If your company shares ownership or a service relationship with another business, those businesses may be considered a legally related group by the Internal Revenue Service (IRS). Legally related groups are treated as a single employer for 401(k) compliance testing, eligibility, and vesting purposes. Expand the sections below to learn about legally related group types, exemptions, and what to do if your company is part of one.
A legally related group is a set of business entities that the Internal Revenue Service (IRS) generally treats as one employer for the purposes of employment status, 401(k) compliance testing, compensation, eligibility, and vesting.
These rules exist because the IRS wants to prevent situations in which a plan sponsor avoids compliance testing or allocates employee benefits unequally by grouping otherwise eligible employees into separate entities. For example, a medical practice could place all doctors in one company and all support personnel in another, then only offer retirement benefits to the doctors.
Because the IRS provides tax benefits to companies that offer 401(k) plans, it wants to make sure those benefits are equally available to all employees.
As a 401(k) plan sponsor, you have a duty to make sure employees have an equal opportunity to participate in any 401(k) plan offered. As a baseline rule, the related group needs to generally make sure that at least 70% of non-highly compensated employees (NHCEs) are covered under a 401(k) plan to the same extent as highly compensated employees (HCEs).
A legally related group can be either a controlled group or an affiliated service group.
For 401(k) plan purposes, employees of a legally related group are evaluated at the group level to determine employment status. If employees move between entities of a legally related group, there is no termination of employment for 401(k) plan purposes. Service with any entity of the related group counts for 401(k) eligibility and vesting rules.
For example, if a 401(k) plan has a six-month service requirement and an employee works for three months at Entity A, then transfers to Entity B in the same related group, that employee becomes eligible for the plan after three months of service at Entity B. If the employee defers into the 401(k) while at Entity B and later returns to Entity A, there is no termination of employment — the employee is not eligible for a distribution based on termination, even if Entity A marks them as "terminated."
A controlled group is a set of companies with a certain level of shared ownership that are treated as one entity for 401(k) purposes. Along with affiliated service groups, controlled groups are referred to as legally related groups.
All entities within legally related groups need to follow specific IRS rules regarding 401(k) implementation and nondiscrimination testing, so it is important to know whether your company is part of one.
There are three principal types of controlled groups.
A parent company owns 80% or more of another company. Child companies are those in which another company holds an ownership interest of 80% or more.
An owner of the parent company is considered to be an owner of the child company in the same percentage as the owner's holdings in the parent entity. A company can be both a parent and a child company, and it is possible to string together multiple parent and child companies.
For example, if Company A owns 85% of Company B, and Company B owns 85% of Company C, then A is the parent of B and C, B is the parent of C and the child of A, and C is the child of A and B. All three companies are considered controlled group members.
A brother-sister group exists when the same five or fewer individuals own more than 80% of two or more companies and have common control (50% or more of the ownership interests are held in the identical manner). You determine identical ownership by considering the smallest amount each individual owns in each entity.
The table below shows ownership percentages across four companies. Company A and Company B form the brother-sister pair (both 80%+ commonly owned with 50%+ identical ownership). Company C and Company D do not qualify.
Company A
Company B
Company C
Company D
Alan
25%
25%
25%
5%
Bob
20%
20%
20%
5%
Carrie
20%
25%
0%
75%
Debra
25%
20%
20%
10%
Subtotal
90%
90%
65%
95%
Others
10%
10%
35%
5%
Total
100%
100%
100%
100%
Example 1: Company A and Company B are brother-sister entities. Alan, Bob, Carrie, and Debra together own 80% or more of both companies, and more than 50% of the ownership of the two companies is identical. You consider the smallest amount owned in both entities to get the identical ownership. Alan holds 25% in both companies, Bob holds 20% in both companies, Carrie holds at least 20% in both companies, and Debra holds at least 20% in both companies. Together, these four individuals own 90%, and they have 85% identical ownership in both entities.
Example 2: Company C is not a related entity to Company A or Company B. While more than 50% of the holdings are identical to Company A and Company B, Alan, Bob, Carrie, and Debra do not collectively own more than 80% of Company C. You need both 80% common ownership and 50% identical ownership to have a brother-sister controlled group.
