Retirement Services

401(k)ology – Related Employers

If your company is part of a related group of employers, the IRS considers all members in that related group as one single employer for the purpose of any qualified retirement plan(s) sponsored by the entities. Being part of a related employer group dictates how nondiscrimination testing is performed, how the highly compensated employees are determined, and whether coverage requirements are satisfied. The related employer determination is likely one of the most challenging issues when it comes to retirement plan compliance and getting the determination wrong could potentially disqualify the tax favored status of the retirement plan(s).

What is a Related Employer?

There are two varieties of related employers – Controlled Groups and Affiliated Service Groups. Controlled groups are based solely on common ownership, whereas affiliated service groups are based on a combination of service organization (e.g., physicians, attorneys, architects, etc.), affiliation with another entity in servicing clients and, in certain arrangements, some common ownership/control.

The primary reason that the Internal Revenue Service (IRS) treats multiple entities as a single employer for retirement plan purposes is to prevent the creation of multiple entities to circumvent certain nondiscrimination requirements. In other words, employers with multiple entities could take advantage of creative plan design approaches to provide a greater retirement benefit to owners and highly compensated employees (HCEs) in one entity than to the rank-and-file employees of another entity.

  • Best Practices: The service providers that perform annual discrimination testing for your retirement plan must be made aware of any potential related employers. When asked to provide any ownership or business relationship, it is vitally important that accurate information be provided so that the related employer determination is accurate. If ownership or business structures change, make sure that services providers are notified.

What is a Controlled Group?

The simple answer is that a controlled group is two or more entities that are related due to common stock ownership. There are three primary types of controlled groups:

  1. Parent-subsidiary controlled group - Parent entity owns at least 80% of total combined voting power or 80% of total value of shares of the subsidiary.

  2. Brother-sister controlled group – Two or more entities in which the same 5 or fewer own at least 80% of each entity AND own more than 50% of the stock of each entity when only the identical ownership is considered.

  3. Combined controlled group – Each entity is either a member of a parent-subsidiary or brother-sister controlled group AND at least one of the entities is the common parent and is a member of a brother-sister group.

The sheer complexity involved in determining whether an entity is part of a controlled group cannot be understated. Unless it is as simple as John owns 100% of the stock of Company A and 100% of the stock of Company B (i.e., a brother-sister controlled group), employers should seek legal counsel for a §414(b) controlled group determination.

There are many variables that factor into the controlled group determination, so a simple numerical test may not yield the correct determination for purposes of the related employer rules. Some of those variables include the type of stock, whether any stock is treated as excluded, and stock attribution (e.g., partners, family members, estates, and trust beneficiaries).

In other words, your social media relationship status would be “it’s complicated.”

  • Best Practices: Involve legal counsel. The cost of the legal determination will be much less than the cost to correct any operational or coverage failures in the retirement plan if the controlled group status is incorrect. Failure to properly assess controlled group status could also jeopardize the retirement plan’s tax qualified status.

What is an Affiliated Service Group?

An affiliated service group is a related group of entities that are primarily service organizations; however, not all the entities must be service organizations. The affiliated service group regulations were enacted to prevent abuse of the controlled group rules in service type organizations (e.g., medical practices, law firms and other service type organizations).

To illustrate, consider Doctor A, who owns 100% of his PC, and Doctor B, who owns 100% of her PC (the doctors are not spouses nor family relation). The doctors both work out of the same medical office with shared staff, of which they each own 50% of the medical office.

Under the controlled group rules, there is not enough common ownership between the PCs and the medical office for the IRS to consider those entities as a single employer for purposes of the retirement plans. Because there is not 80% common ownership with either of the PCs, the door was open for the doctors to have a retirement plan sponsored by the PC with very generous benefits, with no requirement to cover the staff at the medical office. That “loophole” was challenged in tax court and subsequently, §414(m) was added to the Internal Revenue Code.

The affiliated service group rules are even more complicated than the controlled group rules. An affiliated service group is comprised of a service organization (referred to as First Service Organization or FSO) and one or more organizations that are referred to as “A-Organizations” and “B-Organizations” (A-Org and B-Org). An A-Org must be a service organization; however, a B-Org does not have to be a service organization.

In an A-Org affiliated service group, there is at least one A-Org and an FSO. The A-Org will have some ownership in the FSO (there is no minimum ownership required) and will either regularly perform services for the FSO or will be regularly associated with the FSO in servicing clients or third parties.

In a B-Org affiliated service group, there is at least one B-Org and an FSO. The B-Org primarily provides services to the FSO or an A-Org of the FSO, which services are typically performed by employees in the service profession of the FSO or A-Org. In addition, 10% or more of the total ownership of the B-Org is held by Highly Compensated Employees of the FSO or the A-Orgs.

To complicate matters, there can be multiple overlapping combinations of an FSO and multiple A-Orgs and B-Orgs, and there is a third type of affiliated service group which is based on management functions.

In a management affiliated service group, one entity’s principal business is regularly performing management functions for an organization and that organization’s related organizations. The distinct difference with the management affiliated service group is that there is no common ownership required and none of the organizations in the group must be service type organizations.

  • Note: Affiliated service group determinations are extremely complex and should only be made by legal counsel. It is also recommended that the determination be made by legal counsel experienced in ERISA and §401(a) of the Internal Revenue Code. Again, an incorrect determination can jeopardize the tax qualified status of the retirement plan(s) sponsored by related employers.

Why is Knowing if Another Entity is a Related Employer So Important?

