The rules for determining stock ownership in a corporation are laid out in Section 1563 of the Internal Revenue Code. Moreover, Section 318 and Section 267(c) of the same document govern the rules applicable to retirement plans.
Each section refers to corporation stock ownership even though it applies to all business structure types. In addition, these sections determine whether an organization is part of a controlled or affiliated service group.
They’re also used to decide whether an individual qualifies as a highly compensated or key employee for nondiscrimination testing purposes.
These sections of the IRS define attribution rules and indicate how business and family relationships affect an individual’s interest in corporations, partnerships, LLCs, sole proprietorships, or trusts.
Table of Contents
Understanding Controlled Group Status
Brother-sister or parent-subsidiary relationships must exist for a business to gain a controlled group status. Companies can achieve this status under the following conditions:
- A relationship in which one company owns 80% or more of a business while the other controls the remaining ownership percentage can be considered a parent-subsidiary relationship.
- Companies must meet one of two conditions to qualify for a brother-sister relationship:
- Five or fewer individuals that own 80% of each company constitute common ownership.
- Identical ownership occurs when joint owners control an equal share (more than 50% combined) of a business.
If five individuals own a company that controls several businesses, but only two own 80% of the company’s stock, they meet common ownership requirements of the brother-sister relationship.
IRC Section 1563 defines a combined group status as follows:
‘A controlled group exists if a business is the parent organization in a parent-subsidiary controlled group and is also part of a brother-sister controlled group. All members of the two groups are considered to be part of one controlled group.’
These rules prevent business owners from splitting their companies to favor highly compensated employees.
401(k) Plans and Controlled Group Status
Rules set out by Section 1563 are used to determine if a company qualifies for the controlled group status. Each controlled group member is treated as a single employer during 401(k) plan coverage testing.
All members are tested together so that nondiscriminatory status can be reached. Omitting one or more members from testing usually results in a test failure, and correcting this mistake further complicates the process.
All excluded employees must get a Qualified Nonelective Contribution (QNEC) to amend the ‘missed deferral opportunity’ because they cannot make retroactive salary deferrals.
It’s worth noting that the rules for qualifying as a Highly Compensated Employee are defined by Section 318 of the IRC.
IRC Section 1563 and Family Attribution Rules
Section 1563 of the IRC contains family attribution rules applicable to controlled group determinations. These rules apply to spouses, children, parents, siblings, grandparents, and grandchildren of the person who owns an interest in a business.
Spouse – Attribution rules are credited to the spouse of the person that owns stock in a controlled group business. These rules cannot be attributed under the following conditions:
- A couple is legally divorced.
- The spouse doesn’t own stock directly in a corporation during a tax year.
- Attribution rules don’t apply if the spouse doesn’t participate in the management of a corporation during the taxable year or holds an executive position.
- These rules only apply if 50% or less of the business’s income comes from rents, dividends, annuities, and other passive income sources.
- If no conditions exist that restrict the spouse’s right to dispose of the stock and that run in favor of the individual or their children.
This rule also stipulates that if a wife and husband each control 40% of a company, their combined ownership stake in a controlled group company will be 80% (40% direct and 40% attributed).
Parents – Parents will always be attributed ownership of the stock that belongs to their children (under 21). Stock ownership can be attributed to a parent of a child over 21 if the parent controls 50% or more (directly or via attribution) of the company.
Siblings – Any ownership of stock a sibling might have can never be attributed to other siblings.
Children – Minors are always attributed to parent stock ownership, but children over 21 can only be attributed to a parent’s ownership stake if they control over 50% of the controlled group company’s stock.
Grandparent – A grandparent can only be attributed a grandchild’s (of any age) ownership stake if they own more than 50% of the company directly or through attribution.
Grandchild – Grandparent’s stock ownership can only be attributed to a grandchild or grandchildren, regardless of age if the grandparent owns over 50% of the company directly or via attribution.
Organizational Attribution Rules
Aside from family attribution rules, Section 1563 of the IRC also covers organizational attribution rules. According to this IRC section, ownership interests can be attributed proportionally to corporations, estates, trusts, or partnerships.
- Shareholders in a corporation who control more than 5% of the stock can be attributed ownership interests if the corporation meets brother-sister controlled group criteria.
- Partners in a partnership with over 5% of capital or profit interest can be attributed ownership interests if the partnership can be classified as a parent-subsidiary or brother-sister controlled group.
- Trust beneficiaries with 5% or more actuarial interest are eligible for attribution provided a trust is a brother-sister or parent-subsidiary controlled group.
- Beneficiaries of an estate with interest in an organization are eligible for attribution. A beneficiary can be any person qualified to receive the property of a decedent according to a will or pursuant to laws of descent and distribution.
The IRC Section 1563 specifies that attribution to an organization isn’t possible. Hence, a partnership cannot be attributed to a corporation’s stock if one of its partners owns stock in that corporation.
Coverage Testing
The IRS tests 401(k) plans yearly to determine if they don’t discriminate against Non-Highly Compensated Employees. 401(k) plans must meet the ratio percentage or the average benefit requirements to pass the test.
Hence, controlled group employees benefitting from a 401(k) plan must meet or exceed the 70% threshold to pass the ratio percentage test. Moreover, the coverage test treats an entire controlled group as a single employer.
Remember that the test applies to highly compensated and non-highly compensated employees.
Consequently, employers, in collaboration with 401(k), must use Section 1563 attribution rules as well as Section 318 and Section 267(c) rules to determine each employee’s eligibility for this retirement plan.
Controlled group companies that fail the coverage test have 9-1/2 months to address the issues that prevented them from passing it. The IRS classifies companies that don’t amend coverage failure within this period as ‘demographic failures’ that can only be corrected through participation in the Voluntary Correction Program.
Employers must pay fines to qualify for participation in this program. In addition, declining to amend coverage failure can result in plan disqualification, especially if the issue is detected during an audit.
Frequently Asked Questions
According to the family attribution rules in Section 1563, attribution doesn’t apply to spouses of lineal descendants.
Individuals can only be attributed stock ownership from a family member once. After that, the same interest cannot be attributed to other family members.
Section 1563 of the IRC stipulates that corporations that aren’t members of a controlled group at the end of the year but were controlled group members during that calendar year can be treated as additional members for tax purposes.
Rules in Section 1563 of the IRC are created to prevent businesses from favoring high-earning employees, so controlled group companies must pass a 401(k) plan test that ensures all their employees benefit from their retirement plans equally.
Contact a CPA
Approaching IRC Section 1563 out of context isn’t advisable because you must be familiar with other IRC sections to fully grasp the implications of attribution rules.
Section 1563 can help businesses determine their controlled group status and offer guidance to pass the 401(k) plan coverage test. Call 866-8000-TAX or visit Choicetaxrelief.com if you need a CPA who can interpret IRC Section 1563 for you and prepare your business for the coverage test.
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Author:
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.
