Controlled Corporate Groups
If a business grows substantially, it may want to continue growing by creating new business entities that are separate from the original business, which has several advantages:
- limits liability to the original business, by creating another corporation or limited liability company;
- greater potential for attracting investors;
- financing a new business by issuing stock without diluting the original owners' shares;
- allowing the use of different accounting methods, since using different accounting systems in the same business would be complicated;
- allowing different tax years;
- the common paymaster rule minimizes the employer's share of payroll taxes for employees who work in more than 1 business of the group by designating 1 corporation as the common paymaster;
- for instance, if an employee earns $100,000 each from 2 businesses of a controlled group, then, for payroll taxes purposes, it will be treated as if the employee earned $200,000 from 1 business, thereby saving on the corporation's Social Security liability on income above the Social Security wage base;
- consolidated state tax returns;
- losses in 1 business can be offset by gains from other members of a group;
- business units can be sold without selling the entire business;
- allows some of the business owners to diversify into a business for which they are better suited or for which they believe has greater potential.
Because corporations are subject to a progressive tax, a business can save considerably on taxes, if it is not part of a controlled corporate group, by forming multiple entities that each have a lower amount of income which would ordinarily be subject to a lower tax rate. In the case of a controlled corporate group, however, the progressive tax rate applies to the total income of the group.
For instance, if a restaurant owner already owns 1 restaurant that earns $100,000 in income, then the owner must pay $22,250 in taxes on that income. If the owner opened another restaurant that earned the same income and that operated under the same corporation, then an additional $39,000 of taxes must be paid, so operating the other restaurant as a separate corporation would save $39,000 − $22,250 = $16,750. Substantially more can be saved if more restaurants are opened that are operated as separate corporations, but these savings cannot be realized if the restaurants are part of a controlled corporate group, since the progressive tax rate would apply to their total income.
There are other disadvantages of being part of a controlled group:
- A controlled group is subject to the $5 million gross receipt limit for using the cash method of accounting. IRC §448
- The §179 annual dollar limit, AMT exemption, disabled access credit, and some other tax breaks apply to the entire group, not to the individual entities.
- The exemption for computing the alternative minimum tax and the minimum accumulated earnings credit for calculating the accumulated earnings tax applies to the entire group.
- Any losses on sales between members of the group are postponed until those assets are sold outside of the group.
- The rules for retirement plans and other employee benefits apply to employees of the entire group, such as when testing for nondiscrimination in the offering of benefits.
Types of Controlled Corporate Groups
The tax code defines a group of corporations with a significant common ownership as a controlled corporate group, of which there are several different categories.
A brother-sister group is formed when 2 or more corporations with fewer than 6 shareholders, who are individuals, estates or trusts, satisfy the following 2 requirements:
- The stock of the group of corporations is owned or controlled by shareholders who own at least 80% of either the total outstanding stock or the voting power.
- The shareholders have an identical ownership, where the lowest ownership percentage of all owners in each corporation totals more than 50% of the voting power or value.
|Corporation 1||Corporation 2||Identical Ownership|
As can be seen in the above table, the shareholders own more than 80% of both corporations and their identical ownership also exceeds 50%. Therefore, the corporations form a brother-sister group. The above assumes that the shareholders are unrelated, otherwise constructive ownership rules would apply, listed in IRC §1563(e), that attribute ownership in the following cases:
- any person who owns an option that gives the holder the right to buy the stock;
- any stock owned by a partnership is deemed to be owned by any partner with a capital or profits interest 5% or more, and the constructive ownership of the stock by a partner is in proportion to that interest;
- any indirect ownership by an individual through an estate or trust or through another corporation;
- or closely related individuals who own the stock, in which case, the ownership percentages may be combined, such as those of spouses, minor and adult children and grandchildren, and adopted children.
A controlled group can also be considered a parent-subsidiary group which is a chain of corporations in which the parent corporation owns at least 80% of either the voting power or value of another corporation within the group and all corporations within the group collectively satisfy the 80% rule as it is applied to each corporation within the group, where at least 80% of the voting power or value is owned by other corporations within the group.
A controlled corporate group can also be a combined group, consisting of 3 or more corporations where at least 1 corporation serves as the parent of a parent-subsidiary group and also is a member of a brother-sister group. So if you own 100% of the stock of ABC Corporation and DEF Corporation, and DEF Corporation owns 90% of the stock of GHI Corporation, then they would form a combined group. Note that the above brother-sister example does not satisfy the parent-subsidiary relationship, since the individual shareholders own most of the stock, not any of the corporations.