Business Entities · Forming a corporation

Controlled groups

Controlled group status is a definition that does no work by itself: nothing follows from being in a group until another provision says it does. What makes it worth knowing is how many provisions do — the accumulated earnings credit, the large corporation test for estimated tax, and a long list of thresholds elsewhere in the Code all treat the members as one. The definition itself has two limbs that are frequently confused with the affiliated group test used for consolidated returns, and the difference between them is a single word.

The rule

Parent-subsidiary. a parent-subsidiary controlled group is one or more chains of corporations connected through stock ownership with a common parent where stock possessing at least 80 percent of the total combined voting power of all voting classes, or at least 80 percent of the total value of all classes, of each corporation other than the common parent is owned by one or more of the others, and the common parent owns that much of at least one of them (IRC § 1563(a)(1))^TY2026

Brother-sister. a brother-sister controlled group is two or more corporations where 5 or fewer persons who are individuals, estates or trusts own stock possessing more than 50 percent of the total combined voting power of all voting classes, or more than 50 percent of the total value of all classes, of each corporation — counting each person's ownership only to the extent it is identical with respect to each corporation (IRC § 1563(a)(2))^TY2026

And combined. a combined group is three or more corporations each of which is a member of a parent-subsidiary or brother-sister group and one of which is both a common parent of a parent-subsidiary group and a member of a brother-sister group; insurance companies taxed under IRC § 801 that are members of such a group are treated as a controlled group separate from the other members (IRC § 1563(a)(3), (4))^TY2026

Who is a member, and when. a corporation is a component member of a controlled group on a 31 December if it is a member of the group on that date and is not an excluded member, or is not a member on that date but is treated as an additional member — the status being fixed at a single date in the year rather than throughout it (IRC § 1563(b)(1))^TY2026

Who is not. a corporation is an excluded member for a taxable year if it was a member for less than half the days of the year preceding 31 December, is exempt under IRC § 501(a) other than one taxed on unrelated business income, is a foreign corporation subject to tax under IRC § 881, is an insurance company taxed under IRC § 801 outside a § 1563(a)(4) group, or is a franchised corporation (IRC § 1563(b)(2))^TY2026

What follows: one credit between them. $250,000 — the component members of a controlled group on a 31 December are limited, for their taxable years including that date, to one such amount for computing the accumulated earnings credit under IRC § 535(c)(2) and (3), reduced to $150,000 if any component member is a service corporation described in § 535(c)(2)(B). The amount is divided equally among the component members unless regulations permit an unequal allocation (IRC § 1561(a))^TY2026

The credit being shared. $250,000 — the credit is in no case less than the amount by which that figure exceeds the corporation's accumulated earnings and profits at the close of the preceding taxable year. For a corporation whose principal function is performing services in health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting the figure is $150,000. A mere holding or investment company gets only this minimum credit and nothing for reasonable needs (IRC § 535(c)(2), (3))^TY2026

And the estimated tax consequence. $1,000,000 — a large corporation is one that, or whose predecessor, had taxable income of that amount or more for any of the 3 taxable years immediately preceding the taxable year in question, determined without regard to net operating loss or capital loss carryovers (IRC § 6655(g)(2))^TY2026

Current figures

How it works in practice

The word that separates this from the consolidated return rules is “or”. A parent-subsidiary controlled group under IRC § 1563(a)(1) requires stock possessing at least eighty percent of the total combined voting power or at least eighty percent of the total value. The affiliated group definition in IRC § 1504(a)(2), which governs consolidated returns and the hundred percent dividends received deduction, requires eighty percent of voting power and eighty percent of value. So a corporation can be in a controlled group on the strength of voting power alone while falling outside the affiliated group definition entirely — and a practitioner who learns one test and applies it to the other will be wrong in both directions.

The brother-sister test is the harder of the two to apply because of the word “identical”. Five or fewer persons who are individuals, estates or trusts must own more than fifty percent of each corporation, but each person’s ownership counts only to the extent it is identical with respect to each corporation. So a shareholder holding sixty percent of one company and twenty percent of another contributes twenty percent to the identical-ownership total, not sixty. Running the test means building a grid: each person down the side, each corporation across the top, and the lowest figure in each row is what counts.

Note who can be counted in a brother-sister group — individuals, estates and trusts. A corporation cannot be one of the five persons, which is why a structure held through a holding company is tested under the parent-subsidiary limb instead.

Membership is fixed on a single day, the 31 December included in the taxable year (IRC § 1563(b)(1)), so a corporation that was in the group for eleven months and left in November is not a component member for that year, while one that joined in December is. That is a bright-line rule and it creates an obvious planning date, which IRC § 1563(b)(2)(A) partly answers by excluding a corporation that was a member for less than half the days of the year preceding that 31 December.

