Source: https://www.mtfn.com/article-Nichols-DeCleene-Bona-Fide-Reciprocal-Purchase-Agreements.html
Timestamp: 2019-04-20 08:37:35+00:00

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One question that arises at the outset is how the employee exclusion rule is to be applied in the context of entities that are treated as partnerships. The IRS has taken the position that an individual can be either a “bona fide partner” or an employee of a partnership, but not both.12 Thus, there is a real question as to whether or not the employee exclusion rule will ever apply to noncorporate entities. On the one hand, if the individual holding the interest is a “bona fide partner” and, therefore, cannot be an employee, then the rule should have no application. On the other hand, if the individual is not a “bona fide partner,” then presumably he or she does not really own any capital or profits interest in the partnership to begin with and, therefore, would not even be taken into account in applying the 414(c) common control rules.
Also note that in order for the employee exclusion rule to apply, the individual owner must be “an employee of such organization,” i.e., the organization being tested for common control purposes.13 Thus, if the individual is an employee of a related entity, presumably the employee exclusion rule would not apply. Although there is attribution of ownership,14 there does not seem to be any attribution of employment status.
Once this threshold test is met, the employee exclusion rule could easily mean that some or even all of the ownership interests in brother–sister entities could be excluded because restrictions are quite common in closely held business entities in order to assure that the interests in such entities are maintained within a closely knit family or management group. As a consequence, the 414(c) common control rules provide that the employee exclusion rule will not apply if such a restriction also applies “to the interest or stock in such organization held by a common owner pursuant to a bona fide reciprocal purchase arrangement.”18 Note that, in order for this exception to apply, it is merely necessary for the condition to apply to the interest or stock held by “a” common owner, not all of them.19 Thus, if one owner owns 79 percent of the interests in the entity, and the other 21 percent is owned in equal shares by another 21 employees, and they all have a right of first refusal in the event that any of them seeks to sell their stock, their stock should not be excluded. Query: If one owner owns 40 percent of the interests in the entity, and six other owners own 10 percent each and the 40 percent owner has a right of first refusal on all of their interests, would their interest be excluded? Each one of them seems to be a “common owner,”20 and the restriction that applies to each of them “also applies to the interest or stock in such organization held by a common owner.”21 The question would be whether this is “pursuant to a bona fide reciprocal purchase arrangement.”22 Along those same lines, what happens in the fairly common ownership arrangement whereby the interest of each employed owner will be redeemed upon his or her retirement? Does it make a difference in determining whether the agreement is “bona fide” or “reciprocal” that some owners are older than others?
Analyzing closely held business restrictions gets harder when you consider another rule contained in the Code Sec. 414(c) regulations. That rule provides that if an interest in an organization is owned by a person, and such ownership results in common control with another entity, then the interest will be treated as not excluded if the result of applying such exclusion is to knock that other entity out of the common control group.50 Applying this rule in, for example, the 10-shareholder situation described above would wreak havoc if the result would be that the IRS could pick and choose which employees’ stock to exclude and which to include. For example, if the spouse of one of those 10 shareholders happens to own 100 percent of another organization, and such shareholder serves as a member of the board of directors,51 would you conclude that (a) the employee exclusion rule applies because any five of the shareholders own exactly 50 percent of the stock, and (b) both the 10-shareholder business and the spouse’s business would satisfy the 80-percent–50-percent tests if you excluded the stock of all nine of the other shareholders?52 That can’t be right, right?
1Patient Protection and Affordable Care Act (P.L. No. 111-148), 124 Stat. 119.
2 For example, subject to certain transitional rules, applicable large employers with fewer than 100 full-time employees can avoid incurring an assessable penalty during 2015. T.D. 9655, IRB 2014-9, 575–577. Additionally, for 2015, an employer with 100 or more full-time employees can reduce its number of full-time employees by 80, rather than 30, for purposes of calculating its assessable penalty. Id., at 577.
