What Is the Five Percent to 20 Percent Rule?
Learn about the 5% to 20% rule. Uncover how ownership thresholds determine if businesses are treated as one for compliance.
The “five percent to 20 percent rule” refers to specific ownership thresholds used to determine if multiple businesses are considered a single entity for various compliance purposes. This framework, primarily rooted in Internal Revenue Code Section 414, aims to prevent employers from circumventing laws and regulations, particularly those related to employee benefits, by operating separate legal entities. Businesses with common ownership or control are aggregated and treated as one employer under these rules. This aggregation ensures equitable treatment of employees across related businesses regarding benefits and other requirements.
The 5% Ownership Test
The 5% ownership test plays a role in identifying highly compensated employees (HCEs) within a controlled group, which impacts non-discrimination testing for qualified retirement plans. An individual is generally considered an HCE if they own more than 5% of a business at any point during the current or preceding plan year. This ownership includes direct holdings and indirect interests through complex attribution rules.
Ownership attribution extends beyond direct shares. An individual is treated as owning interests held by their spouse, minor children (under 21), or, in some situations, adult children, parents, or grandparents. This broad definition prevents artificial separation of ownership. For example, if a business owner holds 3% directly but their minor child owns 3%, the owner is considered to own 6% for this test.
The 20% Ownership Test
The 20% ownership test is a component of the “brother-sister” controlled group definition, which applies when five or fewer common owners hold significant interests in multiple businesses. For two or more entities to form a brother-sister controlled group, these common owners must collectively possess at least 80% of the total voting power or value of each business. Additionally, the same five or fewer common owners must hold more than 50% of each business, considering only the identical ownership percentage they hold in each entity.
This identical ownership calculation is important for the 50% threshold. It measures the lowest common percentage of ownership each person holds across all businesses being tested. For example, if an individual owns 40% of Company A and 30% of Company B, only 30% is counted towards the identical ownership for the 50% test. The combination of the 80% common ownership and the “more than 50% identical ownership” tests ensures genuine common control.
When These Rules Matter
These ownership rules are important in employee benefits and compliance, particularly under the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA). If businesses are deemed a “controlled group,” they are treated as a single employer for qualified retirement plans, such as 401(k)s, and health and welfare plans. This aggregation means all employees across the controlled group must be considered when applying non-discrimination tests, coverage requirements, and contribution limits for benefit plans.
Failing to recognize a controlled group relationship can lead to compliance issues. For example, a business might unintentionally exclude employees from a retirement plan, leading to failed non-discrimination testing, plan disqualification, and IRS penalties. The Affordable Care Act (ACA) also utilizes controlled group rules to determine Applicable Large Employer (ALE) status, impacting health coverage mandates. If the combined full-time equivalent employees across a controlled group reach 50 or more, all members become subject to the ACA’s employer mandate.