Question 143: If five or fewer individuals collectively own more than 50% of a corporation (exclusive of stock held in an ESOP) then is the ESOP stock excluded from the calculation to determine a controlled group? Without the ESOP four people own 80% in my situation, but when I attribute the ESOP stock and include the ESOP in the test, they only own 75%. Which way is right?
Answer: Either way can be right, depending on whether it will create a controlled group.
If five or fewer individuals, estates or trusts own at least 50% of a corporation, IRC 1563(c)(2)(B)(i) says that for purposes of determining whether a controlled group exists, stock held by a qualified plan will be excluded, but only if that serves to create a controlled group. Thus, this rule can only be used as a "sword," and not as a shield.
Let's take a couple of examples. Suppose ownership of two companies is as follows:
|Owner||Co. X||Co. Y|
|Co. X ESOP Trust||15%||0%|
Assume that Anne's account balance is 50% of the total in the ESOP. Accordingly, once we attribute ownership of ESOP stock to Anne, she has a total of 77.5% of Co. X, which is not quite enough for a controlled group. So, we go to the next step and try excluding the ESOP stock. Now Anne owns 70/85ths of the company, more than 82%. With the exclusion, a controlled group exists and so we exclude the stock.
Now, let's try a different example. Suppose we are interested in companies A and B, with the following ownership:
|Owner||Co. A||Co. B|
|Co. A 401(k) Trust||20%||20%|
2,000 employees participate in the Company A 401(k) Plan and Trust, and no one participant owns more than 1% of its assets.
On these facts, without the exclusion, Company A and B are in a controlled group, because Oscar and the Trust collectively have 80% effective control and 80% controlling interest. So, we stop there. (If we were to go on and apply the exclusion, improperly, we would find that Oscar, all on his own, would have 75% of the remaining, nonexcluded stock and there would be no controlled group.)
Let's apply these principles to your question. The four shareholders in question own more than half of each company, and so exclusion is proper if it creates a controlled group. You say a controlled group exists if you ignore the ESOP stock, and otherwise it doesn't. So exclude the ESOP stock.
Let me make a few other side comments here:
- You are right that the stock ownership is attributed from the ESOP to its beneficiaries. IRC 1563 has a rule for general tax purposes that there is no attribution from a retirement trust to its beneficiaries, but that rule does not apply to determinations under IRC 414 (the retirement plan controlled group rules).
- Remember, as shown in the second example above, that a retirement trust is a trust. Hence, when you are asking if 5 or fewer individuals, estates, or trusts have effective control, you can either look at the trust as a single shareholder, or you can attribute its ownership to its beneficiaries (or attribute it to some and not others if that makes a difference).
- The exclusion rules are some of the most complex and troublesome rules in the controlled group arena. That's why I devote Chapter 8 to them in my book, Who's the Employer? The diagrams that appear in the latest version of my book are particularly helpful in sorting through the logic of exclusion situations.