Controlled Group - Employee-Owned Stock Exclusion

Would appreciate thoughts on this analysis regarding excluded interests under the controlled group/common control rules.

LLC (taxed as partnership) is owned 50/50 by two S corps (S Corp 1 and S Corp 2). S Corp 1 is owned 100% by Individual 1. S Corp 2 is owned 100% by Individual 2. Individuals 1 and 2 are unrelated. Individual 1's spouse is an employee of LLC. The LLC operating agreement has standard terms regarding permitted transfers, right of first refusal, etc. that constitute substantial restrictions on the right of S Corp 1 or S Corp 2 to dispose of LLC interests. 

For the parent-subsidiary controlled group analysis, the stock exclusion rules apply because each parent S Corp owns at least 50% of the subsidiary LLC. For purposes of whether S Corp 1 and LLC are in a parent-subsidiary controlled group, the stock exclusion rules would result in at most 50% direct ownership (or 0% ownership if stock deemed owned by Individual 1's spouse is excluded). The other 50% is owned by an unrelated person and is not excluded under any other rule, so S Corp 1 and LLC cannot be in a parent-sub controlled group.

However, when looking at S Corp 2 and LLC as a parent-sub group, it seems that S Corp 2 would be deemed to own 100% of the outstanding interests in LLC. S Corp 1's 50% interest in LLC is deemed owned by Individual 1, which is then attributed to Individual 1's spouse, who is an employee of LLC. That 50% interest deemed owned by an employee of LLC is subject to restrictions in favor of LLC, so is excluded, making S Corp 2 the deemed 100% owner of LLC.

So the end result is S Corp 1 and LLC are not a parent-sub group, but S Corp 2 and LLC are. 

It seems odd that the people with more involvement in the ownership and operation of LLC avoid affiliation, but the person with less involvement is affiliated. I also see the logic that having an employee own the other 50% gives S Corp 2 more "leverage" in the situation, but the employee's ownership is only deemed through another equal co-owner. 

In any event, would appreciate any thoughts.

EBECatty, is it possible that the answer is that because 1563(e)(5) is not listed in 1563(d)(1)(B), you would not treat individual 1's stock as owned by spouse for purposes of 1563(a)(1)?

Luke, would the outcome not still be controlled by the stock exclusion rules of 1563(c)(2)?

If I'm reading through correctly (which by all means is not certain), I think you still fall into the stock exclusions. Section 1563(c)(2)(A), laying out the stock exclusion rules, starts with "For purposes of subsection (a)(1)..."

Under 1563(c)(2)(A), the parent corporation already directly owns 50% of the subsidiary. The attribution rules in (d)(1) and (e)(4) only apply in that context to determine whether the parent owns at least 50% of the subsidiary to take you into the stock exclusion rules to begin with. Because parent directly owns 50% of subsidiary, the stock exclusion rules apply without any attribution. 

Under 1563(c)(2)(A)(iii), stock in the subsidiary "owned (within the meaning of subsection (d)(2)) by an employee" of the subsidiary is excluded if subject to restrictions. 

Section 1563(d)(2), generally dealing with brother-sister controlled groups, says stock is owned by a person if it's (A) owned directly by the person, or (B) deemed owned under "subsection (e)."

Section 1563(e) contains all the attribution rules, including spousal attribution in (e)(5). 

I see what you're saying, EBECatty.

I have to say I find this very confusing. First, it seems to me that perhaps the S corp 1 and S Corp 2 analyses should be run separately. I.e., analyzing the S corp 1 chain, I guess you could (but see next point) argue that S corp has no interest in the LLC, because it's 50% interest is "excluded," but it's not clear to me under 1563(c)(2) that you then carry that result over when analyzing the S corp 2 chain. Maybe when analyzing that chain you are only interested in stock that would otherwise cause it to own 80%, and you are not finding any reason to attribute or exclude as to it, so you just have 50%.

But also, perhaps when 1563(c)(2) talks about excluding stock, it means stock other than the stock owned directly by the parent. Maybe I'm missing your argument a second time, but I think the problem otherwise is not just the result you are getting in your first post, which I agree does not seem right, but wouldn't it also become circular, i.e. the premise for excluding the stock that S corp 1 owns is that S corp 1 owns 50%, the owner is married to the employee, etc., but then if you follow that chain of reason to its end and exclude S corp 1's 50% ownership of the LLC  because of attribution to the employee spouse, doesn't it then dissolve the original premise that the parent owned 50%, required to have excluded stock? 1563(c)(1) says "for purposes of this part," which would include the 50% ownership condition of 1563(c)(2)(A).

Another argument for universal IRAs/tax simplification, for sure.

"Very confusing" is the most charitable way I would describe it right now....

I think it's a little clearer from S Corp 2's perspective because you drop the circularity of S Corp 1's ownership.

S Corp 2 owns 50% of LLC directly. Under 1563 and 414(c), that's enough to put S Corp 2 into the stock exclusion rules. Both those sections exclude stock owned (whether directly or through attribution) by an employee of LLC. Nothing I see limits the attribution from running up S Corp 1's side and back down to Individual 1's spouse (the LLC employee). 

Maybe looking at it from another angle would help (for me, at least). Say S Corp 2 really did want an employee of LLC to own the other 50% directly. That would clearly exclude the stock and make S Corp 2 and LLC a parent-sub group. If not for attribution, the LLC employee could just have her spouse own the S Corp 2 stock in his wholly owned S Corp (or LLC or directly).

From that perspective, I guess it makes more sense to aggregate S Corp 2 and LLC than it does to aggregate S Corp 1 and LLC. Still seems like an odd outcome.

EBECatty, I'm sticking by my immediately prior. I think if you're trying to determine whether S Corp 2 and LLC are in parent sub relationship, you look at excluded stock with respect to S Corp 2, which there is none, I think, not with respect to S Corp 1. S Corp 1 and S Corp 2 are simultaneous owners each of 50% of the LLC, but the application of 1563(c)(2) to each of the possible parent-sub chains that you need to analyze (the potential S Corp 1 -> LLC chain, and the potential S Corp 2 -> LLC chain) are independent, and the fact that maybe S Corp 1's ownership of LLC is disregarded is irrelevant to the determination of whether S Corp 2 is in a parent sub relationship with LLC.

And I said " the fact that maybe S Corp 1's ownership of LLC is disregarded," because I'm also sticking by my other point, namely that if, for sake of analyzing the S Corp 1 relationship with LLC, you exclude stock owned by an employee subject to restrictions only if the putative parent owns 50% means that you can't end up saying that the putative parent owns 0% because of the stock you end up excluding, because then your gating condition for excluding the stock (i.e., that the putative parent must own 50%) is not met.

The above is either right or I'm too dense to understand. Is what it is.