group rules:
- Treasury stock.
- Nonvoting stock, which is limited and preferred as to dividends.
- If a parent business owns at least 50% of a subsidiary, the following interests are treated as not outstanding for purposes of whether the parent and the subsidiary are members of a parent-subsidiary controlled group:
- Interests are treated as not outstanding for purposes of whether the parent and the subsidiary are members of a parent-subsidiary controlled group: An interest in the subsidiary held by a trust, which is part of a plan of deferred compensation for the benefit of the employees of the parent or the subsidiary; An interest in the subsidiary owned by an individual who is a 5% or more owner, officer, partner or fiduciary of the parent;
- An interest in the subsidiary owned by an employee of the subsidiary if it is subject to conditions which substantially restrict or limit the employee’s right to dispose of such interest and which run in favor of the parent or the subsidiary; and
- An interest in a subsidiary owned by a tax-exempt organization (other than the parent) which is controlled by (i) the parent, (ii) the subsidiary, (iii) an individual, estate or trust that is a 5% or more owner of the parent, (iv) a fiduciary of the parent, or (v) any combination of these.
- If five or fewer persons (individuals, estates or trusts) own at least 50% of a business collectively, the following interests are treated as not outstanding for purposes of determining whether the business is a member of a brother-sister controlled group:
- An interest in the business held by a tax-qualified retirement plan if the plan is for the benefit of the business’ employees;
- An interest in the business owned by an employee of the business if it is subject to conditions which run in favor of a common owner of such business and which substantially restrict or limit the employee’s right to dispose of such interest (unless it is part of a bona fide reciprocal purchase arrangement with the common owner); and
- An interest in a business owned by an organization that is exempt from tax under Code section 501(c)(3) and which is controlled by (i) such business, (ii) an individual, estate or trust that is a 5% or more owner of the business, (iii) an officer, partner or fiduciary of the business, or (iv) any combination of these.
What To Do?
If you have any doubt about whether or not there is a controlled group in your life or the life of someone you care about, you should have the situation analyzed. After all, you don’t want to spend a dark and stormy night arguing about such things, do you?
What To Read Next
To learn more continue to Part III The Aggregation of Employers And Employees . . . Affiliated Service Groups.