Editor: Mark Heroux, J.D.
Sec. 163(j), as amended by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, generally limits a taxpayer's interest expense deduction. However, taxpayers are exempt from this limitation if their average annual gross receipts are less than $25 million. To determine whether a taxpayer qualifies for this exemption, the gross receipts of all related entities must be aggregated and treated as a single employer in accordance with Sec. 448(c)(2). In addition to testing for related entities under Sec. 52 (the controlled group rules), taxpayers must also be aware of and test for related entities under Sec. 414(m), otherwise known as the affiliated service group (ASG) rules.
This discussion focuses on and provides a high-level overview of the ASG rules. There are three ways in which two or more entities can be grouped as an ASG: (1) an A-type group, (2) a B-type group, or (3) a management group.
First service organization: Sec. 414(m)(2) refers to a "first organization," but, because this entity must be a service organization, it is generally referred to as a first service organization or FSO. An FSO can be structured as any type of business entity, but the performance of services must be its principal business. Under the A-type group rules, if it is a corporation, the entity must be a professional service corporation (this limitation does not apply to B-type groups). The principal business of an organization will be considered the performance of services if:
- Capital is not a material income-producing factor for the organization; or
- The organization is engaged in a field listed in Regs. Sec. 1.414(m)-2(f)(2), which includes health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and insurance.
Highly compensated employee: A highly compensated employee (HCE) is determined under Sec. 414(q), which provides that for the employer's current tax year, an HCE is any employee who:
- Was a 5% owner at any time during the year or the preceding year (the lookback year); or
- For the preceding year, received compensation from the employer in excess of $120,000 for 2018 ($125,000 for 2019), and, if the employer elects, was in the top-paid group of employees for the preceding year.
Related organization: Sec. 414(m)(5) provides that for this purpose, the term "related organization" has the same meaning as the term "related person" as defined in Sec. 144(a)(3), which provides that a person is related to another person if:
- The relationship between these persons would result in a disallowance of losses under Sec. 267 or Sec. 707(b); or
- These persons are members of the same controlled group of corporations (as defined in Sec. 1563(a), except that "more than 50%" is substituted for "more than 80%").
Constructive ownership: The Sec. 318 attribution rules apply to ASGs. Attribution under Sec. 318 applies to lineal descendants (e.g., from father to daughter or son to mother) and are not limited by age or ownership requirements as seen in Sec. 1563. There is also no attribution between siblings.
Affiliated service groupings
As noted above, there are three potential types of ASGs.
- An A-type group requires two services organizations — consisting of a first service organization (FSO) and any other service organization (A-org).
- A B-type group requires only one service organization (the FSO), which is paired with another entity that primarily provides services to the FSO (B-org). The B-org does not need to be a service organization (an organization whose principal business is providing services). Note that these rules are potentially much broader than the A-type group rules.
- A management group does not require service organizations but does require a management organization whose principal business is performing management functions for one organization (including any organizations related to the recipient). Therefore, a management group will not exist if the management organization provides services to multiple unrelated organizations.
It is not specified which organization is treated as the FSO in testing for ASG status. Thus, when performing the tests described below, a determination that a configuration does not constitute an ASG is not the end of the test. Rather, the test must be performed again, reversing the configuration.
A-org: To be an A-org, a service organization must satisfy a two-part test:
- Ownership test: The organization is an owner of the FSO (constructive ownership rules apply); and
- Working relationship test: (1) The organization "regularly performs services for the FSO," or (2) is "regularly associated with the FSO" in performing services for third parties.
Facts and circumstances are used to determine if a working relationship exists.
Example 1a: S, an attorney, is the sole owner of a corporation, which is a partner in a law firm. S and her corporation are regularly associated with the law firm in performing services for third parties. Considering the law firm as an FSO, the corporation is an A-org because it is a partner in the law firm and it is regularly associated with the law firm in performing services for third persons. Accordingly, the corporation and the law firm constitute an A-type ASG for Sec. 163(j) purposes.
Example 1b: Assume the same facts as Example 1a, except that S's corporation is a partner in a real estate company that primarily buys and sells real estate. S's corporation is regularly associated with the real estate company in the real estate transactions. In this situation, however, the real estate company cannot be considered to be an FSO, as its capital investments in its real estate inventory are a material income-producing factor for the organization. Accordingly, the corporation and real estate company do not constitute an A-type ASG and will not be aggregated under Sec. 163(j).