Example 3: Company D is not a related entity. Though Alan, Bob, Carrie, and Debra collectively own 95% of Company D and meet the control requirement, they do not meet the identical ownership requirement. Collectively, the identical ownership between A and D and B and D is only 45%, less than the 50% threshold.
Note: Ownership of family members may be attributed to other family members.
A combined group exists when three or more companies are connected through a combination of parent-child and brother-sister groupings. Each organization needs to be either part of a parent-child or brother-sister group, and one organization is both a parent and a brother-sister group. You can think of this as an uncle-nephew relationship.
Partnerships are treated almost identically to corporations, with an interest in the profits or capital of that partnership being treated as an ownership interest. For example, a parent of a partnership has an 80% interest in the profits or capital of that partnership.
In a partnership, the partnership's ownership interest is attributed proportionally to any partner who has an interest of 5% or more in either the profits or the capital of the partnership. The 50% or more ownership interest requirement for corporations does not apply to partnerships.
Under IRS rules, a partnership is considered part of a company's controlled group only if the partnership is engaged in a trade or business — for example, the partnership has an intent to make profit and is regularly providing goods or services with continuity.
Note: All three types of controlled groups typically require at least 80% of shared ownership between the entities. Attribution rules (including family attribution) apply when determining ownership, and complex ownership structures can make the determination difficult.
An affiliated service group is a group of two or more organizations that have a service relationship and, in some cases, an ownership relationship. They are treated as one employer for 401(k) purposes and may or may not have common ownership.
The IRS determination of an affiliated service group can be complex, but there are some key variables they look for:
Business relationship: Does one entity provide services to a second entity that would typically be performed by the second entity's employees? Or do the entities join together to provide services to the same client?
Common ownership: Is there any common ownership between the entities, even if it is not enough to make a controlled group?
Management: Does one entity provide management oversight over the other entity?
Here are some common examples of affiliated service groups:
Partners A, B, and C each form their own professional corporation. Each corporation then provides services to ABC Law Firm.
Doctors A, B, and C each form their own medical practices, but each owns equal shares of a central billing office. The billing office solely serves these three practices.
Company A's principal business is to provide management services to Company B.
Where ownership matters to the affiliated service group determination (it does not always apply), attribution rules will also apply when determining ownership.
Affiliated service groups can be broken down into two main categories: traditional affiliated service groups (further broken down into A-Orgs and B-Orgs) and management groups.
A traditional affiliated service group consists of a First Service Organization (FSO) and one or more other entities (which may be A-Orgs, B-Orgs, or both). The FSO needs to provide a service, and there needs to be at least some ownership between the FSO and the other organization. Ownership can be attributed between entities and certain family members.
"Service" is a keyword in determining whether a traditional affiliated service group exists. Health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and insurance are considered service fields. Any entity where capital is not a material income-producing factor for the organization can be a service organization.
A-Org groups. This group consists of at least one FSO and at least one A-Org. A service organization is an A-Org if it owns some interest (no matter how small) in the FSO, and the organization regularly performs services for the FSO or regularly provides services to third parties with the FSO. The key to a service group is that at least one of the organizations (the FSO) needs to be providing services rather than goods.
Examples of A-Org affiliated service groups:
A doctor is incorporated as a professional corporation, and the doctor's professional corporation is a partner in a Surgical Group. The doctor regularly works with the Surgical Group to provide services to third parties. The Surgical Group is an FSO. The doctor is an A-Org because it is a partner in the medical group and regularly collaborates with the Surgical Group to provide services to third parties.
A corporation that is a partner in a law firm provides paralegal and administrative services for the attorneys in the law firm. All of the employees of the corporation work directly for the corporation, and none of them work directly for any of the other offices of the law firm. The law firm is an FSO. The corporation is an A-Org because it is a partner in the FSO and is regularly associated with the law firm in performing services for third parties.
