The Challenges of Untangling the Tax Code’s Related Party Rules

Many parts of the Internal Revenue Code require corporations to determine the relationship between or among persons. The primary way this is accomplished is through applying “related party” rules—the controlled group and aggregation rules being two examples.

Although this relationship assessment may appear to be straightforward, the nuances of, modifications to, and sheer number of these rules generally require a new review every time a related party or controlled group determination is needed.

Getting to the right controlled group or related party test usually requires cross-referencing various tax code sections. Different tests often use similar-sounding phrases, making it unsettlingly easy to arrive at the wrong answer. The examples below illustrate the complexity of the various related party and controlled group rules in certain tax code provisions.

Employee Retention Credit

Consider this doozy: Under ERC rules, one or more employers is considered a single (aggregated) employer if they’re considered members of the same controlled group within the meaning of Section 52(a). But Section 52(a) itself doesn’t define the term controlled group; instead, it embeds the Section 1563(a) definition of that term.

Although the actual Section 1563(a)(1) definition of a parent-subsidiary controlled group rule is one where one corporation possesses at least 80% voting control of another corporation or at least 80% of the total value of shares of all stock classes of such corporation, Section 52(a) instructs that “more than 50%” replace “at least 80%” every place it appears in Section 1563(a)(1).

And that’s just the beginning. For ERC aggregation purposes, Section 52(b) and Sections 414(m) and (o) also must be considered. That means that you began your odyssey in the ERC provision—Section 3134(d)—and ended it in Section 1563(a)(1), with stops along the way in each of Sections 52(a) and (b) and Sections 414(m) and (o).

Affordable Care Act

While the ACA also uses a single employer concept, the statute (Section 4980H) relies on different parts of the tax code for that purpose—Sections 414(b), (c), (m), or (o). Much like Section 52(a), Section 414(b) doesn’t provide its own controlled group definition but embeds Section 1563(a) rules.

However, Section 414(b) doesn’t modify Section 1563(a)(1) by replacing the term “at least 80%” with “more than 50%” every place it appears. In case this maze was hard to follow, two IRC sections (ERC and ACA) together implicate seven other IRC subsections, plus a modification to an “at least 80%” test.

Definitions of ‘Control’

Speaking of an 80% test, several tax code provisions employ an “at least 80%” test for purposes of determining control. However, not all “at least 80%” tests use the same measuring sticks.

For example, Section 351(a)’s definition of control is based on the definition of that term in Section 368(c). That section defines control as the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of the corporation’s stock.

The differences between Section 1563(a) and Section 368(c) “at least 80%” tests are subtle but meaningful. First, the Section 1563(a) “at least 80%” test is disjunctive, whereas Section 368(c)’s “at least 80%” test is conjunctive. The disjunctive measures in Section 1563(a) are voting power or value, while the conjunctive measures in Section 368(c) are voting power and number of shares.

Definitions of ‘Family’

There’s also a morass of rules when a familial relationship is at issue. Section 267(a) disallows losses from sales or exchanges between persons specified in Section 267(b). One of the Section 267(b) relationships is members of a family, as that term is defined in Section 267(c)(4). Pursuant to Section 267(c)(4), the family of an individual includes his siblings, spouse, ancestors, and lineal descendants.

But Section 267(b) isn’t the only source of a “family” definition. For example, for Section 302(b)(3) purposes, it’s the Section 318 rules that apply, and its family members include only an individual’s spouse, children, grandchildren, and parents.

Section 1563(a)(2) brother-sister controlled group rule provides yet another definition of “family.” In this case, an individual’s family generally consists only of minor children under age 21, provided the individual doesn’t own more than 50% of the total combined voting power of all classes of stock entitled to vote or more than 50% of the total value of shares of all classes of stock.

Setting aside the issue that this is an example of yet another vote-or-value test (but one using “more than 50%” instead of “at least 80%”), the definition of family is expanded to include parents, grandparents, grandchildren, and adult children if the individual at issue does own more than 50%. Therefore, children’s ages can also be an important consideration.

Other Nuances

While the controlled group and related party provisions generally look to the amount (for example, more than 50%) by value, voting power, and/or number of shares for some of these rules, the type of equity also must be considered (for example, common versus preferred; voting versus non-voting).

Additionally, objective criteria aren’t the only ways to determine relationships. For instance, two or more entities are treated as a single employer for ERC purposes if such entities constitute an affiliated service group under Section 414(m) rules.

Although the affiliated service group rules do invoke some quantitative tests, they also contain more nebulous measurements, such as being “regularly associated with,” or performing services “historically performed by employees in the service field” of [the other] organization.

Other rules abound, but hopefully you get the picture: Application of the vast web of the tax code’s related party rules requires careful, repetitive reviews.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Carolyn Linkov, J.D., is a principal and the leader of Eide Bailly’s national tax office’s mergers and acquisitions group. She advises mid-size corporations on federal income tax aspects of reorganizations, spin-offs, asset sales, equity transactions, and entity restructurings.