Employer Beware: Affiliated Service Group Is a Single Employer for Benefit and Health Care Coverage Testing

By Daniel P. Michael, CPA, J.D., MST, St. Clair Shores, Mich.

Editor: Anthony S. Bakale, CPA, M.Tax.

Secs. 414(b) and 414(c) require that all employees of commonly controlled corporations or trades or businesses be treated as employees of a single corporation or trade or business. But by arranging the ownership of related business entities in an artificial manner, the rules established by these sections can be avoided. In Kiddie, 69 T.C. 1055 (1978), and Garland, 73 T.C. 5 (1979), the Tax Court held that where a controlled group situation did not exist, it would not be necessary to aggregate employees for purposes of testing for coverage and discrimination. Congress subsequently enacted Sec. 414(m) to prevent this circumvention by expanding the idea of control to separate but affiliated entities. These are known as the affiliated service group rules.

While these rules are fairly long-established, most practitioners are not fully literate in how they apply to various situations. With the passage of the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, the rules now apply far beyond their original purpose. PPACA mandates that certain employers (i.e., applicable large employers, or ALEs) offer health coverage to their full-time employees. The definition of an ALE generally hinges on the number of full-time equivalent employees (FTEs). And although employers may be temporarily relieved from this mandate due to one or more transition rules, it is still important to be aware of the employer aggregation rules for counting FTEs. Furthermore, while there seems to be at least some general awareness regarding Sec. 414's commonly controlled corporations or trades or businesses rules, the affiliated service group rules frequently can go unnoticed in employee benefit testing. Consequently, it is a critical time to revisit and understand the rules regarding affiliated service groups.

Sec. 414(m) provides in relevant part that, for purposes of most employee benefit requirements, all employees of the members of an affiliated service group shall be treated as employed by a single employer. An affiliated service group is a group consisting of a first service organization (FSO) and:

1. One or more A organizations (as defined in Prop. Regs. Sec. 1.414(m)-2(b));

2. One or more B organizations (as defined in Prop. Regs. Sec. 1.414(m)-2(c)); or

3. One or more A organizations and one or more B organizations.

An affiliated service group can also include a group consisting of an organization the principal business of which is performing, on a regular and continuing basis, management functions for one organization (or for one organization and other organizations related to that organization), and the organization (and related organizations) for which the management organization performs these functions.

"Organization" refers to a corporation, partnership, or other organization—including sole proprietorships, disregarded single-member LLCs, and activities reported on Schedule E, Supplemental Income and Loss (see Sec. 414(m)).


To determine whether a group is an affiliated group, an FSO must be a service organization, as defined in Sec. 414(m)(3), i.e., an organization for which the performance of services is the principal business of the organization. The principal business of an organization will also be considered to be the performance of services if capital is not a material income-producing factor for the organization.

The issue of whether capital is a material income-producing factor will be determined by the facts and circumstances of each case (Prop. Regs. Sec. 1.414(m)-2(f)(1)). Generally, the proposed regulations say, capital is a material income-producing factor "if a substantial portion of the gross income of the business is attributable to the employment of capital in the business, as reflected, for example, by a substantial investment in inventories, plant, machinery, or other equipment." The regulations also specify that capital is a material income-producing factor for banks and similar institutions (id.). However, "capital is not a material income-producing factor if the gross income of the business consists principally of fees, commissions, or other compensation for personal services performed by an individual" (id.).

Prop. Regs. Sec. 1.414(m)-1 provides, when analyzing whether a group with an A organization (see below) exists, a corporation other than a "professional service corporation" cannot be an FSO. Under Prop. Regs. Sec. 1.414(m)-1(c), a professional service corporation is a corporation that is organized under state law for the principal purpose of providing professional services and has at least one shareholder who is licensed or otherwise legally authorized to render the type of services for which the corporation is organized.

Professional services for these purposes means "the services performed by certified or other public accountants, actuaries, architects, attorneys, chiropodists, chiropractors, medical doctors, dentists, professional engineers, optometrists, osteopaths, podiatrists, psychologists, and veterinarians" (Prop. Regs. Sec. 1.414(m)-1(c)). An organization engaged in any one or more of the following fields is a per se professional service organization: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and insurance (Prop. Regs. Sec. 1.414(m)-2(f)(2)).

