Special Health Care Reform Series: Special Focus on The Employer-Employee Relationship, Part I

Alerts / August 15, 2012

Common Control or Overlapping Ownership Can Change How to Identify the "Employer" for PPACA Purposes

This is the third in a series of Executive Alerts in the Special Health Care Reform Series. The first Alert summarized the employer mandate provisions of the Patient Protection and Affordable Care Act (PPACA) and described a timeline for required employer compliance initiatives. The second examined the new public health insurance exchanges PPACA prescribes from the employer's perspective. This third Alert, which is Part 1 of a two-part article, explores how PPACA defines that employer-employee relationship at its most fundamental level. It examines how PPACA identifies the "employer" for a number of regulatory purposes, by looking at the circumstances under which commonly-owned or commonly-controlled organizations must be considered a single "employer" for those regulatory purposes.

PPACA provides a variety of challenges and traps for any organization that employs individuals within the United States. The rules under PPACA are detailed and the penalties for noncompliance can be substantial. In determining exactly how those rules apply, two critical steps must be taken. First, one must review the size and composition of the employing organization's workforce; and second, one must determine whether that employing organization is so closely linked by common ownership (or in some instances, common control) with other organizations that those organizations must be considered a single "employer" for PPACA purposes. These rules are not confined to the for-profit world; many of these same principles apply to non-profit organizations such as hospitals, charities, civic organizations and governmental entities.

Why is Employer Size Important?

PPACA anticipates that most employers will participate in the process of offering affordable health care coverage to individuals who need it. Some employers are given incentives to do so. Others are required to do so or pay penalties. Exactly which PPACA rules apply, and how they apply, generally depends on the size of the employer. Among the PPACA provisions where the size of the "employer" affects how the PPACA rules apply are the following:

  • The Employer Mandate. Beginning January 1, 2014, employers employing 50 or more full-time employees (or full-time equivalents) must offer full-time employees and their dependents affordable health coverage. Multiple employing organizations, required to be treated as a single "employer," will reach the 50-employee threshold pretty quickly.
  • Automatic Enrollment. Under the federal wage-and-hour laws, employers with 200 or more full-time employees are now required to automatically enroll new full-time employees in one of the employer's health benefit plans. (Notably, this requirement is scheduled to take effect once regulations are issued). Again, when multiple employing organizations are required to be treated as a single "employer," they can easily become subject to this new wage-and-hour law.
  • Access to Exchanges. Beginning on January 1, 2014, employers with less than 101 employees may begin shopping for health insurance coverage for their employees on the new public health insurance exchanges. Larger employers—those with 101 or more employees—will not have access to the public health insurance exchanges at least until 2017. The second in this Executive Alert series, entitled "Health Insurance Exchanges—From The Employer's Perspective," examines how the new public health insurance exchanges are intended to work, and what rules apply. As such, organizations that currently assume they soon will be able to look for insured, community-rated coverage on one of the new health insurance exchanges may find that they are ineligible to do so because the existence of related employing organizations make them too "large" to shop there.
  • Small Employer Tax Credits. Since its enactment in 2010, PPACA has provided a tax credit to help subsidize the employer contributions a "small" employer makes toward its employees' health insurance premiums, so long as its employees' average annual wages fall below certain thresholds. But this special tax credit is only available to employers with 25 or fewer full-time equivalent employees. Under the "controlled group" rules, the existence of related employing organizations can cause an employing organization to be ineligible for this tax credit, either by driving up the total number of employees or by increasing the average annual wages (after taking into account the related companies' employees' wages).
  • Non-Discrimination Rules. PPACA introduced a new non-discrimination rule for insured health plans which applies throughout the entire "controlled group" and penalizes any employer which provides insured coverage which favors "highly compensated employees." (Before PPACA, only self-insured health plans had to comply with a non-discrimination requirement.) That rule, which has been in effect since September 2010, requires commonly-owned employing organizations that historically have shopped for health insurance separately to coordinate those coverage purchases in order to avoid incurring potentially substantial tax penalties.

