Question 22: Corp 1 has a qualified ESOP, which owns all of the Corp 1 stock. Evan is the sole participant in the plan. Evan owns 100% of Corp 2. Are Corp 1 and Corp 2 a controlled group?
Answer: For qualified plan purposes, yes. For ordinary income tax purposes, no.
Under IRC 1563(e)(3)(A), stock owned by a trust is deemed to be owned by its beneficiaries. So, Evan is deemed to own 100% of the Corp 2 stock held by the ESOP. Since he is deemed to own 100% of both corporations, the two are a brother-sister controlled group for qualified plan purposes.
For ordinary income tax purposes, however, the two would not be a controlled group. IRC 1563(e)(3)(C) says that stock held by a qualified plan is not attributed to beneficiaries. However, that particular provision is expressly left out of the controlled group rules applicable to qualified plans under 414(b). So, they are a controlled group for plan purposes, but they are not for ordinary income tax purposes. This is just one of several instances in which you cannot look at the income tax return to determine if a controlled group exists.
I was recently asked this question by someone who wondered if the stock held by the ESOP was excluded under 1563(c)(2)(B)(i). That section takes out of the controlled group calculation any stock held by a qualified plan, However, IRC § 1563(f)(4)(C) says that this exclusion applies only as a sword, to form a controlled group, not as a shield to prevent a group from forming.
Because of the confusion this rule creates, I wrote a step by step methodology for using the exclusion rules. Here is that description, taken from Q 8:9 of my book, Who's the Employer?:
To test whether a brother-sister group exists, if there is excluded stock, a practitioner should follow this procedure:
1. Exclude treasury stock and nonvoting preferred stock, if any.
2. Apply the stock attribution rules.
3. Identify groups of five or fewer individuals, estates, or trusts who have effective control, excluding those individuals who have no effective control ownership. If there is no such group, skip to step 5.
4. Test each shareholder group determined to have effective control to see if it also has a controlling interest. If it does, a brother-sister group exists. Stop.
5. If a brother-sister group does not exist, determine if five or fewer individuals, estates, or trusts own or are deemed to own at least 50% of the corporation's voting power or stock value. If not, then stop; a brother-sister group does not exist.
6. If there is a group of five or fewer who own at least 50% of the corporation, then determine if one of the exclusions in [IRC § 1563(c)(2)(B)] applies to make some or all of the corporation's stock excluded stock.
7. If some of the corporation's stock is excluded under step 6 then repeat steps 3 and 4 to determine if a brother- sister controlled group exists.
The following examples illustrate both the conditions for exclusion and the procedure outlined above. In each case we are dealing with two corporations, A and B. Oscar owns 100% of A.
Exclusion Not Allowed. Oscar owns 60% of B out right. 20% is held by the B retirement trust, the trust for B's qualified profit-sharing plan. Oscar is the only participant in the plan. 20% is held by Tom, an unrelated third party. (1) There is no treasury stock or nonvoting preferred stock. (2) For qualified plan purposes Oscar is deemed to own the trust's stock because of attribution. (See Q 7:12.) Thus, Oscar owns 80% of B and has both (3) effective control and (4) a controlling interest. A brother-sister group exists.
Note that the trust's stock falls within the exclusions described in [the Code]. If that stock were excluded, Oscar would own 60/80 of B, or 75% and a controlled group would not exist. Because of the second condition, that the excluded stock rules cannot be used as a shield to prevent the formation of controlled groups, Tom's stock is not excluded. There is a controlled group as of the fourth step, and we do not proceed further.
Exclusion Allowed. Oscar owns 60% of B. Paul, an employee of B, owns 30% of B subject to a nonreciprocal right of first refusal in favor of Oscar. The remaining 10% of B outstanding is treasury stock that B had issued and redeemed. (1) We start by excluding the treasury stock, leaving Oscar with 67% and Paul with 33%. (2) The attribution rules are inapplicable. (3) Oscar has effective control, but (4) Oscar does not have a controlling interest. At this point, a brother- sister group does not exist. So, (5) we find that Oscar owns at least 50% of B and (6) one of the exclusions applies. Thus, we exclude Paul's stock and (7) Oscar now holds 100% of B's nonexcluded stock. A and B are a brother-sister controlled group.
First condition not satisfied. Same facts as prior example, except Oscar owns 45% of B, Paul owns 40% of B, and Elizabeth, an unrelated third party, owns the remaining 15%. (1) There is no treasury or nonvoting preferred stock and (2) the attribution rules do not apply. (3) No group of shareholders has effective control, so we skip step (4). (5) Because Oscar owns less than 50% of B, none of the stock is excluded stock. The two corporations are not in a brother-sister controlled group.