Question 222: John owns 100% of Corp A and 60% of Corp B. Corp B. owns 100% of Corp. B1. Employees of Corp B1 own the remaining 40% of Corp B stock, subject to substantial restrictions running in John's favor. If these employees were employees of Corp B, then their stock could be excluded from the controlled group test under IRC 1563(c)(2)(B)(ii), and thus create a combined group between A, B and B1. But does that rule apply when they are employees of B1, a subsidiary of B? Does 414(b) make them Corp B employees for purposes of this exclusion?
Answer: This is an excellent question of a difficult and technical issue. I have no trouble envisioning a court or the IRS going either way on this issue. But they haven't ruled on it, as far as I'm aware, and I think the statute is actually fairly clear that exclusion does not apply in this situation.
The exclusion rules are not widely understood, so let me take a moment to walk slowly through them. IRC 1563(c)(2)(B) says that if 5 or fewer individuals, estates, or trusts (the common owners) own at least 50% of a corporation's voting power or 50% of the value of a corporation's stock, then the ownership of three classes of stock can be completely excluded if doing so would create a controlled group. The excluded stock is not counted in the numerator or the denominator of any controlled group testing. It is as though the stock had not been issued.
This rule can only be used as a sword, not a shield. It can be used to create controlled groups, but not to break up groups. So you always test to see if a group exists before you apply the exclusion rules. If it does, you don't bother with the exclusions.
There are three types of stock that can be excluded under this rule:
- Stock held by a qualified plan for the corporation's employees.
- Stock held by an employee of the corporation if the stock is subject to conditions which run in favor of the corporation or the common owners and which substantially restrict transfer for the stock. This rule does not apply if this is a bona fide reciprocal agreement between the owners.
- Stock held by a tax exempt organization controlled by the corporation or its officers or principal shareholders.
The Code specifically defines an "employee" for this purpose as being an employee under IRC 3121(d)(1) or (2). This refers to a common law employee or to an officer of the employer in question. (There is a somewhat different definition in the regulations which would include some statutory employees. That definition is out of date and was modified by a subsequent statutory change.)
I have posted a chart from Chapter 8 of my book, Who's the Employer, which shows the logic that should be followed in applying the exclusion rules to a brother sister situation.
The question here focuses on whether, in the words of the Code, the "stock in such corporation [is] owned . . . by an employee of the corporation." The owner is not, in fact, an employee of the corporation, but rather is an employee of a wholly owned subsidiary of the corporation. In other words, that owner does not meet the specific standards required for exclusion.
This is not a casual term. The term "employee" is specifically defined in the Code and Regulations. Those definitions do not expand to take into account related entities. They could. Congress could have drafted it that way. But as it turns out, the one amendment Congress made to the employee definition slightly contracted the class of persons who could be treated as employees. They have done nothing to expand them to related entities.
But, of course, that's in 1563, the controlled group sections. In the employee plan field, we're worried about 414(b), which says that all employees of all controlled group members are deemed to be employed by the same employer. So, the question asks if we should apply those rules to treat an employee of B1 as an employee of B so as to create a controlled group between B and A.
In my view, the answer to that question is "no." IRC 414(b) specifically lists the sections for which controlled group members are treated as a single employer. IRC 414 itself is not on the list. Hence, it cannot be used to bootstrap controlled group status.
The moral of this story is that the controlled group rules are extremely specific. In many senses, that makes them a joy to apply because if you look at the words of the Code long enough, you can generally find a clear answer to most any controlled group question. This provides a pleasant contrast to the affiliated service group rules, which are riddled with ambiguity.