Implementation of the Affordable Care Act (“ACA”) continues at an accelerated pace. Some of its most important provisions for employers are scheduled to take effect in January 2014. With the force of these provisions now less than a year away, employers need to understand their impact and begin to prepare now to comply with the new requirements. The article focuses on one particular aspect of the ACA’s audit implication on private investment funds.
In deciding whether to offer health insurance coverage to its employees, an employer must determine whether it is subject to the penalties imposed by ACA’s employer responsibility provisions. If subject to the penalties, the employer should calculate (i) the penalty it could face if it chooses not to offer coverage, as compared to (ii) the cost of offering health coverage to employees, discounted by the value generated by providing the coverage in the form of its wage effects and its impact on employee health and satisfaction.
The ACA imposes penalties only on employers with 50 or more full-time equivalent employees. To calculate full-time equivalent employees, employers must use the following formula:
Number of full time employees + (Sum of hours worked by each part-time employee in a month (up to 120 hours/employee)/120)
If this sum is equal to 50 or greater, a company will be subject to penalties if both (i) it does not offer health coverage AND (ii) any one of its full-time employees receives a federal premium tax credit to purchase coverage on an exchange. For example, for an employer with 45 full-time employees, and 20 part-time employees, each of whom works 110 hours per month, the number of full-time equivalent employees would be 45 + (2200/120), or 63.3. Because the employer’s number of full-time equivalents exceeds 50, the employer would be an applicable large employer and would face penalties if any of its full-time employees receives a federal premium tax credit, even though it employs fewer than 50 full-time employees.
In calculating your number of full-time equivalent employees, be aware that the sum must include the employees of all entities in a “controlled group,” as defined by Internal Revenue Code section 414. Your company may, therefore, be considered a large employer based on not only your employees but also the employees of your related entities. Section 414 defines controlled groups based on three types of relationships:
A controlled group exists based on a parent-subsidiary relationship when a parent organization owns 80 percent or more of the equity in a subsidiary. If your company owns 80 percent or more of the equity in another company, that company’s employees will count toward your number of full-time equivalent employees for the purposes of determining large employer status. Further, if that subsidiary owns 80 percent or more of the equity in another company or companies, those companies’ employees must also be included within your controlled group.
A controlled group exists based on a brother-sister relationship when the same five or fewer people, who must be individuals, trusts, or estates, together own at least 80 percent of the equity in each of two organizations and at least 50 percent of the ownership of the organizations is identical. For instance, three individuals, A, B, and C, might own stock in two companies, Y and Z. Y and Z are members of a controlled group if A, B, and C collectively own 80 percent of each company and at least 50 percent of the ownership of the companies is identical. If A owns 20 percent of Y and five percent of Z, B owns 10 percent of Y and 20 percent of Z, and C owns 50 percent of Y and 60 percent of Z, Y and Z are members of a controlled group. A, B, and C collectively own 80 percent of Y and 85 percent of Z. Additionally, 65 percent of the ownership of Y and Z are identical – A’s five percent interest in Z is mirrored in Y, B’s 10 percent interest in Y is mirrored in Z, and C’s 50 percent interest in Y is mirrored in Z. If, however, B and C’s ownership interests are different, such that B owns 10 percent of Y and 60 percent of Z and C owns 50 percent of Y and 20 percent of Z, Y and Z would not be members of a controlled group. Though A, B, and C would still collectively own 80 percent of both Y and Z, there would be only 35 percent identical ownership between the two companies.
A controlled group also exists in the case of an “affiliated service group,” where several service organizations regularly collaborate in the services they provide and are linked by at least 10 percent cross-ownership.
How do the “controlled group” tests impact private investment funds?
This “controlled group” analysis is especially critical when examining whether private investment funds and their individual portfolio company investments are subject to the penalties imposed by ACA. Based on the first of the above described relationship tests – the parent/subsidiary relationship – to the extent that any private investment fund owns at least 80 percent of the equity in a portfolio company, that private investment fund will technically be aggregated with that portfolio company as part of a controlled group and prospectively subject to the penalties imposed by ACA. However, private investment funds themselves (whether formed as limited partnerships, limited liability companies, offshore corporations or otherwise) generally do not actually have employees since they are only pools of capital, and those who manage (i.e., “work for”) a private investment fund are employed by the fund’s sponsor and/or investment manager, which is a separate entity that does not, itself, have an ownership interest in the portfolio company under normal circumstances. Accordingly, to the extent a portfolio company has 50 or more full-time employees and a private investment fund with no employees owns at least 80 percent of the equity of that portfolio company, the private investment fund would be considered a large employer under the parent/subsidiary relationship test, but is not likely to be subject to penalties under ACA (the result may be different, however, in the rare case of a private investment fund that actually has employees).
Nonetheless, there may be other consequences to a private investment fund that would impact its bottom line from an economic standpoint. For example, if any of its portfolio companies acquired other companies, the same controlled group analysis using the parent/subsidiary relationship test would be applied in connection with those acquisitions. As a result, a private investment fund could be aggregated with the subsidiaries of its portfolio companies if the 80 percent equity ownership threshold is met in relation to the acquired subsidiaries. Any penalties imposed on the portfolio companies and their subsidiaries under ACA could, therefore, have a negative impact on the private investment fund’s returns.
Another important consideration occurs in the case of many different portfolio companies that are commonly owned by a single investment fund and whether these different portfolio companies would be aggregated to create a controlled group. In this case, the brother-sister relationship test may be applicable, depending on the ultimate ownership of the fund. The requirement for the brother-sister test is that the common owners must be individuals, trusts or estates and that the same five or fewer people own at least 80 percent of each organization (with at least 50 percent ownership being identical). The only way to trigger this test in the investment fund context would require a “look through” to the ultimate ownership of the investment fund. The rules are not abundantly clear in describing circumstances as to when such a look-through would be imposed. To the extent that such a look-through were indeed prescribed, the nature and character of the investment fund’s investors would need to be carefully examined. Accordingly, a private investment fund having an ownership structure that lines up with the test imposed by the brother-sister test (i.e., five or fewer individuals, trusts or estates holding greater than 80 percent of the investment fund with at least 50 percent ownership being identical) should carefully analyze this rule with its legal counsel. Alternatively, the typical private investment fund that has an investor base consisting of several public and private pensions and other institutional investors should not be captured by the brother-sister relationship test. Given the critical nature of this issue, however, it is highly recommended that all private investment funds consult with legal counsel in order to analyze the application of this rule to their unique circumstances.
For a more detailed analysis of the ACA, including a discussion of required coverage amounts, penalty calculations, eligible employees and tax implications, please see the Patton Boggs Client Alert dated March 26, 2013. That Alert can be found here.