Question 270: What do you think of the new IRS proposed regulations on common control and tax-exempt entities?
Answer: I am delighted to see the IRS addressing an issue which has long needed formal guidance. Let me deal with the issues in a question and answer format. In doing so, I should note that my focus is the proposed 414(c) regulation, not the 403(b) issues (which make up the bulk of the proposal).
1. What's the background on this issue?
There has been no solid public guidance on common control issues affecting tax-exempt entities. In fact, in 1995 the IRS issued Notice 95-48, which said that until we heard otherwise, the IRS would accept a taxpayer’s “reasonable, good-faith interpretation” of the controlled group and common control rules as they relate to tax-exempt and government organizations. So the issue has been in a sort of legal limbo for 9 years.
Why is the issue so difficult? IRC §414(b) and (c), the controlled group and common control rules, refer to ownership. Because nobody "owns" a tax-exempt entity, the rules do not seem apply to tax-exempt entities. IRS regulations under IRC §414(c) up until now have not addressed the issue.
Privately, the IRS has issued a series of rulings on tax-exempt entities. In GCM 39616, the IRS takes the position, based on other regulations outside of the pension sections of the Code, that control of the board of a tax-exempt is equivalent to ownership of the tax-exempt entity. If Charity 1 can appoint 80% or more of the directors on the board of Charity 2, then the two would be under common control. Subsequent private letter rulings have followed this result.
In the past, I have noted that these rulings go outside the parameters of the law as it presently stands. I have previously written:
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. For that matter, a Court would likely uphold them if they were to incorporate those regulations directly into the IRC §414(c) regulations. But they have not done so and are limited to what they have done.
I hasten to say that the IRS has addressed my concerns by issuing these proposed regulations under authority of IRC §414(c) and (o). There is no question about the IRS authority to issue these proposals.
2. To what organizations do the new proposed regulations apply?
The proposed regulations apply to organizations described in IRC §501. This includes not only the familiar IRC §501(c)(3) charities, but also includes civic and business leagues, social clubs, fraternal societies, and credit unions. The regulation has only limited application to churches and church controlled organizations, as defined in IRC §3121(w)(3).
The new regulations do not apply to government organizations. Apparently, those still are under the good-faith standard of Notice 95-48.
3. How do the new rules change the definition of a group under common control?
The new rules have 4 main parts: (a) mandatory aggregation, (b) voluntary aggregation, (c) voluntary disaggregation, and (d) a “catch-all.”
The mandatory aggregation rules essentially follow the old GCM. Common control exists between two exempt organizations if at least 80% of the directors or trustees of one of the organizations are either representatives of, or are controlled directly or indirectly by, the other. A director is a representative of another organization if the director is a trustee, director, agent or employee of the other organization. An organization controls a director if the organization has the power to remove that director and appoint another in his or her stead. Other facts and circumstances might indicate control.
The proposed regulations give the example of three exempt corporations: A, B, and D. Corporation B owns 100% of the stock of taxable Corporation C, which puts B and C in a controlled group under existing rules. A has the power to appoint or otherwise control at least 80% of the boards of B and D. Hence A, B, C and D are considered a single employer.
The proposed regulations introduce a concept totally new to the controlled group/ASG arena: permissive aggregation. Until now, status as a single employer has been determined solely by reference to the facts of the case. The employer’s wishes had nothing to do with it. Under the proposed regulations, however, exempt organizations that cosponsor a single plan can choose to treat themselves as being under common control if the organizations coordinate their day-to-day activities. Such a plan can either be a single-employer plan under IRC §414(c), or a multiple employer plan under IRC §413(c), at the choice of the employers involved. The proposals do not indicate how the employers make this choice, but the annual Form 5500 filing certainly could manifest the decision.
As for permissive disaggregation (another new concept), the proposed regulations provide that an IRC §414(e) church plan can disaggregate church and non-church entities that would otherwise be under common control.
Finally, the catch-all in the proposed regulations gives the IRS authority to treat two entities (at least one of which is tax-exempt) as being under common control if the structure of those entities is designed to avoid or evade common control treatment.
4. When do the new rules go into effect?
The new rules are proposed to be effective for years beginning after 2005 (e.g., the 2006 calendar year or taxable years beginning in 2006). Given the broad scope of the regulations, it would be good for the IRS to amend the effective date clause to expressly consider limitation years and plan years as well as taxable years.
5. What happens in the meantime?
The word “rely” does not appear anywhere in the 102 pages of proposal. In other words, we cannot rely on the proposed regulations until they are finalized. But I am confident that the IRS would view a plan which followed the proposed regulations as adopting a reasonable, good-faith interpretation of the law.
6. What plans are affected by the new rules?
IRC §414(c) cuts a broad swath through the benefits sections of the Code. The following would all be subject to the new regulation:
- Qualified plans
- The nondiscrimination rules of 403(b) arrangements
- SIMPLE IRA arrangements
- Cafeteria plans
- Other benefit programs listed in Code §414(t)
See Chapter 12 of my book, Who's the Employer, for more information on the common control rules.