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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Using options to create controlled groups

(Posted June 19, 1999)

Question 26: Most of the questions in this column and in most books seem to be centered around trying to keep multiple companies from being aggregated, mine is the opposite.
I have 4 companies that from the outset appear to be a single employer, and prefer to be treated as a single employer for their 401(k) plan. The 4 companies are contruction companies, each doing a different contruction contracting aspect (cement, drywalling etc.).
There are 5 total owners, but based on the control group rules they do not appear to be a true control group. Since they don't appear to be an affiliated service group, I'm having trouble seeing them together.

All 5 owners basically run the 5 companies, same building, same equipment, same trucks etc. Is there a possibility to see these a single employer under the management company guidelines? I hate to have to treat them as a multiple employer when there is basically no real testing needed anyway. Any hints?

Answer: This situation is more common than you think, and indeed my book addresses one of the more commonly used strategies to create a controlled group.

The attribution rules provide a vehicle for creating a controlled group. Under these rules, someone is deemed to own stock who does not actually own it. Probably the easiest of the attribution rules to employ in this manner is the option attribution rule. If I own an option to buy stock, it is as though I own the stock. At this point, let me quote from Q 7:7 of my book Who's the Employer?:

Can options be used deliberately to create a controlled group?

Usually, taxpayers wish to avoid having corporations treated as a controlled group. Sometimes, however, taxpayers want to create a controlled group where one does not otherwise exist (perhaps to simplify filing requirements or deductibility in a multiple employer plan).

Potentially the most painless way to create a controlled group is to give the owner of one corporation an option to purchase the other. However, this approach is fraught with pitfalls.

The most obvious problem is that the person given the option might choose to exercise it, now or in the future. If this is not what the parties intend, such a result could be a calamity for the party that has to sell. For this reason, such a move should only be considered if both parties are represented by competent legal counsel.

One way around this problem is to set the option price so high that nobody would ever want to exercise it. If your stock today is worth $100, and you give me an option to buy it for $1,000,000, it is a fairly safe bet I will not want to exercise the option (unless the corporation acquires a winning lottery ticket). Although there are no reported cases dealing with this issue, the IRS could argue that an option with a grossly inflated price is illusory. The IRS would argue that the option has no substantial economic effect, and therefore should be ignored.

It is certainly possible to have an option price somewhat higher than the current fair market value. In fact, such options are often granted to key employees of large corporations as an incentive to increase stock values. However, an option price grossly in excess of the current value is likely to cause the IRS to ignore the option if it suits the government's interests to do so.

Of course, in granting such an option, one must insure that all appropriate corporate formalities are followed. The grant of an option is the issuance of a security which, in some states, may require a filing with a state agency or a specific exemption from filing. Naturally, options can be granted only to individuals who can actually own the stock. Hence, in most states a nurse cannot be given an option to buy stock in a professional medical corporation, because the nurse cannot legally own the stock.

Let me add another caveat. By creating a controlled group for qualified plan purposes, we are also creating one for ordinary income tax purposes. If two or more corporations regularly show a profit on their tax return each year, they may end up paying higher corporate income taxes because of the creation of the controlled group.

Yes, it would also be possible to set up a management group, assuming that even though the corporations are not in a controlled group, they are at least "related" (in other words, the same persons own more than 50% of each corporation). If that is true, then set up a management company, perhaps owned by all 5, which provides management services to the five businesses. If they are not "related," however, this won't work, because of the definitions in 414(m)(5).

You are correct that this isn't otherwise an affiliated service group, because contractors are generally not "service organizations."

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.