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Question 21: Company A performs, on a regular and continuous basis, management functions for Companies B and C. Company B is owned 100% by individual X. Company C is owned 100% by individual Y. Company A is owned 1/3 each by individuals X, Y and Z. X, Y and Z are unrelated. Company A also receives revenue for providing marketing services for Company D, which is unrelated to A, B and C. However, the primary source of A's revenue is from B and C. Are A, B and C members of a management affiliated service group? Code Section 414(m)(5) provides that an affiliated service group exists if an organization perform management functions for one organization. Does this mean that if an organization provides management functions for 2 unrelated organizations, there is no affiliated service group?
If A, B and C are members of an affiliated service group, at what point would A's revenue from D cause A's "principal business" not to be the management of B and C?
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Answer: 414(m)(5) requires that providing management functions for 1 other business (or 1 business and organizations related to that 1 business) be the principal business of the management company.
So, let's take a simple situation. Management Co has as its sole business managing the ABC nursing home. Management Co and ABC are an ASG, regardless of their ownership. DEF nursing home likes Management Co's work so well that it hires them as well. Sam owns 60% of both ABC and DEF. ABC and DEF are related parties because of Sam's ownership (even though they are not a controlled group) and so Management Co is still providing services to one entity and to businesses related to that entity. All three are an ASG.
Well, Management Co is going along just fine, and now a completely unrelated nursing home comes along, GHI. Management Co bills the same fees for each nursing home and spends roughly the same time managing each nursing home. Although managing ABC and DEF is no longer Management Co's sole business, it is certainly their principal business, because it provides 2/3 of their revenue.
Soon, two more unrelated nursing home join the stable, JKL and MNO. Now the ABC and DEF group is only 40% of its revenue, and it appears that their principal business is no longer the provision of management functions to 1 other business (or 1 business and organizations related to that 1 business). Accordingly, even though Management Co still does nothing other than manage nursing homes, it is no longer a management function group and none of the businesses are an ASG.
What constitutes principal business? Unfortunately, we have no regulations on the subject, but let me quote from Q13:17 of my book, Who's the Employer? on how to view this question:
Two methods of analyzing the situation suggest themselves, time and money. If the time spent managing a client (and/or its related entities) constitutes more than half the productive time of an organization, then that would be its principal business. Alternatively, if more than half the gross receipts of a business comes from managing a client and/or its related entities, then that would be its principal business. The withdrawn proposed regulations relied primarily on gross receipts, but indicated that time or other factors would be considered in appropriate situations.
In a close case, consider applying for a determination letter from the IRS on the issue. The IRS appears to rely on gross receipts as an indicator of principal business. Rev. Proc. 98-6 instructs those wishing a letter to give: A description of what part of the employer's business constitutes the performance of management functions for the member (or possible member) of the group (including the percentage of gross receipts derived from management activities as compared to the gross receipts from other activities). |
So, with that background, let's go to the specifics of the question. Company B and Company C are not related. The fact that they are part owners of the management company does not make them related. So, Company A is doing work for three businesses. Does any of the three account for more than half of its gross receipts? Are there other indications, such as time, that would indicate that one of them is the principal business? If not, then an ASG does not exist. On the other hand, if Company B, for example, provides 55% of A's gross receipts, then B and A would be an ASG.
While the question was looking at 414(m)(5), I should not leave the issue without looking at a traditional B-Org situation. Management functions are, depending on the type of business, frequently provided by employees. Assuming that X and Y are HCE's of their respective companies, it is likely that A and B are a B-Org ASG, and A and C are a B-Org ASG.
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