CONTROLLED GROUP RULES FOR TAX-EXEMPT ORGANIZATIONS Danny Miller Erica Summers Conner & Winters, LLP 1627 I Street, N.W. Suite 900 Washington, D.C. 202-887-5711 (800) 579-0811 Controlled Group Rules for Tax-Exempt Organizations Danny Miller and Erica Summers Conner & Winters, LLP Washington, D.C. This outline discusses the controlled group rules as they apply to tax-exempt organizations for employee benefit purposes. The outline first discusses IRS guidance on this subject leading up to the promulgation of a set of final regulations under section 414(c) of the Internal Revenue Code of 1986, as amended (“Code”), which were issued in July 2007. The outline then provides an overview of these final regulations. 1. Statutory Provisions: On their face, Code sections 414(b) and 414(c) have no application to not-for-profit, non-stock entities. • “Controlled group of corporations” – the controlled group determination under Code section 414(b) is based on ownership of at least 80% of the corporation’s stock. • “Two or more trades or businesses under common control” – the controlled group determination under Code section 414(c) is based on ownership of 80% of stock interest, organization profits, capital interest or actuarial interest 2. Pre-2009 Regulations. The controlled group regulations under Code section 414(c) that are currently in effect also do not cover not-for-profit, non-stock entities on their face. 1 3. Existing Guidance for Tax-Exempt Organizations • Private Letter Ruling 8702063 (Oct. 16, 1986). IRS concluded that, in the case of non-stock, nonprofit organizations, an entity has effective control of another organization if at least 80 percent of its trustees or directors are either representatives of, or directly or indirectly controlled by, such entity. A trustee or director is deemed to be a representative of the controlling entity if such entity has the power to remove the trustee or director and to designate a new trustee or director. • Gen. Couns. Memo 39616 (Mar. 12, 1987). This GCM was issued concurrently with the above letter ruling and reaches the same conclusion. • Notice 89-23, 1989-1 C.B. 654. The nondiscrimination safe harbors described in Notice 89-23 include a controlled group rule. Under this Notice, the controlled group of a contributing employer includes: o any entity of which at least 80% of the directors, trustees or other individual members of the entity’s governing body are either 1 As discussed in paragraph 4 below, recently-issued controlled group regulations that cover tax-exempt entities will become effective January 1, 2009. These new regulations are an add-on to the current regulations under Code section 414(c). representatives of or directly or indirectly control, or are controlled by, the contributing employer; and o any entity that provides directly or indirectly at least 80% of the contributing employer’s operating funds, if there is a degree of common management or supervision between the entities. (Note: Under Notice 89-23, a degree of common management or supervision is said to exist if the entity providing the operating funds has the power to appoint or nominate officers, senior management or members of the board of directors (or other governing board) of the entity receiving the funds. A degree of common management or supervision is also said to exist if the entity providing the funds is involved in the day-to-day operations of the second entity.) • 4. Notice 96-64, 1996-2 C.B. 229. “Until further guidance is issued, governments and tax-exempt organizations (including churches) may apply a reasonable, good faith interpretation of existing law in determining which entities must be aggregated under section 414(b) and (c). Any further guidance will be applied on a prospective basis only and will not be effective before plan years beginning in 2001.” Final Controlled Group Regulations. On July 26, 2007, the IRS issued final regulations under Code section 414(c) regarding controlled group rules for taxexempt entities.2 These rules are effective for plan years beginning after December 31, 2008 and apply to qualified 401(a) plans, 403(b) plans, and various welfare benefit plans. The regulations specifically provide that they do not apply to either churches or qualified church-controlled organizations (“QCCOs”). However, these rules do cover non-QCCOs.3 • Basic Rule. Tax-exempt organizations are considered to be under common control if 80% of the directors or trustees of one 501(c)(3) organization either are representatives of, or are directly or indirectly controlled by, another exempt organization. A trustee or director is treated as a representative of another exempt organization if he or she is also a trustee, director, agent or employee of the other exempt organization. A trustee or director is controlled by another organization if the other organization has the “general power to remove such trustee or director and designate a new trustee or director.” The 2 The final regulations are substantially the same as proposed regulations under Code section 414(c) which were issued on November 16, 2004. 