B-org:To be a B-org, an organization must meet the following requirements:
- A significant portion of its business must be the performance of services for an FSO, or for one or more A-orgs determined with respect to the FSO, or for both;
- The services must be of a type historically performed by employees in the service field of the FSO or the A-orgs; and
- 10% or more of the interests in the organization must be held, in the aggregate, by designated group members (the officers, the highly compensated employees, and the common owners of an organization) of the FSO or A-orgs.
A B-org does not need to be a service organization — only the FSO must meet this requirement.
Example 2a: P, a performing arts theater, is owned 25% by a managing partner, 10% each by three senior partners, and 45% by nine partners, equally. One senior partner, B, prior to coming to P, had formed and solely owns L, a lighting company. L was intended to provide lighting for theaters in P's area, but the business struggled. Now, it primarily provides lighting for P. By providing services in the performing arts, P is in a listed field and qualifies as an FSO. L, owned by a 10% partner of P, provides lighting to P in a manner that would historically have been performed by an employee of P and, thus, qualifies as a B-org. Accordingly, P and L constitute a B-type ASG.
Example 2b: Assume the same facts as Example 2a, except that P is a construction company where capital is a material income-producing factor. P would not qualify as a B-org, as it is not performing services for an FSO. In reversing the testing configuration, L would qualify as an FSO, as capital is not a material income-producing factor for the organization.P, however, would not qualify as a B-org, as it does not provide services to L. Accordingly, P and L do not constitute a B-type ASG under either configuration, and the two companies will not be aggregated under Sec. 163(j).
Example 2c: Assume the same facts as Example 2a, except that in in this case, B has no ownership in P and collects an annual wage of $60,000 as an employee. Again, P would qualify as an FSO, as it provides services in a listed field. L, however, does not qualify as a B-org since B is not an HCE of P. Accordingly, P and L do not constitute a B-type ASG.
Management group. A management-type ASG consists of:
- An organization (the management organization), the principal business of which is performing management functions on a regular and continuing basis for a single recipient organization (or for one organization and other organizations related to that one organization — as defined above under "related organizations"); and
- The organization (and related organizations) for which the management organization described above performs the management functions.
There does not need to be any common ownership between the management organization and the organization for which it provides services.
The term "management functions" is not defined in the statutes or final regulations. However, the IRS provided guidance on the definition of "management functions," in Chapter 7 of its Tax Exempt and Government Entities Manual, "Controlled and Affiliated Service Groups," where it says it includes two concepts: (1) "management activities," and (2) "historically performed by employees." Both must be satisfied for the activity to constitute management functions. These activities may include:
- Daily operations (e.g., production, sales, marketing, purchasing, and advertising);
- Personnel (e.g., staffing, training, and supervising);
- Employee compensation and benefits;
- Short-range and long-range business planning (e.g., product development, budgeting, financing, expansion of operations, and capital investment);
- Organizational structure and ownership (e.g., corporate formation, stock issues, dividends, mergers, and acquisitions); and
- Any other management activity or service.
Example 3a: BB is a shoe manufacturer whose employees work in various capacities in a factory — operating machinery, moving materials, etc. DWT oversees BB by providing management services, such as employment decisions, working with suppliers and service providers, etc. The performance of these management functions is DWT's principal business and is provided on a regular and continuing basis. Additionally, DWT solely provides management services to BB and has no other clients. In this situation, DWT is treated as a management organization, and BB is treated as a recipient organization for purposes of Sec. 414(m)(5). Accordingly, both entities constitute a management group and will be treated as an ASG under Sec. 163(j).
Example 3b: Assume the same facts as Example 3a, except that DWT performs management functions for BB and a second entity, W. BB and W do not meet the Sec. 144(a)(3) requirements to be treated as related organizations. Further, DWT performs services for BB and W equally. Accordingly, no combination of entities in this fact pattern constitutes a management group, as services are provided to more than one recipient organization. Therefore, each entity would determine its eligibility for the Sec. 163(j) small business exception on its own.
Mark Heroux, J.D., is a principal with the Specialty Tax Services Group at Baker Tilly Virchow Krause LLP.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.