Question 224: John owns 100% of Acme Inc. and 75% of Widget Inc. Mary owns the other 25% of Widget Inc. There's no attribution or exclusion between them. Why wouldn't this be a controlled group? After all, John and Mary are fewer than 5 individuals, they collectively own at least 80% of each company, and John owns more than 50% of each company.
Answer: This is not a point you find from reading IRC 1563. Rather, we learn it from the 1982 Supreme Court decision, U.S. v. Vogel Fertilizer. Without question it is the most important decision in the controlled group arena. It comes up in most of the controlled group situations I review.
In that case, the Supreme Court held that the same 5 or fewer individuals, estates, trusts must be used for both the "controlling interest" (80% or more) and "effective control" (greater than 50%) tests of IRC 1563. Moreover, because those whose interest is zero under the effective control test are not counted in performing that test, they cannot be counted in performing the controlling interest test. Since the Supreme Court ruling, the relevant IRS regulations have been modified to incorporate this principle.
This leads to some valuable side effects. Vogel Fertilizer says we can ignore people who don't own stock in both businesses (after applying the attribution rules). Hence the first step I run is to count up the shares that are disregarded via this rule. If those disregarded shares come to more than 20% of either company, a controlled group cannot exist, barring attribution or exclusion under IRC 1563(c).
Let's apply that to your facts. Mary does not own stock in Acme. So we can disregard her stock under Vogel Fertilizer. Since she owns more than 20% of Widget, Acme and Widget cannot be part of a controlled group.
Of course, if Mary were John's daughter, or had given John an option to buy her stock, then the attribution rules would treat John as owning her stock. In that case, John would be deemed to own 100% of both and a controlled group would exist.
Alternatively, suppose Mary was a Widget employee and had given John a nonreciprocal right of first refusal on her stock. In that case, her stock would be excluded under IRC 1563(c)(2)(B)(ii). Vogel Fertilizer would never have a chance to come into play, because once again John would be deemed to own 100% of both companies.
This is a vital point. You cannot understand the controlled group rules without understanding Vogel Fertilizer. I discuss it at length in Chapter 6 of my book, Who's the Employer.