Controlled Group

[flosfur]

Husband and Wife run separate businesses as Sole Props and file separate Sch Cs.

Husband's business has no employees but the wife's business has 3 employees.

They want to set up two separate DB plans. One plan covering the Husband only and the other covering the wife and her employees.

Are they controlled group to be considered as one Employer for 401(a)(26) and 410(b) etc?

[Guest merlin]

Check 1563(e)(5) to see if they meet the exception to the usual spousal attribution rules. But if they have a minor child the attribution of each parent's ownership to the child,creating a controlled group regardless of the exception. ALiving in a community property state may blow the exception also.

[Blinky the 3-eyed Fish]

Merlin is correct, although the issue with the minor children does not certainly create a controlled group; there are differing opinions. I think people are of one mind that a community property state does blow the exception.

[Belgarath]

Blinky - while I agree with you on the community property issue, you'd be surprised at how many don't. We've had clients come to us with legal opinions saying they are not a controlled group in this situation.

[Blinky the 3-eyed Fish]

That's interesting, personally I have not come across dissenting opinions. Of course there were many abusive 412(i) plans that relied on a legal opinion and we know what the IRS thinks of them.

[Belgarath]

"Truer words were never spoke!"

[AndyH]

I have in front of me a Derrin Watson outline (a few years old) and in it he states that some practitioners take the position that community property ownership should not be treated as direct ownership, but that he disagrees.

[SoCalActuary]

Even in a community property state, you can have sole and separate property if it is set up at the beginning of the business and the capital comes from separate property.

But most times, the exception is not met and both must be considered.

Why not set up a single DB plan? I know you have discrimination issues that might make her employees mor expensive, but it allows them to proceed.

[mbozek]

Why does cp residency require attribution of spousal interest which is exempt under IRC 1563(e)(5)? A plain reading of IRC 1663(e) (5) states that the spousal intrerest is exempt if it meets the requirements of A-D. Therfore compliance with those rules will exempt the spousal interest in a CP state. Interpretating an implied exception to the exclusion of the spousal interest under IRC 1563(e)(5) for spouses in a CP state is contradictory with congressional policy to have uniformity of taxation of taxpayers in all states. The intent of Congress to provide for uniformity of taxation of married taxpayers regardless of which state they reside is expressed in IRC 408(g) which prohibits the application of CP laws to ownership of the interest in an IRA. There is substantial authority for the position that there is no attribution of a spousal interest in a corp which is exempted under IRC 1563(e)(5) if the married couple resides in a CP state.

[Blinky the 3-eyed Fish]

There is substantial authority for the position that there is no attribution of a spousal interest in a corp which is exempted under IRC 1563(e)(5) if the married couple resides in a CP state.

Care to share?

And SoCal, good addition.

[mbozek]

The substantial authority comes from the literal reading of the statute. If a taxpayer meets the specific requirements for obtaining a benefit under the income tax law then the taxpayer has met the requirements for claiming the tax benefit. The fact there may be some uncertainity regarding a tax law does not prevent the rendering of an opinion based on substantial authority which is why taxpayers obtain tax opinions.

[Belgarath]

Mbozek - I freely admit that much of this is beyond my understanding, so I give you instead some excerpts from S. Derrin Watson, who in my humble opinion is one of the foremost practitioners and acknowledged experts in this arena. And I'm picking a couple of excerpts, which doesn't really do justice to the logical progression and development of his arguments.

"Community property ownership is direct ownership. Under the laws of each community property state, if stock is held as community property, each spouse has an equal ownership of the stock."

"This means that both spouses have direct ownership in community property assets. Their ownership does not come through attribution. It comes by operation of state law, just as any other ownership does. This was the holding of the court in the Aero Industrial case..."

