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What is a controlled group and why does it matter for 401(k) plans?
What is a controlled group and why does it matter for 401(k) plans?
Updated over a week ago

A controlled group is a set of companies with a certain level of shared ownership and are, therefore, treated as one entity for 401(k) purposes. Along with affiliated service groups, controlled groups are referred to as legally related groups.

All entities within legally related groups must follow specific IRS rules regarding 401(k) implementation and nondiscrimination testing, so it’s important to know whether your company is part of one and to share this information with Guideline.

Types of controlled groups

There are three principal types of controlled groups:

Parent/child groups

A parent company owns 80% or more of another company. Likewise, child companies are those in which another company holds an ownership interest of 80% or more.

An owner of the parent company is considered to be an owner of the child company in the same percentage as the owner’s holdings in the parent entity. A company can be both a parent and a child company, and it’s possible to string together multiple parent and child companies.

For example, if Company A owns 85% of Company B, and Company B owns 85% of Company C, then A is the parent of B and C, B is the parent of C and the child of A, and C is the child of A and B. All 3 companies are considered to be controlled group members.

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Brother/sister groups

A brother/sister group exists when the same 5 or fewer individuals own more than 80% of 2 or more companies, which they also have common control of (50% or more of the ownership interest is held in an identical manner). See the example below, in which Alan, Bob, Carrie, and Debra are unrelated persons:

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Example 1:
Company A and Company B are brother/sister entities. Alan, Bob, Carrie, and Debra together own 80% or more of both companies, and more than 50% of the ownership of the 2 companies is identical because you consider the smallest amount owned in both entities to get the identical ownership. Alan holds 25% in both companies, Bob holds 20% in both companies, Carrie holds at least 20% in both companies, and Debra holds at least 20% in both companies. Together these 4 individuals own 90%, and they have 85% identical ownership in both entities.

Example 2:
Company C is not a related entity to Company A or Company B. While more than 50% of the holdings are identical to Company A and Company B, Alan, Bob, Carrie, and Debra don’t collectively own more than 80% of Company C. Remember, you need both 80% common ownership and 50% identical ownership to have a brother/sister controlled group.

Example 3:
Company D is not a related entity. Though Alan, Bob, Carrie, and Debra collectively own 95% of Company D, and thus meet the control requirement, they don’t meet the identical ownership requirement. Alan owns at least 5% of companies A, B, and D. Bob owns at least 5% of companies A, B, and D. Carrie owns at least 20% of companies A and D and at least 25% of B and D. Debra owns at least 25% of company A and D and at least 20% of B and D. Collectively, the identical ownership between A and D and B and D is only 45%, less than the 50% threshold.

A simplified diagram:

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Note that ownership of family members may be attributed to other family members.

Combined groups

A combined group exists when 3 or more companies are connected through a combination of parent/child and brother/sister groupings. Each organization must be either part of a parent/child or brother/sister group, and one organization is both a parent and a brother/sister group. You might think of this as an uncle/nephew relationship. In the diagram below, Companies A, B, and C are a combined group.

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A note on partnerships

Partnerships are treated almost identically to corporations, with an interest in the profits or capital of that partnership being treated as an ownership interest. For example, a parent of a partnership has an 80% interest in the profits or capital of that partnership. In a partnership, however, the partnership’s ownership interest is attributed proportionally to any partner who has an interest of 5% or more in either the profits or the capital of the partnership. The 50% or more ownership interest requirement for corporations does not apply to partnerships.

Additionally, under IRS rules, a partnership is considered part of a company’s controlled group only if the partnership is engaged in a trade or business. For example, the partnership has an intent to make profit and is regularly providing goods or services with continuity.

Why these relationships matter

Before legally related group rules were established, employers could avoid paying benefits to some employees by grouping otherwise eligible employees into separate entities. For example, a medical practice could place all doctors in one company and all support personnel in another and only offer retirement benefits to the doctors.

But, because the IRS provides tax benefits to companies offering 401(k) plans, it wants to ensure the benefits are equally available to all employees. These regulations help prevent situations in which a plan sponsor allocates employee benefits in an unequal manner. As a result, the IRS requires that certain related companies be subject to annual compliance testing as a single employer.

In certain circumstances, larger employers with distinct divisions operating in different industries that have more than 50 employees will be qualified as separate lines of business (QSLOBs), which can be evaluated independently, despite having overlapping ownership. For example, a conglomerate like General Electric might operate multiple distinct divisions that maintain separate retirement plans. The rules around QSLOBs are very complex and you should work with a tax professional when making the determination and required filings.

What happens if my company is part of a legally related group?

At Guideline, all members of a legally related group are required to have a 401(k) plan with us so we can properly service the group as a whole. Each plan of the legally related group must also have the same plan start date and design and be considered together for profit sharing and other discretionary contributions.

Compliance testing will be conducted at the group level as though the related entities are one. Therefore, we will need employee data, including each employee's salary, age, and contribution amounts, as well as year-end contribution balances, for each company in the legally related group.

Please ensure you report legally related entities to Guideline so we can help ensure your plan complies with IRS requirements. If you believe that related companies may not have been included in compliance testing for the prior year, please notify us as soon as possible.

This information is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal and/or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.

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