Identifying the "Employer" Through Ownership and Control

At first glance, complying with the above numerical tests and their associated requirements or benefits would seem straightforward. But before an organization can start counting full-time or part-time employees, or calculate full-time equivalents, the organization must determine whose employees must be counted. And under the "controlled group" rules, the employees of the entire controlled group need to be counted.

Close examination reveals that the term "controlled group" is a bit of a misnomer: the emphasis is on direct ownership or overlapping (i.e., "common") ownership rather than on actual, hands-on control. The primary controlled group rules, set forth under Internal Revenue Code (the "Code") Sections 414(b) and 414(c), generally provide that "all employees of all corporations which are members of a controlled group of corporations" and "all employees of trade[s] or business[es] (whether or not incorporated) which are under common control" are to be treated as employed by a single employer. That means that organizations related in a parent-subsidiary relationship (a controlled group of corporations) are to be treated as a single employer under PPACA. That also means that trades or businesses (whether or not corporations, limited liability companies, partnerships or otherwise) which meet a defined level of common ownership (found in the Treasury regulations) also are to be treated as a single "employer" under PPACA -- even if the trades or businesses are not linked to each other by direct ownership. (Because this latter rule relies on the presence of common owners rather than a direct ownership link, it also is known as the "brother-sister" rule.)

The "controlled group" rule that comes closest to requiring actual "control" is a third rule, known as the "affiliated service group" rule (Code Section 414(m)). That rule, which applies only to service organizations such as law firms, accounting firms, civic organizations, temporary staffing companies and third party administrators, applies when separate organizations linked by at least some ownership (the statute refers to a 10% threshold) closely collaborate in the services they provide. Whether this third, lesser-known "controlled group" rule will be aggressively enforced under PPACA remains to be seen, but it bears watching -- especially by professional service firms inclined to (among other things) purchase better health insurance coverage for those who also own the firm.

A "parent-subsidiary" controlled group exists wherever a parent organization owns 80% or more of the equity in a subsidiary organization. (For corporations, the 80% + test is based on attaining that level of voting power or total value based on all classes of stock; for partnerships, the 80% + test is based on attaining that level of profits interest or capital interest; for trusts and estates, actuarial interests are used.)

A "brother-sister"/common control group exists wherever the same five or fewer persons (counting individuals, estates and trusts as "persons") (i) collectively own 80% or more of the equity in two separate trades or businesses, and (ii) taking into account the level of ownership each of those five persons holds in each of the two organizations (using a lowest common denominator approach) collectively own more than 50% of the equity in both of the trades or businesses.

An "affiliated service group" exists wherever several organizations regularly collaborate in the services they provide to the public (typically, integrated services), and the several organizations are linked by a material level of cross-ownership.

The primary key to determining the organizations that must be included within the controlled group -- and thus, be considered part of the same "employer" -- accordingly is ownership. And except for the affiliated service group rule, organizations within a controlled group do not need to have the same management, or even operate in the same industry or in the same state.

The classic example of a controlled group is a parent-subsidiary controlled group, such as a diversified conglomerate where a "parent" company holds a dominant ownership interest in several subsidiary corporations which operate in various industries. However, a controlled group also can take the form of several different trades or businesses, if those trades or businesses have a small number of common owners and thus operate like a close-knit "family" of companies (which explains the use of the term "brother-sister" to describe the relationship). For example, a small medical supply company owned by the company president and an investor group consisting of four doctors could be part of a controlled group which includes the medical practice those same four doctors co-own, even if the supply company markets and sells its products to hospitals (and not the doctors' medical practice). How could this occur? Through overlapping ownership. If the company president owns 20 percent or less of the medical supply company, leaving the four doctors to collectively own 100 percent of their medical practice and also 80 percent of the medical supply company, the requisite level of overlapping ownership has been reached.

The controlled group rules are made more difficult to avoid by special operating rules, which are designed to prevent owners of closely-held companies from easily avoiding the controlled group rules. Under those operating rules, an individual's interest ownership must be attributed to certain family members, which can cause unrelated businesses held by family members or trusts to be caught up under the rules. Similarly, an ownership interest in a corporation or a trade or business which has been transferred to a trusted employee is required to be ignored (for purposes of identifying the common owners) if that employee is required to forfeit that interest, or sell it for a nominal amount, upon termination of employment.