The exclusions in IRC § 1563(b)(2) are worth learning as a list because they come up in questions. A corporation is an excluded member if it was in the group for less than half the relevant days, is exempt under IRC § 501(a) other than one taxed on unrelated business income, is a foreign corporation subject to tax under IRC § 881, is an insurance company taxed under IRC § 801 outside a § 1563(a)(4) group, or is a franchised corporation. The foreign corporation exclusion is the one most often tested, because a group structure with an overseas subsidiary looks larger than it counts.

What follows from membership is the point of the definition. IRC § 1561(a) gives the component members one accumulated earnings credit between them, divided equally unless regulations permit otherwise, and reduced to the lower service-corporation figure if any member is a service corporation. Separately, IRC § 6655(g)(2)(B)(ii) aggregates component members for the large corporation test, so a group whose members are individually small can collectively cross the million-dollar threshold and lose the prior-year estimated tax safe harbour for all of them.

Scenarios

How this has changed

IRC § 1563 has been stable in structure for decades. The significant movement has been in IRC § 1561, which once limited a long list of multiple tax benefits — the graduated corporate rate brackets, the alternative minimum tax exemption, and the accumulated earnings credit among them — and now limits only the accumulated earnings credit.

The reason is that the benefits it used to ration have mostly disappeared. The graduated corporate rate schedule was replaced by a single flat rate for taxable years beginning after 2017, so there are no brackets to share; and the corporate alternative minimum tax that IRC § 1561 once addressed was repealed and replaced by a book-income regime with a billion-dollar threshold that no small group approaches. The section’s heading and its remaining content are a good deal narrower than most descriptions of it, and material listing the multiple benefits IRC § 1561 restricts is describing a provision that has been pared back.

What has not narrowed is the reach of IRC § 1563 itself, because dozens of provisions outside part II borrow the definition. The estimated tax large corporation test, the gross receipts test for the cash method, the small business exemptions from inventory accounting and uniform capitalisation, and the research credit rules all aggregate controlled group members. The definition matters more than the part it sits in.

Exam focus

The parent-subsidiary computation is the reliable question: check each subsidiary against eighty percent of voting power or value, and then remove any excluded members. The foreign subsidiary is the most common exclusion offered.

For brother-sister questions, build the grid and take the lower figure for each person. The distractor is usually the total ownership rather than the identical ownership.

Where a question asks what follows from controlled group status, the answers within this section are the single accumulated earnings credit and the aggregation for the estimated tax large corporation test. Remember that a group cannot file a consolidated return on controlled group status alone — that needs the affiliated group test.

Check yourself

1. A parent owns stock possessing 85 percent of a subsidiary’s voting power but only 40 percent of its value. Is there a parent-subsidiary controlled group?

Answer: yes. IRC § 1563(a)(1) requires stock possessing at least 80 percent of the total combined voting power of all classes entitled to vote or at least 80 percent of the total value of all classes. The voting limb is satisfied. The same facts would not create an affiliated group under IRC § 1504(a)(2), which requires both tests.

2. Two individuals own two corporations. In the first: Person A 80 percent, Person B 20 percent. In the second: Person A 30 percent, Person B 70 percent. Is there a brother-sister group?

Answer: yes. Identical ownership takes the lower figure for each person — 30 for A and 20 for B, a total of 50 percent. That is not more than 50 percent, so on these figures there is no group. The margin is exact and the test requires more than half, so 50 percent fails.

3. A parent owns 90 percent of a foreign corporation subject to tax under IRC § 881. Is that corporation a component member of the parent’s controlled group?

Answer: no. IRC § 1563(b)(2)(C) treats as an excluded member a corporation which is a foreign corporation subject to tax under IRC § 881 for the taxable year. The ownership percentage is irrelevant once the exclusion applies.

4. Four corporations are component members of a controlled group, none of them a service corporation. What accumulated earnings credit is available to each?

Answer: one quarter of the single statutory amount each. IRC § 1561(a) limits the component members to one $250,000 amount for computing the accumulated earnings credit under IRC § 535(c)(2) and (3), divided equally among them unless regulations permit an unequal allocation. Had any member been a service corporation described in IRC § 535(c)(2)(B), the shared amount would have been $150,000.

5. Three corporations in a brother-sister controlled group each have taxable income of $500,000. Are they large corporations for estimated tax purposes?

Answer: yes. IRC § 6655(g)(2)(B)(ii) aggregates component members of a controlled group in applying the large corporation test, and $1,500,000 exceeds the $1,000,000 threshold. Each therefore loses the prior-year branch under IRC § 6655(d)(2)(A) except for the first instalment, even though none of them reaches the threshold alone.