"Some practitioners take a different approach, believing that community property ownership should not be treated as direct ownership. These practitioners feel that Congress "clearly intended" to create a spousal exception and would not have wanted to make a difference between community and separatre property states. The author disagrees. Congress knows how to put community property and separate property jurisdiction on an equal footing and did not do so." To support that last line, Mr. Watson has a footnote to "Compare e.g., IRC 219(f)(2), 402(d)(4)(E), 402(g)(6), and 408(g)."

He does go on to say that there is a way around this rule. "They can have their stock treated as separate property. Usually this is accomplished through an agreement between the parties, signed before or after the marriage."

Note: He then goes on to warn about serious side effects of such an agreement, (in a divorce, stock basis after death, etc.) and says that it should not be considered unless husband and wife are separately represented by experienced counsel.

So, we get some clients (the vast minority, to be sure, but some nonetheless) who get a legal opinion that they are not a CG in the CP state. But most, when they get an opinion, find that their attorney agrees with Mr. Watson's conclusion.

[mbozek]

I dont agree. The tax code sections cited by Watson are designed to prevent married taxpayers who live in CP states from using CP laws to get tax benefits not available to married taxpayers living in non CP states, e.g., by assigning 1/2 of the interest in an IRA to the spouse for distribution purposes, not prevent them from taking a tax benefit available to married persons who live in non CP states. Without these provisions taxpayers in CP states could argue that CP law permits them to lower their taxation or obtain tax benefits not available to residents in non CP states. These 4 provisions are consistent with my theory that income tax laws are not supposed to differ in application depending on whether a married taxpayer lives in a CP or non CP state.

Similarily a married taxpayer who lives in a CP state should not be denied the benefits of non attribution under IRC 1563(e)(5) merely because of the attribution of 50% of the corporate interest to the spouse under state CP law because this would prevent uniformity of treatment under the tax law of residents in CP and non CP states. Most tax advisors would agree that compliance with the literal requirements of the tax law is substantial authority for claiming an income tax benefit; the fact that some tax advisors would read in CP law attribution where none exists under IRC 1563(e)(5) so as to prevent such exclusion of interest is consistent with the principle that taxpayers are free to deny themselves a tax benefit if they choose to do so. [old story but relevant- when Gerald Ford became president after Richard Nixon resigned he ordered his tax preparers not to use tax shelter losses which would lower his taxes even though the losses were permitted under the tax law.]

The answer to this question depends on the confidence that a tax advisor has in applying his or her advocacy skills to interpretation of inscrutible statutes.

[Belgarath]

Infinite are the arguments of the mages.

Thankfully, we depend upon the client and their attorney(ies) to make the decision! We just operate on the basis they instruct us to. But the subject does provide opportunities for interesting discussion. Thanks for sharing your viewpoint on this.

[JAY21]

I don't see why the IRS can't define the terms of what it will consider a Controlled Group without having to recognize state marital ownership laws. The Controlled Group rules cited are under the Tax Code so it would seem to me if the IRS wants to ignore community property issues then it has the ability to write the rules of the game whatever way they want to. I realize the IRS did not directly address community property issues in the tax code cited, but to me the language sounds like a universal standard to be applied to all persons and companies and I don't believe they have a strong history of applying state laws (except marraige). I don't disagree that Darrin Watson is the guru, I just wonder if practically speaking we're not living up to a higher standard than the IRS is trying to impose. I understand that informal comments from the IRS has been "we're aware there is an issue there". That's pretty non-committal and probably supports neither side. I tend to advise clients of the issue, suggest counsel involvement, and leave it up to the client.

[flosfur]

Merlin is correct, although the issue with the minor children "does not" certainly create a controlled group; there are differing opinions.  I think people are of one mind that a community property state does blow the exception.

Do you mean "does"? Apprently, Merlin seems to be stating that having a minor child "creates" a contol group!?

[flosfur]

From the discussions so far, the arguments in favor of aggregation invoke the fact that the US Federal law/IRS pays deference to the States' law.

I am not a constitutional lawyer (or even a lawyer) but that should not stop me from opining and with all due respect to the "gurus" on this topic ...

