Question 339: A private equity firm says it's not a trade or business, and that the controlled group rules and affiliated service group rules don't apply to them. If a private equity firm buys 80% of company A and buys 80% of company B using its investors' money, aren't A and B part of a controlled group?
Yes, because they are under common control.
Let's start with the easiest case. If the parent, A, and B are incorporated, then the three are a controlled group of corporations. There is no "trade or business" requirement.
However, trades or businesses become important when we discuss "a group of trades or businesses which are under common control" under Code 414(c)(1). There is some debate about the status of private equity companies as trades or businesses, particularly in the context of liability for underfunded multiemployer plans. I discuss this in Chapter 12 of the forthcoming 7th edition of Who’s the Employer.
Fortunately, your question can be answered without resolving that issue. Treas. Reg. 1.414(c)-2(b) says there is a parent-subsidiary group of trades or businesses under common control when there is “one or more chains of organizations conducting trades or businesses connected through ownership of a controlling interest with a common parent organization if —“ the parent has a controlling interest (80% ownership or deemed ownership) in at least one of the subsidiaries and a controlling interest in each subsidiary is held by another member of the group.
Notice the very careful wording. There is no requirement that the parent operate a trade or business. The only requirement is that the subsidiaries be trades or businesses. The parent need only be “an organization.” The regulation defines an organization as a sole proprietorship, partnership, trust, estate, or corporation. Surely one of those terms describes the private equity firm.
So, while there may be a question about whether the private equity firm itself is a trade of business, the two subsidiaries themselves are indisputably under common control if they are operating trades or business. And for most qualification purposes that is all that really matters because the private equity firm likely does not have employees.
Incidentally, it's only about two weeks away from the release of my 7th edition. I'm excited about it and pleased with the initial response. In anticipation of that, the 6th edition is no longer being sold. (There are two folks selling used copies on Amazon, one of those for $10,000! Buy the 7th edition instead.). For those who have purchased the 6th edition within the last six months, please contact me at email@example.com for special pricing on the 7th edition.