Peter Mehta, J.D., LL.M, is TCC’s Managing Director and National Service Leader for our R&D Tax Credit practice. With over 20 years of tax experience with the Big 4 and a law firm, Peter has significant expertise with R&D tax credit matters and federal and state practice and procedure issues.
Increasingly, we’re fielding inquiries regarding applying the aggregation and controlled group rules for both the Research Credit (RC) and the new Employee Retention Credit (ERC). Since different controlled group rules apply to the RC and ERC, we felt it was important to articulate the controlled group rules, explain differences in application of the rules between the RC and the ERC and provide recent examples regarding their application. In Part 1 of this two-part blog series, we addressed the Research Credit. In this Part 2, we’ll dive deeper into the new ERC.
COVID-19 Employee Retention Credit Adds Another Test for Controlled Groups:
Similar to the Research Credit, the IRS incorporates Controlled Group Rules to calculate the Covid-19 Employee Retention Credit. Specifically, all persons treated as a single employer under subsection (a) or (b) of section 52 of the Internal Revenue Code of 1986, or subsection (m) or (o) of section 414 of such Code, shall be treated as one employer for purposes of this section.
Unlike the research credit, the ERC adds another test under 414(m), the “affiliated services group” test, one that is not based on ownership to determine if a controlled group exists:
- Under section 414(m) of the Code, an “affiliated service group” is treated as a single employer based on rules related to the performance of services by one entity for another or by one entity in association with another for third parties, even if the entity does not have sufficient ownership or control of the other entity to form a controlled group.
An affiliated service group refers to two or more organizations with a service relationship, and sometimes, an ownership relationship, described in I.R.C. section 414(m).
An affiliated service group is a group consisting of a first service organization (FSO) and one or more of two other types of organizations. An FSO must be a “service organization” (i.e. performance of services is the principal business of the organization as defined in section 414(m)(3)). “Organization” refers to a corporation, partnership, or other organization.
The two other types of organizations with which a first-service organization can be affiliated to form an affiliated service group are:
- Another service organization, commonly referred to as an “A” organization; and
- An organization, commonly referred to as a “B” organization, that performs services for the first-service organization or an “A” organization that are of a type historically performed in the group’s service field by employees.
The second major type of affiliated service group is a group consisting of a management organization and a recipient organization. A management organization is any organization that has as its principal business the performance of management functions for a recipient organization on a regular and continuing basis. A recipient organization is any organization and related organizations for which management functions are performed.
Recently, a client asked about the scope of the controlled group rules to calculate the ERC, which can be summarized in the following hypothetical. Taxpayer consists of a controlled group whose members engage in two separate and distinct lines of business (e.g., a defense contractor and hand sanitizer manufacturer). The hand sanitizer division makes up a tiny portion of total company revenues. The defense divisions and hand sanitizer divisions report to two separate corporate entities, each a member of the taxpayer’s-controlled group. Assume the hand sanitizer division is shut down due to state governmental order, while the defense contractor is not.
The issue presented is whether the controlled group rules apply so the taxpayer’s entire business is considered shut down even though the governmental order only shuts down a different line of business that accounts for a tiny fraction of the company’s total revenues.
FAQ 37 provides:
- If the operations of a trade or business of one member of an aggregated group are suspended by a governmental order, are the operations of that trade or business of the other members of the aggregated group considered to be fully or partially suspended for purposes of the Employee Retention Credit?
- Yes. All members of an aggregated group are treated as a single employer for purposes of the Employee Retention Credit. Accordingly, if a trade or business is operated by multiple members of an aggregated group and if the operations of one member of the aggregated group are suspended by a governmental order, then all members of the aggregated group are considered to have their operations partially suspended, even if another member of the group is in a jurisdiction that is not subject to a governmental order.
While the language could be read to limit the shutdown to only those controlled group members within the “same trade or business,” we believe this interpretation would not be correct. Read literally, the FAQ document does not impose a “same trade or business requirement.
While the FAQs cannot be relied upon to support a position, this answer aligns with legislative intent in applying the controlled group rules to the ERC. Congress wanted to prevent employers earning the ERC fully for an employee in one entity and then shifting the employee to another entity and earning it again. Treating all members of a controlled group as a single employer prevents this result. If employers (the aggregated group) can distinguish between so called “lines of business” they could claim additional wages for the same employee, bypassing Congressional intent.
 Under Prop. Regs. §1.414(m)-2(f)(2),an organization engaged in any one or more of the following fields is a service organization: Health, Law, Engineering, Architecture, Accounting, Actuarial science, Performing arts, Consulting, and Insurance.
 An “A” organization is a service organization that is a shareholder or partner in the first-service organization.
 A “B” organization is an organization that performs services for the first-service organization or an A organization that are of a type historically performed in the group’s service field by employees.