Question 159: Let's change the facts just a bit on Q&A 158. Corporation X owns 49% of Corporation Y. Y's ESOP owns the remaining 51% of Y. Oscar owns 100% of X and is a participant in the ESOP. 65% of the Y stock held by the ESOP is allocated to Oscar's account. Are X and Y now a controlled group and for what purposes?
Answer: Oh, what a difference 2% makes! If X owns 49% of Y, rather than 51%, none of the reasoning of Q&A 158 applies.
IRC 415(h) no longer applies to make the two companies a parent-subsidiary group for purposes of section 415. 415(h) only applies when the parent owns or is deemed to own more than 50% of the subsidiary.
The ESOP stock is no longer excluded stock under the parent-subsidiary rules, even though it is owned by a deferred compensation plan. Why? Because X no longer owns more than 50% of Y, a condition to parent-subsidiary exclusion.
So, let's consider the possibility of attributing the stock to Oscar, so as to create a brother-sister controlled group. After all, he owns 49% of Y by attribution through X, and 33.15% (51% multiplied by 65%) of Y by attribution through the ESOP.
But IRC 1563(e)(3)(C) says there is no attribution from a qualified retirement plan and trust to its beneficiaries. That prevents attribution of the ESOP's stock to Oscar. Therefore, on these facts a controlled group does not exist for normal income tax purposes.
The situation is different for retirement plan purposes, however. IRC 414(b) says to ignore IRC 1563(e)(3)(C) in applying the controlled group rules to retirement plans. Hence, under 414(b) the ESOP's stock is attributed to Oscar and he is deemed to own at least 80% of each corporation, even though not a single share of the Y's stock is in his name. For retirement plan purposes, then, the two companies are in a brother-sister controlled group and their employees are deemed to be employed by a single employer.
Incidentally, although it does not affect the result, now that Oscar is deemed to own half of Y, the brother-sister exclusion rules come into play and we can exclude all of the ESOP stock that Oscar does not own. This would give him 100% of both companies. Two readers wrote to point this out.
This is one of several circumstances in which two businesses might be a controlled group for retirement plan purposes but not for ordinary income tax purposes.
For more examples of attribution of stock held by a qualified plan, see Q 7:13 of my book Who's the Employer. Also, see Private Letter Ruling 8851079, mentioned to me by an astute reader. This ruling demonstrates the exclusion and attribution rules applicable to this situation. I have posted it in the Who's the Employer Reading Room.