Your Comprehensive Guide to Understanding Brother-Sister Relationships in the Tax Code
The U.S. tax code uses complex family relationships to determine tax responsibilities and compliance, and among these is the “brother-sister relationship.” In tax terminology, this concept applies not only to biological siblings but also to a range of business and family-owned structures. This blog will explore the concept of a brother-sister relationship in tax terms, how it affects businesses and tax liabilities, and strategies for maintaining compliance.
What Is a Brother-Sister Relationship in the Tax Code?
A brother-sister relationship in the tax code describes a situation where two or more corporations are owned by the same individuals or family members, with ownership that meets specific thresholds set by the IRS. This structure generally falls under the broader category of "controlled groups," which are groups of related businesses or entities with shared ownership. The IRS imposes special rules on these groups to prevent manipulation of tax obligations and to ensure compliance with federal tax regulations.
Controlled groups are separated into three categories:
- Parent-Subsidiary Controlled Groups
- Brother-Sister Controlled Groups
- Combined Groups (a mix of the first two types)
A brother-sister controlled group consists of two or more corporations that share a common ownership structure among a small number of shareholders, typically individuals or family members.
IRS Definition of a Brother-Sister Controlled Group
The IRS defines a brother-sister controlled group using a two-part test:
- The 80% Ownership Test: This test requires that the same five or fewer people own at least 80% of the shares or voting rights in each corporation within the group.
- The 50% Identical Ownership Test: In addition to the 80% ownership, these same individuals must have more than 50% identical ownership in each corporation when combining their shares in each company.
To simplify, a brother-sister group means that two or more corporations are owned and controlled by a small group of common shareholders whose ownership percentage meets specific IRS thresholds. If the conditions are met, the entities are considered related, triggering certain tax rules and restrictions.
How Brother-Sister Relationships Affect Taxes
For tax purposes, the IRS has a strict approach to brother-sister controlled groups. These businesses may be subject to consolidated tax rules, limitations on certain deductions, and joint liability on specific tax responsibilities. Here are some of the primary ways that a brother-sister relationship can impact tax compliance:
1. Tax Deduction Limitations
- Section 179 Deductions: The IRS places caps on the amount businesses can claim as deductions under Section 179 for tangible business assets. If two businesses are in a brother-sister relationship, they share the deduction limits rather than each entity being entitled to the full deduction independently.
- Employee Benefit Deductions: Controlled groups are required to treat employee benefits and retirement plans as part of a single entity, which can affect contribution limits to employee retirement accounts, insurance plans, and fringe benefits.
2. Tax Rate Benefits
Brother-sister controlled groups may face limitations in terms of tax rate benefits. For example, the IRS does not permit businesses in a brother-sister controlled group to apply lower tax brackets individually, as if they were independent entities. Instead, they must allocate the benefits as a group, which can limit the tax advantages for each entity.
3. Employee Benefits and Retirement Plan Testing
When it comes to employee benefit plans, brother-sister controlled groups are required to undergo special testing to ensure compliance with the Employee Retirement Income Security Act (ERISA). Businesses must perform nondiscrimination testing to ensure that benefit plans do not disproportionately favor highly compensated employees. Compliance can be challenging, especially when several businesses with differing employee demographics and benefit offerings are involved.
4. Consolidated Tax Filing Requirements
While brother-sister groups are not always required to file a consolidated tax return, there are instances where the IRS may require these entities to consolidate their returns if they meet certain thresholds or filing requirements. A consolidated tax filing would combine income and expenses for all corporations within the controlled group, potentially impacting each entity's tax obligations.
5. Limitations on Losses and Deductions
The IRS may restrict the ability of one entity within a brother-sister group to claim losses or deductions that would otherwise reduce taxable income. For example, if one company in the group incurs significant losses, the IRS may limit the application of those losses across the entities to prevent overuse of deductions.
Strategies for Managing Brother-Sister Tax Compliance
If your business structure falls under a brother-sister controlled group, proper planning and compliance are essential. Here are a few strategies to manage the unique tax challenges associated with brother-sister groups:
- Detailed Ownership Tracking: Keeping accurate records of ownership percentages is essential for meeting IRS requirements and ensuring compliance with ownership tests. Regularly update and verify ownership records to ensure you meet (or avoid) the thresholds set by the IRS, as well as with your required BOI filings.
- Tax Planning and Consolidation Strategies: Work with tax professionals to develop a strategy that optimally allocates tax benefits and deductions across the group. Consider if consolidated tax filing would be advantageous, and evaluate the impact on individual entities.
- Benefit Plan Structuring: Implement benefit plans that meet nondiscrimination testing requirements and ensure consistency across all entities within the group. Carefully assess retirement plan contributions and employee benefits to maintain compliance with IRS and ERISA regulations.
- Consult a Tax Advisor with Controlled Group Experience: Consulting a tax advisor familiar with controlled groups is invaluable for understanding compliance, maximizing tax benefits, and planning for potential audits or IRS reviews.
- Annual Review of Tax Liabilities: Regularly review your group’s tax position to understand changes in liabilities, benefits, and deductions that may arise due to alterations in ownership or IRS regulations.
Potential Pitfalls to Avoid
While managing brother-sister controlled group relationships, there are several potential pitfalls to be aware of:
- Unplanned Ownership Changes: Ownership changes can inadvertently push entities into a brother-sister group or alter the status of an existing group. Any changes in ownership structure should be reviewed for potential tax implications.
- Benefit Plan Violations: Brother-sister controlled groups are often scrutinized for benefit plan compliance. Failing to comply with nondiscrimination rules can lead to fines and penalties.
- Failing to Allocate Tax Brackets: Since tax brackets are shared across brother-sister groups, failing to properly allocate income can result in higher overall tax burdens for each business.
Final Thoughts
The concept of a brother-sister relationship in the tax code is intricate and often misunderstood, yet it has significant implications for tax compliance and liability. If your business is part of a brother-sister controlled group, staying informed about the associated tax rules is essential to avoid costly errors, penalties, and missed deductions. With proper planning, careful management of employee benefits, and assistance from tax professionals, you can navigate the complexities of these relationships and make the most of available tax benefits.
Understanding and managing brother-sister controlled groups ensures that businesses can operate effectively within the bounds of the IRS requirements while optimizing tax positions and mitigating risk.
Need Help Managing Tax Compliance Within a Brother-Sister Control Group?
Compliance issues can become a major concern with control groups, especially within the brother-sister relationship. If you don't have an expert advising on proper compliance, contact us today. We are happy to help ensure your businesses maximize their tax savings without compromising their tax code compliance.