A Organizations

To be an A organization, a two-part test must be satisfied: (1) The organization is a partner or shareholder in the FSO (regardless of the ownership percentage), determined under the Sec. 318(a) constructive ownership rules; and (2) either (a) the organization "regularly performs services for the [FSO]," or (b) is "regularly associated with the [FSO] in performing services for third persons" (see Prop. Regs. Sec. 1.414(m)-2(b)). The facts and circumstances determine if such a working relationship exists.

B Organizations

To be a B organization, the organization must meet the following requirements:

1. A significant portion of its business must be the performance of services for an FSO, for one or more A organizations determined with respect to the FSO or for both; Prop. Regs. Sec. 1.414(m)-2(c)(2) specifies that whether providing services (for the FSO, for one or more A organizations, or for both) is a "significant portion" of the business of an organization will be based on the facts and circumstances. The service-receipts-safe-harbor test or total-receipts-threshold test may be used for substantiating the facts and circumstances;

2. The services must be of a type historically performed by employees in the service field of the FSO or the A organization(s); and

3. 10% or more of the interests in the organization must be held, in the aggregate, by persons who are highly compensated employees of the FSO or A organization(s). Under Sec. 414(q), a highly compensated employee includes any employee who was a 5% owner at any time during the year, regardless of the amount of compensation.

Management Groups

Management groups consist of an organization, the principal business of which is performing, on a regular and continuing basis, management functions for one organization (or for one organization and other organizations related to that one organization, and the organization (and related organizations) for which those functions are so performed by the organization). The statute does not define the term "management functions." Under withdrawn proposed regulations, management functions included "determining, implementing or supervising" a firm's daily business operations, long-term planning, personnel matters, or employee benefit functions. In addition, the proposed regulations provided that any professional service, such as medical services, could be treated as a management activity (Prop. Regs. Sec. 1.414(m)-5(c), removed by T.D. 8474).

Until the IRS issues additional guidance under Sec. 414(m), the withdrawn proposed regulations may provide some limited guidance regarding how the IRS might interpret Sec. 414(m)(5). The term "related organizations" has the same meaning as the term "related persons" when used in Sec. 144(a)(3). Related persons under Sec. 144(a)(3) include all Sec. 267 relationships, which includes siblings. Note that there does not have to be any ownership between the management entity and the organization receiving the management services.

Testing for an Affiliated Service Group 

Example: A medical service group involves three entities—G, E1, and E2. G has one or more employee benefit plans and is owned by seven individuals. G performs physician consulting services for E1 and is regularly associated with E1 in providing endoscopic services for patients. The annual fee G receives for these services is $60,000—G's average gross receipts (over the last three years) is $9,300,000. G also provides management and bookkeeping services toE2.

E1's principal business is performing professional services, and it has employees, but none of them are also employed by G. E1 performs no services for G nor does it bill jointly or otherwise in conjunction withG.

E2 is an investment holding entity—it owns 50% of E1—and has no employees. The same seven individuals who own G ownE2.

E1 would fall within the definition of an FSO.

Is G an A organization? G does provide physician consulting services to E1 in conjunction with regularly performing endoscopy services for third parties. However, G owns no interest—either directly or indirectly under the Sec. 318(a) constructive ownership rules—in E1. G and E1 thus do not constitute an A organization group.

Is G a B organization? Although G's owners would be deemed highly compensated employees of E1 because of their (indirect) ownership in E1 through E2, its services provided to E2 do not amount to a significant portion of its business. Specifically, the $60,000 fees earned are much less than 5% of the total $9,300,000. E1 likewise provides no services to G. Therefore, G and E1 are not a B organization group, either.

These entities are also not a management group because they do not provide management services to each other.

Finally, E2 has no employees and therefore did not need to be considered when testing for the presence of an affiliated service group among the organizations.


It does not take too long a reading of the affiliated service group rules and this relatively straightforward example to realize that these issues require a detailed, thorough understanding of the client's facts, followed by a careful, step-by-step, mechanical application of the rules when testing for the presence of an affiliated service group.

Overlooking the presence of an affiliated service group could result in failing to offer individuals required health care coverage or improperly excluding them from employee benefits and could falsely affect employee benefit testing—all of which can result in significant adverse consequences.


Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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