Answer: This is the first of three columns that will address the new 415 regulations and the sometimes surprising impact they have on employee and related-employer issues. This column considers the regulations’ clearly erroneous application of Code §415(h). Subsequent columns will consider the regulations’ position on predecessor employers and the new post-severance compensation guidelines.
Code §415(h) is one of the most frequently misunderstood provisions in the Code, even though it is quite short: "For purposes of applying subsections (b) and (c) of section 414 to this section, the phrase 'more than 50 percent' shall be substituted for the phrase ‘at least 80 percent’ each place it appears in section 1563(a)(1)."
Code §1563(a) defines a controlled group. Code §1563(a)(1) defines a parent-subsidiary controlled group, while Code §1563(a)(2) defines a brother-sister controlled group. For qualified plan purposes, Code §1563(f)(5) now modifies that latter definition.
Normally a simple parent-subsidiary group exists if a parent owns at least 80% of a subsidiary. But thanks to Code §415(h), for 415 purposes two corporations are a single business if the parent owns more than 50% of the subsidiary. Thanks to the citation of 414(c), the rule would apply to other types of businesses, such as partnerships, as well. All this is unambiguous and well-understood.
What is more poorly understood, perhaps because people don’t bother to follow the Code references, is that 415(h) does not apply to brother-sister groups at all. If Congress had wanted the rules to apply to brother-sister groups, 415(h) would have cited 1563(a). It did not. Code §415(h) only modifies 1563(a)(1). So a brother-sister group must satisfy both the 80% controlling interest test and the 50%+ effective control test. Let me illustrate this with two examples.
Example 1. Corporation P owns 60% of Corporation S. The two corporations are not a controlled group for tax purposes or for most plan purposes. But they are a controlled group for 415. So if Sue participates in P’s profit sharing plan and S’s 401(k) plan, her total annual additions between the two cannot exceed $42,000 in 2005. The result should not be different if S is a partnership rather than a corporation.
Example 2. Jon owns 100% of Corporation J and 60% of Corporation K. The two corporations are not a controlled group for any purposes related to qualified plans, including Code §415, because Jon does not own at least 80% of K. (See Code §1563(a)(2)(A) as modified by Code §1563(f)(5)(A).) So Jon can receive a $42,000 allocation in the J plan and a $42,000 allocation in the K plan in 2005 without violating 415. (However, thanks to last year’s JOBS bill, J and K are a controlled group for ordinary income tax purposes.)
What does all this have to do with the newly proposed 415 regulations? Well, while the authors of the regulations have generally done a good job at thinking through the issues and bringing the rules up to date (although the defined benefit community has some bones to pick with the IRS), someone in Washington blew it here.
Here’s what the proposed regulations say: “Pursuant to section 415(h), for purposes of section 415, sections 414(b) and 414(c) are applied by using the phrase 'more than 50 percent' instead of the phrase 'at least 80 percent' each place the latter phrase appears in section 1563(a)(1), in §1.414(c)-2, and in §1.414(c)-5.”
The IRS got it right in dealing with controlled groups. That was the easy part. They just had to quote the statute. But to deal properly with common control, they had to actually understand the statute, and it looks like someone was asleep at the switch.
Let’s talk about the two regulations they cite, starting with the second. Reg. §1.414(c)-5 is the new proposed regulation on common control with tax exempt organizations. That section, once finalized, would provide that two tax-exempts are under common control if 80% of the directors or trustees of one organization are representatives of or are controlled by the other organization. Click here for more information. By citing that provision here, the IRS would drop that to a majority control test for 415 purposes. I have no quarrel with that. The Service invoked 414(o) for the 414(c) regulation, which lets them write their own laws in this area. Besides, it’s a reasonable choice.
But the problem comes with Reg. §1.414(c)-2, which defines groups of trades or businesses under common control. It defines both parent-subsidiary groups and brother-sister groups. By applying the 415(h) modification to the whole regulation, the proposal goes well beyond the statute. It also creates the bizarre situation that for controlled group purposes, the 80% test applies for qualified plan rules (including 415), but the 80% test does not apply for common control groups under 415.
The inconsistency is senseless and is evidence to me that a mistake was made. There are 165 pages of section 415 regulations (talk about a need for limitations!), so there were bound to be some blunders. That’s one reason we have a comment period for proposed regulations. Incidentally, I did submit a formal comment on this issue (in which I was substantially more diplomatic than I am here).
Let me close with a bit of that diplomacy. I think the folks at the IRS National Office are legitimately trying to do it right. These are tough and complex issues. I’m sitting here picking away at one sentence in a mammoth effort on their part. I have little doubt that they will correct this by the time they issue final regulations.
Incidentally, I’ve spent a lot of time with the proposed 415 regulations because I’m doing a webcast for SunGard Corbel on the topic on July 19, complete with an analysis of the other 164 pages and a new Broadway parody. For details, go to their website.