Question 19: Under what circumstances can a tax exempt organization be under common control with another entity?
Answer: That is an outstanding question, to which the IRS does not have an answer. That is a shame, because the correct answer is fairly obvious, at least under the law as it stands today.
For the time being, the IRS has decreed that "a reasonable, good-faith interpretation" of the controlled group and common control rules, as they applied to tax-exempt organizations and governmental entities, will be accepted. (Ann. 95-48.) The IRS has also said that any guidance they do give will be prospective only and not effective for plan years beginning before 2001. (Ann. 96-64.) Obviously, at the moment this issue is not a high priority.
That, of course, leaves employers with the question of what constitutes a reasonable, good-faith interpretation. Let us suggest two possibilities. The first comes from IRS private letter rulings and related materials. The second comes from reading the Code and Regulations.
In 1987, some tax-exempt organizations came on bended knee to the IRS seeking a private letter ruling. They had been filing a single form 5500 for years, and realized with horror that if they were not under common control, then they were delinquent for many returns. The problem was that most of the entities did not have "owners." That is the nature of charitable organizations. However, they had interlocking directors, with one organization having the power to choose directors in others.
The IRS accommodated them. Not finding a definition of "control" in the 414 regulations that dealt with the situation, they started looking at totally unrelated Code provisions. They found a definition that is used in the IRC 512 regulations on a completely separate topic:
In the case of a nonstock organization, the term "control" means that at least 80 percent of the directors or trustees of such organization are either representatives of or directly or indirectly controlled by an exempt organization. A trustee or director is a representative of an exempt organization if he is a trustee, director, agent, or employee of such exempt organization. A trustee or director is controlled by an exempt organization if such organization has the power to remove such trustee or director and designate a new trustee or director.
Under this rationale, the Code and Regulations requirements of ownership were replaced with the ability to appoint the Board. (GCM 39616, PLR 8702063.) This has been followed in subsequent rulings. (PLR 9722039 and 9629033.) An exempt organization that wishes to find itself under common control can doubtless follow these rulings secure in the knowledge that they will be found by the IRS to represent a reasonable, good-faith interpretation of the statute.
There is really only one problem with the rulings. In my opinion, these rulings are not, in fact, reasonable interpretations of 414(c). Why?
1. IRC 414(c) only applies to trades or businesses. It is questionable whether a tax-exempt organization as such or a governmental entity is a trade or business.
2. Perhaps more important, IRC §414(c) instructs the IRS to write regulations to define groups under common control on the same principles as controlled groups, which are clearly based on stock ownership. The IRS has done so, and done so well. Interlocking directorates are not the same as stock ownership, and the IRC §414(c) regulations are correct not to combine the two. For the Treasury to ignore its own regulations, and pull another statute out of the air to justify its rulings, is suspect.
Of course, it would be easy for the IRS to write regulations addressing this issue. They have the authority to do so under IRC 414(o). If the IRS wrote and finalized regulations under that section dealing with tax-exempt organizations, there would be no question at all of their validity.
In my view, it is a reasonable good-faith interpretation of the Code and Regulations as they now stand for a group of tax-exempt entities or governmental units, which are not a controlled group, to say that they are not under common control. Without ownership, there cannot be control under the IRC 414(c) regulations. Without trades or businesses, there is no group of trades or businesses under common control.
Since the IRS has said taxpayers can use any reasonable, good-faith interpretation until they give us guidance, organizations wishing to find they are under common control can use the reasoning of the private letter rulings cited earlier. Those who wish to be separate can use my reasoning above. Consider the following examples:
Church and Day School. A tax exempt church organizes a day school as a separate charitable trust. It provides the initial funding for the school. The church chooses the trustees of the school. Under the IRS private letter rulings, the church and the school would be under common control. Under my analysis they would not, because the church does not own the school and because it is uncertain whether the church is a trade or business.
Parental Control. Same facts as the prior example, except the church selects 3 of the 5 trustees and the remaining 2 trustees are elected by the parents who send their children to the school. The church does not control 80% of the trustees and so the IRS private letter rulings would not apply. If they wanted to argue that they were under common control, perhaps they could argue that the school's initial financing by the church would substitute for ownership of "value of outstanding shares."
City and Hospital. An incorporated city organizes a tax-exempt hospital. The city council chooses the directors of the hospital. Under the IRS private rulings the two would be under common control. However, since the IRS allows any reasonable, good faith interpretation of the law pending their formal guidance, the city could argue that they do not own the hospital and hence the two are not under common control.
There are circumstances where under any interpretation a tax-exempt organization might be part of a controlled group. For example:
Charity and Business. Mercy Hospital, Inc. an IRC 501(c)(3) tax exempt corporation, owns 100% of the stock of High Price Clinic. It uses the profits from the clinic to finance its charitable services. The hospital and the clinic are a parent-subsidiary controlled group under IRC §414(b). A corporation does not need to have a trade or business in order to be part of a controlled group (although running a hospital probably would be treated as a business, whether it was done for a profit or not).
This material is drawm from Q12:9 of my book Who's the Employer?