Firstly, I thought it was generally the other way around, i.e. the State law should defer to the Federal laws. If such was not the case, some States in the US will still have "legalized" slavery, separate drinking fountains, seating areas on the buses and trains, segregated schools and other "state level legal" segregation practices.

Secondly, and very topically, as we are all aware, recently the IRS, US Attorney General Ashcroft and other federal authorities have opined that parties in the same sex marriages are not afforded the status of "spouse" and its attendant benefits under the federal laws (including ERISA) even though some States (one for now) confer such status and its attendant benefits.

Thirdly, let's not forget many other conflicting State & Federal laws - such as: medicinal use of "weed" in California and Euthanasia/assisted suicide in Oregan being OK but not OK under the Federal law.

So what comes first - the Chicken or the Egg? Federal law or the State law? Who knows!

Finally, the IRC does not (and did not) say that a married couple can file separate tax returns (when, in the days of marriage penalty, it was tax advantageous to do so) "if and only if" they live in a "non-community property" State? Or does it? So why would the applicability of IRC 1563(e)(5) depend on where the married couple lives?

Above pontification notwithstanding, is there a case law where, absent minor children, the IRS have successfully prevailed in courts in imposing aggegation of separate businesses owned by spouses in a community property for section 414(b)?

[flosfur]

Check 1563(e)(5) to see if they meet the exception to the usual spousal attribution rules. But if they have a minor child the attribution of each parent's ownership to the child,creating a controlled group regardless of the exception. ALiving in a community property state may blow the exception also.

Only mention of minor children is in 1563(e)(5) is in (5)(D) which reads:

(D) Such stock in such corporation is not, at any time during such taxable year, subject to conditions which substantially restrict or limit the spouse's right to dispose of such stock and which run in favor of the individual or his children who have not attained the age of 21 years.

I don't read this as: If there are minor children then the spousal exemption does not apply. It is only so, if the spouse is restricted/limited from disposing of his/her stock and the restriction run in favor of minor children. Doesn't this refer to a situation such as - a person inherits some stock and is not allowed to dispose of it until children are 21?

How could a spouse owning 100% of a business actively run by him/her and which he/she started be restricted from selling any part of the business just because there are minor children unless of course they had an agreement that he/she will not sell the business without spouse's consent and/or until kid are 21!?

Also, I don't see any mention of living in a community/non-community proprty State.

And this (e)5) exemption is not excluded by section 414(b), which refers to 1563 for controlled group determination.

Is there another Code section which overrides 1563©(5) if living in a comminty proprty State?

[mbozek]

A taxapyer reesiding in a CP state has substantial authority under the income tax law for claiming a tax benefit if the taxpayer meets the requirements of the code and the regulations. The IRS can only only administer the law, not interpret the law and cannot add any additional requirements not in the tax law or regulations unless Congress explicitly adds such a requirement as it did in DOMA when it defined spouse for all purposes under federal law, not just tax law (e.g., social security and veterans benefits). IRC 1563 was enacted 40 years ago and if Congress wanted to make a distinction between residents of CP and Non CP states it has had ample opportunity to do so.

Finally Congress allowed filing of joint income tax returns by married couples in 1948 to provide the benefits of income splitting to married couples who lived in non CP states that was avialable to residents of CP states.

All of this leads to two conclusions:

1. Congressional policy is to apply the income tax laws uniformly in all states.

2. If Congress wants to change any requirements for a tax benefit it will enact appropriate legislation. Until then a taxpayer can rely on existing law.

