LAST REVIEWED Dec 10 2019 15 MIN READ
By Damian Davila
An important part of managing your company’s 401(k) is to meet all employer requirements set by the IRS. One of those requirements is making sure that a business owner properly uses what’s called the controlled group 401(k) designation. Being familiar with this term and 401(k) common ownership rules can help save your company money and empower your employees.
What is a controlled group for 401(k) purposes?
In layman terms, the 401(k) controlled group definition is: a set of companies with shared ownership that is eligible to pool its employee base into a single 401(k) plan. IRS Code section 414(b) and (c) define controlled groups are two or more trades, corporations, and/or businesses with specific relationships. We’ll break down those relationships in the next section.
Think of Elon Musk and the string of companies that he has helped to build up and holds a stake in (Zip2, PayPal, SpaceX, Tesla, SolarCity). You may not be exactly like Elon Musk, but if you are a partial owner of a few different businesses or your family owns several businesses, this article will help you identify whether you are or aren’t considered a 401(k) or IRS controlled group and all that that entails. With a controlled group 401(k), a business owner could simplify retirement planning and use a single plan to cover eligible employees across all companies.
What are the criteria to determine if a company is part of a controlled group?
There are four scenarios in which companies represent a controlled group.
If your company belongs in any one of these categories, it is considered a controlled group.
Type 1: Parent-Subsidiary Controlled Group
In the most straightforward scenario, a parent company owns at least 80% of a subsidiary company. Think of Procter & Gamble (P&G), one of the largest multinational consumer goods corporations in the world. P&G holds a large stake in several companies, such as Charmin, Crest, and Dawn.
As long as a parent company maintains 80% of ownership on a subsidiary, the parent company can use a controlled group 401(k) to cover employees from both the parent and subsidiary.
Type 2: Brother-Sister Controlled Group
Since not all companies have a single owner, the IRS has set rules that allow companies with several owners to qualify for controlled group status. Brother-sister controlled groups must meet qualifications for both Identical & Common ownership; not one or the other.
Identical ownership: Common owners hold at least 50% ownership of all companies within the group.
|Owner||Ownership in Company #1||Ownership in Company #2||Identical Ownership in #1 & #2|
Michael and Tanya own at least 50 % of companies #1 and #2, so they can set up a controlled group 401(k) to cover all employees of both companies.
Common ownership: Five or fewer owners hold at least 80% ownership of companies within the group.
|Owner||Ownership in Company #1||Ownership in Company #2|
|Common Ownership in #1 & #2||90%||80%|
Michael, Tanya, Jamal, and Maria have common ownership of at least 80% of companies #1 and #2, so they can set up a controlled group 401(k) to cover all employees of both companies.
Type 3: Combined Controlled Group
Combined controlled groups are groups of three or more corporations, trades, and/or businesses in which (i) the companies have either brother-sister or parent-subsidiary controlled groups and (ii) one company is a common member in two groups.
Type 4: Attributed Ownership Controlled Group: Parents, Spouses, etc.
Certain family relationships allow direct family members to achieve common or identical ownership controlled group status.
Prenuptial agreements for married couples, as well as common-law marriages (depending on the state you live in) need to be assessed on an individual basis to determine whether a controlled group is necessary.
While there are brother-sister controlled groups, siblings are never attributed the ownership of other siblings under IRS rules. There are specific rules that attribute ownership of companies to other family members. For example, a parent or legal guardian is always attributed the ownership of a minor child (under age 21).
U.S. Code 1563 provides the specifics for attributed ownership controlled groups. Here is a quick summary:
If the child is under 21: Always attributed ownership.
If the child is 21 or older: Attributed ownership only if the parent owns more than 50% of the company.
Generally attributed spouse’s ownership as long as all conditions in U.S. code 1563(e)(5) are satisfied.
Attributed ownership of grandkids of any age only if the grandparent owns more than 50% of the company.
Is a controlled group 401(k) subject to non-discrimination testing?
Yes. Under U.S. code 1410(b)(2), a controlled group 401(k) must benefit at least 70% of an employer’s non-highly compensated employees (NHCEs) within the controlled group. Since controlled group status involves owner/employees that may have ownership well above 5% to qualify for parent-subsidiary or brother-sister controlled group status, non-discrimination testing is a key area to prevent hefty IRS fines.