As noted above, being a member of either a controlled group or an affiliated service group dictates how nondiscrimination testing is performed, how highly compensated employees are determined and whether coverage is satisfied. It is virtually impossible to get accurate nondiscrimination testing results if the entities that must be combined (treated as a single employer) are not correctly identified.

Coverage is likely the biggest problem when related employers are not properly identified. It is perfectly acceptable for related entities to sponsor separate retirement plans, if those plans can demonstrate that coverage is satisfied when counting the employees of the other entity(s) as “not benefiting.”

For example, Company A sponsors a 401(k) plan that covers 100% of the highly compensated employees (HCEs) across the related employer group. Related Company B does not have a retirement plan. Company A’s 401(k) plan must cover at least 70% of all non-highly compensated employees (NHCEs) of both Company A and Company B combined. For simplicity, let’s assume that Company A has only one (1) HCE and five (5) NHCEs. Company B has five (5) NHCEs. In total there are ten (10) NHCEs but only 50% are covered by Company A’s 401(k) plan (5 out of 10). Company A’s plan fails coverage. As a result, two (2) of the NHCEs from Company B must receive corrective contributions equal to the average of the contributions of the NHCEs in Company A’s 401(k) Plan.

Coverage failures can be very expensive to correct. In some instances, it may not be 2 NHCEs that must be covered but 200 or more. With an average NHCE contribution rate of 8% and average compensation of $50,000, a corrective contribution to 200 NHCEs could be $800,000. Worth the cost of that legal determination!

HCEs must be determined based on compensation paid across all the related employers. What if the same employee works for two entities but only makes $100,000 at each? At $200,000 combined, that employee should be counted as an HCE in each plan. Similarly, what if the HCE determination is based on the 20% Top Paid Group Election? Perhaps across all related entities, the top paid group does not have an impact on who is an HCE such that anyone over the HCE compensation limit ($135,000 for 2022) is an HCE. If a single plan does not consider the compensation paid to employees in other related entities, the HCE determination could be incorrect, which means that all the nondiscrimination tests would also be incorrect.

Failed coverage and other operational failures caused by incorrect related employer determinations can be very costly, not only in additional required contributions, but in legal fees to apply to the IRS under the Employee Plans Compliance Resolution System (EPCRS) requesting a compliance statement to maintain the plan’s tax qualified status. Self-correction is not available for coverage failures.

What Happens if We Were a Related Employer But Now, We Are Not?

Like family dynamics, sometimes there are related employer changes. Changes in ownership and business affiliation can just as easily create two unrelated employers that are covered by one retirement plan. When unrelated employers inadvertently participate in the same plan, it creates a multiple employer plan (MEP).

A common situation is when a slight change in ownership of the entities in a brother-sister controlled group reduces the controlling interest (80% test) or the common control (50% test) such that the entities are no longer related employers for retirement plan purposes. Because the entities are no longer related, they cannot be tested together for coverage and nondiscrimination. In effect, there are two or more “single employers” whose employees are covered by one retirement plan.

There is nothing that prohibits unrelated entities from continuing to sponsor the same retirement plan. In fact, many unrelated employers that have some common ownership or business nexus choose to remain in the same plan. The service providers will perform the annual testing for each of the unrelated entities separately; however, a single Form 5500 may be filed for the plan (which indicates that the plan is a MEP).

Conversely, if there was a bad break up or divorce of the previously related entities, the now unrelated employers can spin-off into separate retirement plans. In this situation, one or more of the unrelated entities would establish a new retirement plan and the assets attributable to the employees of that single employer would then transfer to the newly established plan.

How Do Plan Documents and Adoption Agreements Typically Address Related Entities?

Not all plan documents handle related employers in the same manner. Service providers have different methods of including or excluding related employers, so it is important to review the implications with your plan document provider.

For example, some plan documents are written to automatically include all related entities. An employer may not realize that the plan document is “all inclusive” which can result in eligible employees being inadvertently omitted from plan participation. In a 401(k) plan, that can result in missed deferral opportunities that require correction under EPCRS.

On the other hand, some plan documents are written to automatically exclude all related employers until such time that the related employer formally adopts the plan. In this type of plan document, the related employer must either be designated as a related participating employer or may be required to execute a formal participation (joinder) agreement.

Unless the plan document is the “all inclusive” type, the name of each related employer and the tax identification number associated with that employer must be included in the plan document for the employees of that entity to be eligible for participation in the plan. Therefore, it is extremely important to review the specific requirements and plan provisions with your plan document provider.


The purpose of this blog was not to teach the mechanics of related employer determinations, rather to educate on the complexity and factors involved in the determinations and to highlight the importance of related employer determinations in maintaining the tax qualified status of your retirement plan. Our retirement service team at Newfront is available to assist you with questions regarding related employers or other retirement plan questions that may arise.

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Helpful Quick Links

Employee Plans Compliance Resolution System

Controlled Groups and Affiliated Service Groups

Tax Consequences of Plan Disqualification

401(k)ology Missed Deferral Opportunity

Joni L. Jennings
The Author
Joni L. Jennings, CPC, CPFA™

Chief Compliance Officer, Newfront Retirement Services, Inc.

Joni Jennings, CPC, CPFA is Newfront Retirement Services, Inc. Chief Compliance Officer. Her 30 years of ERISA compliance experience expands value to sponsors of qualified retirement plans by offering compliance support to our team of advisors and valued clients. She specializes in IRS/DOL plan corrections for 401(k) plans, plan documents and plan design.

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