3 A non-QCCO is generally a church-controlled organization that both offers goods, services, or facilities for sale to the general public, other than those sold at a nominal charge, and normally receives more than 25 percent of its support from either governmental sources or receipts from admissions, sales of merchandise, performance of services, or furnishing of facilities. Examples of non-QCCOs are church-related universities, colleges, hospitals and nursing homes open for attendance or admission to the general public. 2 regulations provide that whether a person has the power to remove or designate a trustee or director is based on facts and circumstances. • Permissive Aggregation. Tax-exempt organizations can choose to be aggregated and treated as a “single employer for all purposes for which section 414(c) applies” if they maintain a plan4 covering one or more employees from each organization and if the organizations regularly coordinate their day-to-day exempt activities. Treas. Reg. § 1.414(c)-5(c). The final regulations do not define what constitutes regular coordination of day-to-day activities. However, they do indicate, as an example of “permissive aggregation,” that a tax-exempt hospital and another tax-exempt organization with which the hospital coordinates the delivery of medical services or medical research can treat themselves as under common control if their employees participate in a single plan5 and if the coordination is part of their regular activities. • Permissive Disaggregation for Church Plans. In the case of a church plan receiving contributions from more than one entity, at least one of which is a non-QCCO, the employers that would be treated as members of a controlled group under the basic rule may be disaggregated so that non-QCCOs are treated separately from churches and QCCOs (to which the section 414(c) controlled group rules do not apply). Treas. Reg. § 1.414(c)-5(d). The final regulations provide an example of a group of entities which includes a church, a secondary school, and several church-related nursing homes.6 The final regulations provide that the nursing homes may treat themselves as being under common control with each other, but not as being under common control with the church and the school, even though the nursing homes would 4 The final section 414(c) regulations differ from the proposed regulations on this point in that the proposed regulations indicated that the permissive aggregation rules applied to taxexempt organizations that maintain a “single plan,” while the final regulations provide that the permissive aggregation rules apply to tax-exempt organizations that maintain “a plan to which section 414(c) applies.” It appears that this change is intended to clarify that these permissive aggregation rules apply with respect to all types of plans subject to the 414(c) rules (i.e., not just retirement plans, but certain welfare plans as well). 5 Note: Although as discussed in footnote 4, supra, the final regulations eliminated the term “single plan” in describing the permissive disaggregation rule, the example in the final regulations continues to use the term “single plan.” We believe that this usage was probably an oversight. 6 This example in the final regulations differs from the one used in the proposed regulations. The proposed regulations included an example of a church, a secondary school and a single church-related nursing home. In the final regulations, the single nursing home has been changed to “several” nursing homes. Although it is not clear what the intent was in making this change, this provision could be interpreted to mean that, in a situation in which a church controls multiple non-QCCOs (through the power to appoint and remove directors or trustees), those nonQCCOs will be treated as being in the same controlled group. 3 be under common control with the church and school under the basic rule described above.7 • Anti-Abuse Provision. The controlled group regulations also include an antiabuse rule which allows the IRS to treat an entity as under common control with an exempt organization if it “determines that the structure of one or more exempt organizations . . . or the positions taken by those organizations has the effect of avoiding or evading . . . [a] requirement under section 401(a).” Treas. Reg. § 1.414(c)-5(f). Query: Do any controlled group rules apply to “steeples” and QCCOs? As discussed above, the final regulations specifically state that they do not apply to churches or QCCOs. However, the final section 414(c) regulations specifically reserve a section to allow room for any future regulations regarding the application of the controlled group rules to churches and QCCOs. In addition, the preamble to the final regulations states that “the Notice 89-23 good faith reasonable standard will continue to apply to . . . certain church entities” for determining the controlled group, thus suggesting that churches and QCCOs continue to be subject to these rules.8 In Revenue Procedure 2007-71, 2007-51 I.R.B. 1184, the IRS indicated that governmental plans and church plans must apply a reasonable, good faith standard in applying controlled group rules to their respective plans, “taking into account the special rules applicable under IRS Notice 89-23 . . . .” 