3 Code Sec.4980H(c)(2)(C)(i) (“All persons treated as a single employer under subsection (b), (c), (m), or (o) of section 414 of the Internal Revenue Code of 1986 shall be treated as 1 employer.”). For purposes of the Affordable Care Act, applicable large employers are required to provide minimum essential coverage to their employees. Code Sec. 4980H(a)(1), (b)(1). An “applicable large employer” is an employer who, on average, employed 50 or more full-time employees during the preceding calendar year. Code Sec. 4980H(c)(2)(A).
4 Act Sec. 2716 of the Public Health Service Act (PHSA) (P.L. 78-410) (“The plan sponsor of a group health plan ... may not establish rules relating to the health insurance coverage eligibility ... of any full-time employee ... based on the total hourly or annual salary of the employee ... .”); see also 42 USC §300gg-16(a), (b)(2) (“A group health plan ... shall satisfy the requirements of section 105(h)(2) of title 26 ... . The term ‘highly compensated individual’ has the meaning given such term by section 105(h)(5) of title 26.”). Act Sec. 2716 and the other provisions of Part A of Title XXVII of the PHSA are made applicable to group health plans. Code Sec. 9815(a)–(b). In addition, other fringe benefits are also subject to grouping rules. See, e.g., Code Sec. 79(d) (group term life insurance); Code Sec. 105(h) (health reimbursement accounts); Code Secs. 4980E, 4980G (health savings accounts); Code Sec. 4980I (Cadillac plans; note however, that the Cadillac plan provisions do not kick in until 2018).
6 Code Sec. 414(b) (referencing Code Sec. 1563(a)’s common control test).
test. Compare Code Sec. 1563(a)(2) with Reg. §1.414(c)-2(b)(2). However, this elimination of the 80-percent test is applicable only for purposes of determining whether corporations are members of the same brother–sister control group under the multiple surtax-exemption rules. Code Sec. 1563(f)(5); see Code Sec. 1561(a) (dividing the exemption equally among component members of a controlled group). By contrast, whenever a provision outside of Code Secs. 1561–64 references the Code Sec. 1563 common control rules, the text of Code Sec. 1563(a)(2) is applied using the familiar 80-percent test. Code Sec. 1563(f)(5)(A)(2).
9 Reg. §1.414(c)-3(c)(3); see also Code Sec. 1563(c)(2)(B)(ii) (applying a similar requirement); Reg. §1.1563-2(b)(3)(ii) (using substantially the same language as under the Code Sec. 414(c) regulations); In re Mushroom Transp. Co., Inc., DC-PA, 90 BR 718, 727 (1988) (reasoning that the cases interpreting Code Sec. 1563’s substantial restriction language are persuasive in interpreting the regulations under Code Sec. 414(c) and adopting Superior Beverage’s reciprocity standard).
11 See Id.; see, e.g., Superior Beverage Co. of Marysville, Inc., CA-9, 75-2 ustc ¶9808, 525 F2d 186, 187–189; In re Mushroom Transp. Co., Inc., DC-PA, 90 BR 718, 727 (1988); Barton Naptha Co., 56 TC 107, 109–111, 116–119, Dec. 30,737 (1971).
12 Rev. Rul. 69-184, 1969-1 CB 256; see also IRB 2015-32, 161 (affirming the IRS’s position with respect to this revenue ruling).
14 See Reg. §1.414(c)-3(c)(1), -4.
15 Reg. §1.414(c)-3(c)(1)(i)–(iii). Note that the percentage requirement for the employee exclusion rule is not identical to the effective control test. When determining whether five or fewer individuals, trusts or estates have effective control of a trade or business, those individuals must possess “more than 50 percent” of the stock or interests in that organization. Reg. §1.414(c)-2(c)(1)–(2)(iii). In contrast, the threshold requirement for the employee exclusion rule is met when five or fewer individuals, trusts or estates own “50 percent or more” of the stock or interests in a trade or business. Reg. §1.414(c)-3(c)(i)–(iii). But see Reg. §1.414(c)-3(f) (requiring non application of the employee exclusion rule where it would prevent application of the 414(c) common control rules).