[Guest merlin]

Flosfuhr,

The parents' ownership is attributed to the minor child under 1563e6. This creates a controlled group, because the minor child now owns 100% of each company. This question was part of the Q&As at the ASPA conference some years back, and the written response (it was not discussed by the panel) was that that was the correct interpretation. Granted, this is probably an example of the Law of Unintended Consequences, but "... A strict reading of the statute leads to the conclusion that the existence of minor children creates a controlled group when each spouse owns at least 80% of his or her respective business." (The ERISA Outline Book, 2003 edition, p. 1.34)

[Lame Duck]

It seems to me that the argument has been focusing on whether the ownership is "attributable" to the non-owner spouse in a cp state. However, this argument ignores the actual basis for determining whether it is a controlled group, an argument that was put forward by Belgarath in quoting S. Derrin Watson

Community property ownership is direct ownership.

Under the laws of cp states, the spousal exception of 1563(e)(5) fails because it fails 1563(e)(5)(A).

[mbozek]

There is no case or IRS ruling listed for attribution of spousal interest under 1563e5 in CCH or BNA tax manual 554 in the 40 years since enactment. So it solely a matter for counsel to opine on.

[GBurns]

It could be that the IRS sees no need for a ruling as per their general refusal to rule on obvious issues. They might have thought that no one would argue that there could be a question as to whether or not there is spousal attribution in a CP state.

Corporations and business entities are creatures of state law, if the state allows the entity, the IRS accepts it.

The ownership of corporate entities etc is decided by state law. Why would anyone question the ownership attributed to a spouse in a CP state? The IRS accepts whatever it is that the state allows.

[flosfur]

There is no case or IRS ruling listed for attribution of spousal interest under 1563e5 in CCH or BNA tax manual 554 in the 40 years since enactment. So it solely a matter for counsel to opine on.

Unfortunately anyone (legal counsel or otherwise) can opine whatever they like and collect their fee - but would it hold up when challenged? That's the problem. And the opining person may be long gone when this happens and the taxpayer is stuck with the consequences.

[flosfur]

It could be that the IRS sees no need for a ruling as per their general refusal to rule on obvious issues. They might have thought that no one would argue that there could be a question as to whether or not there is spousal attribution in a CP state.

Corporations and business entities are creatures of state law, if the state allows the entity, the IRS accepts it.

The ownership of corporate entities etc is decided by state law. Why would anyone question the ownership attributed to a spouse in a CP state? The IRS accepts whatever it is that the state allows.

Well this appears not to be that "obvious" of an issue. Otherwise there won't be conflicting opinions on this message board and in the "legal" community as pointed out here.

As to the IRS accepting the State's law, we are back to the Chicken & the Egg thing - as stated before, Federal law & federal agencies do not always defer to the State law! I quoted few examples - should I mention some more?

Anyway, for S414(b), it is not the question of "ownership right" per se but the "level of control" one person/entity has over the running of another person's/entity's business.

Also, in the case of pension plans, we are not concerned with the business entities with passive investment income. So let's focus on "active participation" businesses and...

Consider an MD with his own medical practice and his wife (for simplicity) who sells Mary Kay products living in a cp State.

Are you saying that their businesses must be aggregated and considered a controlled group? So if the MD sets up a pension plan for his business, the plan must cover his wife's employees, if she has any?

I fail to see how the MD can control his wife's business of selling Mary Kay products & her employees and Vice Versa!

Same goes, if his wife is also an MD with her own practice.

What if the two had their businesses before they married? Is that considered an ipso facto merger if they live in a cp State?

[flosfur]

Flosfuhr,

The parents' ownership is attributed to the minor child under 1563e6. This creates a controlled group, because the minor child now owns 100% of each company.  This question was part of the Q&As at the ASPA conference some years back, and the written response (it was not discussed by the panel) was that that was the correct interpretation. Granted, this is probably an example of the Law of Unintended Consequences, but "... A strict reading of the statute leads to the conclusion that the existence of minor children creates a controlled group when each spouse owns at least 80% of his or her respective business." (The ERISA Outline Book, 2003 edition, p. 1.34)

We are not talking about ownership per se. There is no question about the spousal "ownership right" in a cp State whether or not there are any minor children.

But the spouses are specifically exempted by (e)(5), if conditions of (A) to (D) therein are satisfied, no matter how the attribution comes about.