Take, for example, a simple situation that could easily be overlooked as a controlled group: a small manufacturing company which is owned by a single individual, and a lawn care company which is owned and operated by the 18-year-old son of the manufacturing company's owner. Under the controlled group operating rules, the son's ownership interest in the lawn care company is attributed to the manufacturing company owner because the son is under the age of 21. However, once the son reaches age 21 the ownership of the lawn care company no longer is attributed to the manufacturing company owner, and the two entities will cease to be treated as a controlled group -- and as a single "employer" for PPACA purposes.

How Controlled Group Rules Can Make a Difference: An Illustration

A restaurant chain, currently operating 100 restaurants, is operated by a corporate "parent" entity which employs 100 full-time employees (executives, finance and accounting employees, marketing employees, commissary employees, etc.). To function properly, each restaurant unit needs a staff of 12 full-time employees (managers, a head chef, supervisors, etc.) and 50 part-time employees (shift cooks, waiters, etc.). If ownership of the restaurant chain is structured so that the corporate parent franchises each of the restaurants to separate, independent franchisees, the corporate parent and each restaurant unit is treated as a separate "employer" for PPACA purposes. This may enable many or all of the restaurants to avoid the employer mandate (assuming that most could avoid regularly employing 50 or more full-time employees or full-time equivalent employees by monitoring their part-time employees' hours), even if the corporate parent on January 1, 2014 must offer affordable health care coverage providing minimum essential health benefits to its 100 full-time employees and their dependents to avoid paying a $140,000 annual non-deductible penalty. Each restaurant unit also may be able to purchase its own community-rated health insurance on one of PPACA's new health insurance exchanges. Depending on staffing and income levels, it might even be possible for some of the units to qualify for the tax credit available to truly small employers.

Conversely, if the corporate parent owns, outright, 99 of the restaurant units, and the one remaining unit is 45% owned by the corporate parent, 45% owned by a local investor and 10% owned by the on-site general manager, the 99 restaurants (but not the independently-owned unit) would be considered to comprise a controlled group along with the corporate parent -- and the choice gets much more costly and difficult. Under that scenario, on January 1, 2014, that restaurant chain must choose between offering affordable health care coverage providing minimum essential health benefits to all full-time employees of the 99 restaurants and the corporate parent (1,288 employees) and their respective dependents, or not offer coverage and pay a $2,516,000 annual non-deductible penalty - and risk losing its best people to competitors. And if the chain does offer the coverage, it must automatically enroll full-time employees into its group health care plan as soon as they become eligible. (The remaining unit would not be part of the controlled group, and likely could avoid (among other things) PPACA's employer mandate.)

Not For Profit Entities and Governmental Entities

Non-profit entities also are subject to the controlled group rules -- thus potentially causing many non-profits to be subject to more of the new PPACA requirements than they may think. While not all non-profit organizations are capable of being "owned" (typically, non-profit entities do not issue stock or other forms of ownership; they frequently are just controlled by their "members"), that distinction does not matter. Regulations issued under Code Section 414 specifically address how the controlled group rules apply to tax-exempt organizations (with special carve-outs and other rules for churches and church-affiliated organizations) by substituting the right to "control" for ownership, and looking at who has the right to elect or appoint (and remove) the tax-exempt organization's trustees or directors.

Consider a private university that funds and operates a non-profit small-business incubator being managed by a handful of the university's professors. The incubator may employ only a small handful of employees, such as a full-time office administrator and a few other staff members, but when that incubator's staff is added to the university's total number of employees, all of PPACA's "large employer" rules kick in: the incubator would be subject to PPACA's employer mandate requirement, the automatic enrollment rule would apply if the incubator did offer coverage to its full-time employee(s) and their dependents, and the incubator would not be eligible to shop for community-rated coverage on the new health insurance exchanges (at least, not prior to 2017).
These rules do not just apply to non-profit entities, they also potentially apply, in some form, to governmental entities. However, without further regulatory guidance, it is not clear exactly how the controlled group rules will be made to apply to such governmental entities as municipalities, sewer districts, park districts, villages and townships, many of which even now are considering whether to consolidate or find ways to combine their staffs or enter into shared services arrangements (thus, further blurring the lines of who will function as the "employer").