Almost 60,000 plans across the country failed their most recent controlled group non-discrimination testing, resulting in $794 million in corrective refunds to employees! However, companies can correct their controlled group plan in the event of a failed coverage test. Employers can adopt an amendment in the 9 1/2 months following the end of the failed plan’s plan year. However, this can be tricky because any retroactively added participants can’t make retroactive 401(k) deferrals. Instead, a qualified nonelective contribution (QNEC) must be made to the new non-highly compensated employees.
Employers must also retroactively make up missed employer contributions. Completing a controlled group determination regularly, such as after each non-discrimination test or if there are changes in company ownership, can help protect the business.
If you’d like more context on non-discrimination testing in general and as part of the IRS controlled group rules, here are some more general articles. We recommend starting with the first one!
What are the pros and cons of a controlled group 401(k)?
Implementing a controlled group 401(k) can deliver some advantages to both the employer and the employees.
Pro #1: Lower fees
Leveraging a larger pool of employees, a business owner can secure lower total fees compared to what he would pay by maintaining several plans. Some 401(k) plans can have a miscellaneous fee category on top of sales and account maintenance charges. Such miscellaneous fees range from recordkeeping to legal to furnishing statement expenses! By combining plans, both employees and employers pay less for the plan.
Pro #2: More investment options
The bigger the total account balance held in a plan, the larger the number of investment options available. Many funds require a minimum investment, so combining assets grants plan holders access to more options.
There are many investment options out there:
Pro #3: Simplified plan management
One plan, one set of rules. This surely makes the plan administrator happy as it results in streamlined plan management and employee education across all subsidiary companies. Controlled group plans have only one joint service provider, so there are fewer relationships, plans, and contracts to manage.
Pro #4: Make the most of plan startup tax credit
Qualifying businesses can receive a tax credit for up to 50% of startup costs, up to $500 a year for three years (for a total of $1,500). Companies can use the credit to offset expenses of setting up, administering, and educating employees about the plan.
Having a controlled group 401(k) allows the owner(s) to stretch out this tax credit and provides an incentive to deliver a comprehensive employee education program about the new plan (more tax credits to offset education costs for a single program instead of many).
However, controlled group retirement plans have a few challenges, too.
Con #1: The initial setup requires more work.
The plan manager must determine the company’s or companies’ controlled group status before implementing a plan. Managers must also organize centralized administration and control of the plan to best meet the maintenance and reporting requirements.
Con #2: More compliance testing
In addition to the necessary 401(k) compliance testing, the plan administrator needs to keep an eye on assessing controlled group status. Some controlled groups can be more complicated than others with more than one type of brother-sister relationship. Adequate recordkeeping may be beyond the ability of the current administrator.
If the businesses have more than 100 employees, they may be subject to independent audits.
Con #3: One size may not fit all
The final set of features of the controlled group 401(k) may not meet the unique needs of every company within the group, let alone of every employee. Remember that a retirement plan is a key way to attract and retain talent. If the plan doesn’t deliver on that promise, employees may no longer be fully satisfied with their company benefits (yikes!).
The IRS does allow companies in a controlled group to treat themselves as a separate company. Plan managers can request treatment as a Separate Line of Business. However, these businesses must meet these four requirements:
The separate line of business must have a valid business purpose.
There must be at least 50 employees.
The IRS must be notified and approve the request.
The organization must meet the restrictions on HCE ratios in each separate line of business.
If you want to realize the benefits of having a controlled group 401(k) but the administration requirements are overwhelming, Human Interest can help set up and administer the plan.
Where can employers find more information about setting up a controlled group 401(k)?
Human Interest has helped several eligible companies to set up, implement, and maintain a controlled group 401(k). We’ll take care of:
Creating employee accounts
Processing contributions every pay period and syncing them with your payroll provider
Ensuring that compliance testing and paperwork is completely taken care of
If you would like to learn more about the process of setting up a controlled group 401(k) or any other plan that better suits your organization’s needs, please click here to contact us and we’d be happy to help!
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.