16 See Reg. §1.414(c)-4(b)(1) (options); Reg. §1.414(c)-4(b)(2) (attribution from partnerships); Reg. §1.414(c)-4(b)(3) (attribution from estates and trusts); Reg. §1.414(c)-4(b)(4) (attribution from corporations); Reg. §1.414(c)-4(b)(5) (attribution from spouse); Reg. §1.414(c)-4(b)(6)(i) (attribution between parents and children under 21 years old); Reg. §1.414(c)-4(b)(6)(ii) (attribution from parents, grandparents, children and grandchildren over 21 years old where individual is in effective control of an organization).
17 Cf. Reg. §1.414(c)-3(e), Example 2 (applying an analogous exclusion rule in the parent subsidiary context by taking excluded stock into account for purposes of the threshold test).
18 Reg. §1.414(c)-3(d)(6)(ii) (Emphasis added).
20 Reg. §1.414(c)-3(c)(1) (defining the five or fewer individuals, trusts or estates used for the 50-percent threshold test as “common owners”).
21 See Reg. §1.414(c)-3(d)(6)(ii) (emphasis added).
25 Compare Reg. §1.1563-2(b)(4)(ii) with Reg. §1.414(c)-3(d)(6)(ii).
26 LTR 9723016 (Mar. 3, 1997).
27 Superior Beverage Co. of Marysville, Inc., CA-9, 75-2 ustc ¶9808, 525 F2d 186.
33 See supra note 9 for a case detailing why the cases interpreting Code Sec. 1563 are persuasive in interpreting the regulations under Code Sec. 414(c).
(1963), reprinted at 1964 U.S.C.C.A.N. 1313, 1428 (“[C]ertain outstanding stock, ... could, unless neutralized for purposes of determining control, be used by some owners as a means of divesting themselves of sufficient stock to avoid the application of this section without, as a practical matter, divesting themselves of the benefits of ownership of a corporation.”).
35 LTR 8428073 (Apr. 11, 1984).
37 United Food and Commercial Workers Union v. Progressive Supermarkets, DC-NJ, 644 FSupp 633, 634–635 (1986).
38 Id., at 641. This case was decided under the temporary Code Sec. 414(c) regulations in effect at that time. Cf. T.D. 7388, IRB 1975-2, 180.
39 In re Mushroom Transp. Co., Inc., DC-PA, 90 BR 718 (1988).
45 Barton Naptha Co., 56 TC 107, Dec. 30,737 (1971).
48 Id., at 113–114, 117 (“It is plainly the use of substantial restrictions as a method of retaining the reins of corporate control which is the sole concern of the statute.”).
49 Id., at 114–116, 118–119.
51 Reg. §1.414(c)-4(b)(5)(ii)(B). Generally, an individual is attributed the ownership interests in an organization owned by his or her spouse. Reg. §1.414(c)-4(b)(5)(i). However, an individual is not attributed his or her spouse’s interest in an organization if (1) the individual does not have a direct ownership in the organization, (2) the individual is not a fiduciary or employee of the organization or on its board of directors and does not participate in the management of the organization, (3) the organization does not derive 50 percent or more of its gross income from passive activities and (4) the spouse’s interest cannot be subject to a substantial condition (referencing Reg. §1.414(c)-3(d)(6)(i)) that runs in favor of the individual or individual’s children, which restricts the spouse’s right to dispose of the interest. Reg. §1.414(c)-4(b)(5)(ii)(A)–(D).
same five persons for the 80-percent/50-percent tests is grounded in the Supreme Court’s decision in Vogel Fertilizer, SCt, 82-1 ustc ¶9134, 455 US 16, 102 SCt 821 (1982). See 48 FR 52081, 52081 (1983). However, this case was issued between promulgation of the proposed regulations and issuance of the final regulations under Code Sec. 414(c) and was incorporated into the final regulations as originally published. Compare T.D. 8179, 1988-1 CB 122, 53 FR 6603, 6606 (1988) (including the requirement in the final regulations under Code Sec. 414(c)) with T.D. 7388, 1975-2 CB 180 (“the same five or fewer persons ... own ..., singly, or in combination, a controlling interest of each organization” (emphasis added)). However, the Vogel Fertilizer case did not deal with the employee exclusion rule and so had a freer hand in finalizing the regulations with respect to that rule.

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