Consequences of Getting it "Wrong"

As the above examples illustrate, a failure to correctly identify the "employer" can cause an organization to not properly understand which PPACA rules apply to that organization, and exactly how those rules apply. And while PPACA has a variety of different rules which apply on a number of different levels, there is a common theme: a small(er) employer is subject to relatively few requirements and actually has a few financial incentives to encourage it to offer coverage; conversely, a large(r) employer is subject to a variety of requirements and potential penalties, and has comparatively little flexibility in what it can do.

The PPACA requirement that by far has received the most attention is the new "employer mandate," and for good reason. The penalties for noncompliance with the employer mandate indeed can be steep. Employers that do not offer health coverage to all their full-time employees and their respective dependents starting on January 1, 2014, must pay an assessable penalty if any of their full-time employees applies for and receives a federal premium tax credit in connection with purchasing coverage on a public health insurance exchange. That penalty is equal to $167 per month ($2,000 per year), multiplied by the total number of the employer's full-time employees, less thirty. (However, if the entity is part of a controlled group, this thiry-employee reduction will be shared ratably among the controlled groups, so that the offending entity's penalty is reduced only by a portion of the thirty.) And when counting the number of full-time employees an employer has for purposes of calculating the penalty, all full-time employees within the controlled group count (if the employer is part of a controlled group). Additionally, employers that do offer coverage to all their full-time employees and their dependents can still be assessed a penalty if the coverage being offered either is unaffordable, fails to provide minimum essential coverage or fails to provide minimum value, if at least one of their full-time employees receives a federal premium tax credit in connection with purchasing coverage on a public health insurance exchange. That assessable penalty is equal to $250 per month ($3,000 per year) for each full-time employee who actually receives the premium tax credit, or if less, the penalty for failing to offer the coverage at all (i.e., the $2,000/full-time employee penalty described above).

Not only are the penalty amounts for failing to satisfy PPACA's employer mandate potentially onerous, but it is far from clear exactly who can and will be held liable for paying those penalty amounts. The statute suggests that the penalty falls on the "person" that failed to satisfy the mandate, but exactly who that "person" is (or, could be) is not likely to be known until regulations are issued. There may even be circumstances under which individual officers or directors could be held liable for the indicated penalty. Again, how these penalty provisions will apply -- and to whom they will apply -- will only be truly known after regulations are issued by the U.S. Treasury Department.

While the employer mandate requirements dominate discussion, it nonetheless pays to not overlook all of the other PPACA requirements, each of which can have potentially significant economic consequences. For example, Treasury officials have signaled that a violation of the new non-discrimination rules for insured coverage could trigger a penalty of $100 per day for each non-highly compensated employee who receives coverage that is less favorable. And future regulations, to be released by the U.S. Department of Labor regarding PPACA's automatic enrollment provisions, may impose substantial penalties for noncompliance. Only time will tell whether these penalties will rival in size and importance those slated to be imposed for failing to comply with PPACA's employer mandate rules, but they clearly are influenced by employer size. As such, they bear watching by any organization whose size may be understated due to a misperception of the controlled group rules.


Without careful planning and examination of an organization's ownership structure (or in some cases, how it is controlled), some employers, namely those who are part of a group of commonly-owned or commonly-controlled organizations related entities, may unknowingly find themselves subject to PPACA's employer mandate, or be unable to shop for community-rated, insured group coverage on one of the new public health insurance exchanges, or be subject to a variety of new and unwelcome PPACA requirements. Nonetheless, with careful planning, an employing organization may be able to avoid, or at least minimize, the impact the controlled group rules will have on it, and on its responsibilities under PPACA. In a future Alert (Part 2 of this particular article), we will examine which workers and service providers count as "employees" for purposes of determining how -- and how heavily -- PPACA's rules apply.

Deborah K. Bracy and John J. McGowan

If you have any questions regarding the articles appearing in this edition of the Executive Alert, please contact John J. McGowan at or 216.861.7475, Jennifer A. Mills at or 216.861.7874 or Deborah K. Bracy at or 216.861.7354.

Special thanks go to summer associate Emily Myers for having helped with this Executive Alert.

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