Question 18: Can I use options to break up a controlled group? Suppose, for example, John owns all 100 shares of Corp. A and 85 of the 100 shares of Corp. B, a classic brother-sister controlled group. (The remaining 15 shares of Corp B is owned by an unrelated party, Xavier.) Corp. B grants Charlie (an unrelated party) an option to buy 10 shares. Now John owns 85/110s (77%) of Corp B, because Charlie is deemed to own the 10 shares, and there isn't a controlled group.
Answer: No. Neither attribution through options nor any of the other attribution rules can have the effect of dividing a controlled group. They do not change the ownership prior to the attribution, they merely create an alternative stock ownership. A controlled group exists if the ownership tests are met either under the actual ownership or under an alternative ownership through the attribution rules.

In the example above, John now owns 85% of Corp. B, and the attribution rules do not change that fact. That being the case, the two corporations are in a controlled group, regardless of what changes may happen to ownership percentages after attribution.

The attribution rules never break up a group, but they can create groups that otherwise would not exist. Suppose, for example, that there was a Corp C in which Charlie and John each owned 50%. Before attribution, Corp. B and Corp C are not in a controlled group (because B owns less than 80% of Corp. C and Charlie doesn't own any Corp. B stock and hence is ignored under Vogel Fertilizer.) After attribution because of the option, Charlie does own Corp. B stock and John and Charlie together have both effective control (more than 50%) and a controlling interest (at least 80%) in both corporations and a controlled group exists between Corp. B and Corp. C.

Incidentally, this means that Corp. B is in two different controlled groups, (A and B) and (B and C). For ordinary income tax purposes, this means that B can choose which group it is in. However, for corporate plan purposes, it is a part of both groups. My position is that since all employees of Corp. A and Corp. B are deemed to be employed by a single employer, and all employees of Corp. B and Corp. C are deemed to be employed by a single employer, then there is one employer of the employees of all three corporations and they are tested together.

The option attribution rules give rise to several interesting questions that are discussed, with examples, at Q 7:4 - 7:8 of my book Who's the Employer?

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