What Is a Parent-Subsidiary Controlled Group?
Understand the rules that determine when legally separate companies are combined for tax and employee benefit plan purposes due to their ownership links.
When multiple corporations are linked by common ownership, the Internal Revenue Service (IRS) may view them as a single entity for specific tax and compliance purposes. This structure is known as a controlled group. The rules governing these groups are designed to prevent business owners from splitting a single enterprise into multiple corporations to gain tax advantages. This article focuses on the parent-subsidiary relationship, where one corporation holds a controlling interest in another.
Defining a Parent-Subsidiary Controlled Group
A parent-subsidiary controlled group is a chain of corporations linked through stock ownership under a common parent corporation. In this arrangement, the parent company directly owns stock in at least one subsidiary. This structure can extend through multiple tiers, where the parent owns a subsidiary, which in turn owns another. For example, if Corporation P owns a significant portion of Corporation S’s stock, and Corporation S owns a majority of Corporation X’s stock, then P is the common parent of a group including S and X. This structure is distinct from a brother-sister controlled group, where five or fewer individuals, trusts, or estates hold a controlling interest in multiple corporations.
The Stock Ownership Test
To qualify as a parent-subsidiary controlled group, the corporations must meet a stock ownership test. This test requires that at least 80% of the stock of each subsidiary corporation (except the common parent) be owned by other corporations within the group. The common parent corporation must also directly own at least 80% of the stock of at least one of the other corporations in the chain.
The 80% rule has two prongs, and meeting either is sufficient. The ownership must represent at least 80% of the total combined voting power of all classes of stock entitled to vote, or at least 80% of the total value of all classes of stock. This dual requirement prevents companies from circumventing the rule by creating classes of stock with high value but no voting rights, or vice versa.
Certain types of stock are excluded when calculating the 80% ownership threshold. This includes non-voting preferred stock, treasury stock, and stock owned by a principal stockholder (owning 5% or more) or an officer of the subsidiary corporation.
Key Tax and Compliance Consequences
The primary consequence of being classified as a parent-subsidiary controlled group is that member corporations are treated as a single taxpayer for several tax benefits and limitations. This aggregation prevents the group from multiplying tax advantages by spreading operations across multiple corporate entities.
This single-entity treatment extends to other tax items. The group is collectively entitled to only one accumulated earnings credit, which is $250,000 for most corporations. For the Corporate Alternative Minimum Tax (CAMT), the income of all members is combined. This 15% tax generally applies to corporations with an average annual income exceeding $1 billion over a three-year period.
The group must also share a single Section 179 deduction, which allows for the immediate expensing of certain business property. A controlled group must allocate this single limit among its members, preventing each corporation from claiming the full deduction. Failure to properly limit these items as a group can lead to significant tax deficiencies, interest, and penalties upon an IRS audit.
Employee Benefit Plan Aggregation Rules
Beyond general tax compliance, the controlled group rules have profound implications for employee benefit plans. All employees of the corporations within the parent-subsidiary group are treated as if they work for a single employer for purposes of plan qualification and testing. This aggregation rule is designed to prevent business owners from creating separate entities to exclude certain employees from benefit plans, like 401(k)s.
This single-employer treatment affects several areas of plan administration. For 401(k) plans, coverage testing must be performed on a group-wide basis. This test ensures the plan benefits a sufficient number of non-highly compensated employees (NHCEs).
An NHCE is generally any employee who is not a highly compensated employee (HCE), a category that includes individuals with more than 5% ownership or who earned above a specific threshold in the prior year. Overlooking a subsidiary’s employees can cause a plan to fail this test, risking penalties or plan disqualification.
The aggregation rules also apply to nondiscrimination testing, which examines whether contributions and benefits provided under the plan favor HCEs. All service years with any member of the controlled group must be counted when determining an employee’s eligibility and vesting schedule. Furthermore, the rules for top-heavy plans, which primarily benefit key employees, are applied to the entire group.