Ownership rights notwithstanding, I think S414(b) is concerned more about "control of power" in running another entity's business. All those who can control/influence how your spouse's business is run, please step forward.

[mbozek]

F: No tax advisor can make an incomprehensible law comprehensible. No advisor is going to guarantee a favorable result but will use caveats in rendering the opinion such as "while not entirely free from doubt" or "it is more likely than not" to alert the taxpayer to the uncertainty in the law. The purpose of providing the opinion is give the taxpayer substantial authority for claiming the tax benefit in the event of an audit by the IRS which will 1) provide a reasoned basis for the position taken and 2) prevent the imposition of penalities for substantial understatement of taxes so the worst case for the taxpayer is that taxes and interest will be owed but not the penalities of up to 75% of the taxes due. Of course the client is free not to obtain an opinion and aggregate the spouses interest for the purpose of IRC 414(b) or assume audit risk without an opinion.

[mbozek]

Merlin I dont want to quibble but I am not sure that the constructive ownership interest of a minor child automatically creates a controlled group between both parents business interests. See Reg. 1.1563-3©(2) and 1.1563-3(b)(6)(iii) example ©. Such attribution creates an anomolous situtation for married couples with separate businesses who have minor children soley because of ownership of a business while the child is under 21 (or inheritance of a business interest).

[Guest merlin]

mbozek,

Feel free to quibble. It's a nutty intepretation ("anomolous" is Latin for nutty), but it seems to hold up.

Anyway, I don't get your references. All they say to me is that a) there is no double attribution, and b) adopted children are treated the same as natural chidren. How does that impact the notion that the parents' independent ownership flows to the child, resulting in a cg?

[SoCalActuary]

The IRS should logically conclude that minor children don't "control" their parents' businesses, but, until they do, we have to choose how to interpret these rules.

[mbozek]

I have always assumed that the rule prohibiting double attribution of the constructive interest of the child prevented the absurdity of a controlled group consisting of the child and the business interests of each parent for pension plan aggregaton purposes. Such an extension of the family aggregation rules is even more absurd if you consider it would require aggregation of the business interests of grandparents as well as the inherited interests of parents and children so as to create a marriage penalty for all married couples who own separate businesses with a retirement plan and have children or grandchildren.

[Blinky the 3-eyed Fish]

Mbozek, I don't understand your comments. A controlled group determination uses 1563 attribution, which means that to be attributed any shares you have to own more than 50% of the business. The exception of course is a child under 21 is attributed ownership of the parents. This isn't going to cause all the issues you raise.

[Guest merlin]

Mbozek, my understanding of 1.1563-3c2 is that it is intended to prevent my constructive ownership, say as attributed from my father, from being attributed again to my spouse. Only my direct ownership would be attributed to my spouse.

[mbozek]

But what if you spouse inherited 100% interest in a business from a deceased parent which has 10 employees and no pension and you had a a HR-10 plan for your own business. Wouldnt there be a controlled group on account of the child having a constructive interest in both businesses?

As for grandparents my question was whether the separate businesses controlled by each grandparent (a Dr and CPA) would be aggregated as a controlled group if there is a grandchild under 21 under reg 1.414©-4(b)(6), similar to the analysis for the aggregation of the parents interest for which I understand the anwer is no. But then why is there a distinction between parents and grandparents?

[jane123]

Sort of different question- I really hope you can help.

What if two sisters have ownership in two businesses.

1 owns 100 % of business A and 40 percent of Business B (let’s her Jane)

The other owns 40 % of business B, lets call her Daisy.

Can Jane participate in the plans for both Company A and Company B?

Does the employees of Company B have to participate in the plan adopted by Company A?

Can Daisy participate in the plan for both companies and receive $41,000 in contribution to each?

Thanks very much

[GBurns]

It might be helpful to know the corporate entity structure of these businesses/companies.

[jane123]

Good point- Both are C- corporations

Thanks

Jane