B-Org groups. This group consists of an FSO and at least one B-Org. An organization is a B-Org if at least 10% of the B-Org is owned or deemed to be owned by one or more highly compensated employees of the FSO or its A-Orgs. A significant part of the B-Org's business is performing services for the FSO or its A-Orgs, and those services are in the same field as those of the FSO or its A-Orgs. If at least 10% of the B-Org's business is performed for the FSO or its A-Org, it is deemed to be significant (if 5% but less than 10%, a facts and circumstances test needs to be met). The B-Org does not need to be a service organization.
Examples of B-Org affiliated service groups:
A financial services organization has 11 partners. Each partner owns 1% of the stock in a corporation that provides services to the partnership and other financial services organizations. The corporation's services are of a type historically performed by employees in the financial services field, and a significant portion (more than 10%) consists of providing services to the financial services organization. The financial services organization is an FSO, and the corporation is a B-Org.
If the financial services organization's 11 partners each owned 1% of a landscaping business that earned a significant portion of its business mowing the lawn for the financial services organization, this would not be an affiliated service group because landscaping is not historically a service provided by financial services organizations.
A management group is more of a facts and circumstances determination. There is no "service" requirement and no ownership requirement, although the entities need to be "related." A management group consists of a management firm and its client. A management firm is an organization that performs management functions for a client or organizations related to that client on a regular and continuous basis. There does not need to be any common ownership between the two organizations, and the client organization does not need to be a service organization.
Example of a management group affiliated service group:
A doctor with a busy practice hires a business that manages several doctors' offices. One owner of the management business breaks apart as a sole proprietor and focuses on managing only the doctor's practice, keeping one employee on staff. Once the sole proprietor earns substantially all of her income and spends all of her time managing the doctor's practice, the two businesses become a management group and are treated as one employer.
Note: There is very little IRS guidance on what creates a management group. If the facts are not clear, consider working with legal counsel to determine whether an affiliated service group exists.
All employees of all the businesses in an affiliated service group are considered to be employed by a single employer for purposes of several plan functions, including:
ADP/ACP tests.
Coverage tests.
Participation rules.
Vesting rules.
Top-heavy rules.
Eligibility for distributions.
Any 401(k) plan sponsored by one business in an affiliated service group needs to consider all the entities in the group, and the participants generally need to be considered together for benefits and testing.
In certain circumstances, larger employers with distinct divisions operating in different industries with more than 50 employees may qualify as separate lines of business (QSLOBs), which can be evaluated independently despite having overlapping ownership. For example, a conglomerate might operate multiple distinct divisions that maintain separate retirement plans.
Another exemption is when the businesses are owned by spouses who are not involved in each other's businesses. To be exempt, all of the following need to apply:
Each spouse has no involvement in the other's business.
Neither spouse is a board member, employee, fiduciary, or participates in the management of the other's business.
No more than 50% of the income from either business is from passive income, like royalties, rents, dividends, interest, or annuities.
The spouse's ownership is not subject to restrictions that benefit the spouse or minor children.
QSLOB determinations are complex and require notification to the IRS. You should consult a qualified financial adviser or tax professional when making this determination.
If your company is in a legally related group with another business, compliance testing will be conducted at the group level as though the related entities were one. We will need employee data for each company in the legally related group, including:
Each employee's salary.
Age.
Contribution amounts.
Year-end contribution balances.
Whether your plan passes compliance testing depends in part on the coverage and participation of employees in the legally related companies. This creates challenges if one company in the group offers a more generous 401(k) plan than another, has higher participation rates, or has a different ratio of highly compensated and non-highly compensated employees. If any tests fail, plan corrections will need to be made.
This is why we require all members of a legally related group to have a Starter or Premium 401(k) plan with Gusto Retirement with the same plan start date and design. Each plan of the legally related group needs to be considered together for profit sharing and other discretionary contributions.
Report legally related entities to Gusto Retirement so we can help make sure your plan complies with IRS requirements. If you believe that related companies may not have been included in compliance testing for the prior year, contact us immediately.
This information is general in nature and is for informational purposes only. It should not be used as a substitute for specific tax, legal, or financial advice that considers all relevant facts and circumstances. You are advised to consult a qualified financial adviser or tax professional before relying on the information provided herein.