5. Special Church Aggregation Rule. Code section 415(c)(7) provides that all years of service as an employee of a church or a convention or association of churches, or with an employer controlled by or associated with a church or convention or association of churches, is considered as years of service for one employer. In addition, all amounts contributed for annuity contracts by each such church (or convention or association of churches) are treated as having been contributed by one employer. Note: This service aggregation rule is contained in Code section 415 and, therefore, under a literal reading of the statute, is not technically applicable to the determination of service aggregation under other sections of the Code. However, the final regulations under Code section 403(b) specifically state that this special church service aggregation rule applies for purposes of determining whether 7 The final regulations could be construed to authorize permissive disaggregation only to the extent that the different church entities are participating in one plan. Thus, the regulations could be read not to allow permissive disaggregation in the case of a non-QCCO and a related church that each maintains its own retirement plan. For example, a non-QCCO would not have to be aggregated with a convention of churches that appoints 80% or more of its trustees if the nonQCCO participates in the 403(b) plan sponsored by the convention. But if the same non-QCCO established its own separate 403(b) plan, the regulations do not appear to permit such disaggregation. 8 In another place, the preamble indicates that churches and QCCOs can rely on the rules in Notice 89-23 for purposes of determining controlled groups, thus suggesting that churches and QCCOs can choose whether or not to apply these rules. 4 a participant has completed 15 years of service so that he/she is eligible to make the special “catch-up” contributions permitted under Code section 402(g)(7). 6. Application of Controlled Group Rules – Retirement Plan Issues: All non-profit organizations within the same controlled group are treated as one employer for the following purposes:9 7. • Nondiscrimination and coverage testing for all 401(a) plans sponsored by churches, QCCOs and non-QCCOs. • Nondiscrimination and coverage testing for 403(b) plans sponsored by nonQCCOs. • Code section 415 limitations. The employer aggregation rules of Treasury Regulation sections 1.415(a)-1(f)(1) and (2) provide that a plan maintained by any member of a controlled group of employers or an affiliated service group is deemed to be maintained by all members of the group for purposes of the Code section 415 limitation on contributions and benefit accruals. • Definition of highly compensated employee. Code section 414(q)(7) provides that the controlled group rules of Code section 414(b) and 414(c) apply “before the application of this subsection.” • Code section 401(a)(9) minimum distribution requirements. • Code section 402(g)(7) catch-up contribution rules. • Severance from employment?10 Application of Controlled Group Rules –Welfare Plan Issues: • Code section 105(h) provides that the nondiscrimination rules applicable to accident and health plans apply on a controlled group basis, and specifically refers to Code section 414(c). • Code section 414(t) provides that all employees who are treated as employees of a single employer within the meaning of Code section 414(b), 414(c) or 9 The final nonprofit 414(c) controlled group regulations also apply for purposes of the affiliated service group, employer aggregation rules contained in Code section 414(m), although it is not clear exactly how they would apply in this situation. 10 The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) amended the Code to substitute the term “severance from employment” for “separation of service” in certain sections of the Code, including those sections that limit distributions of salary reduction contributions made to 403(b) and 401(k) plans. Subsequent IRS guidance suggests that there is no severance from employment where an employee changes jobs and moves from employment with one member of a controlled group to another. See Notice 2002-4, 2002 I.R.B. 298. See also, however, the final section 403(b) regulations, where a transfer from employment with a section 501(c)(3) organization to employment with a related for-profit employer is treated as a severance from employment. 5 414(m) are treated as employees of a single employer for purposes of the following Code provisions: o Group term life insurance (Code section 79).11 o Cafeteria plans (Code section 125). Code section 125(g)(4) specifically provides that the controlled group rules of Code section 414(c) apply. o Accident and health plans. (Code section 106). o Group legal services plans (Code section 120). o Educational assistance programs (Code section 127). o Dependent care assistance plans (Code section 129). o Certain fringe benefits (Code section 132). o VEBAs (Code section 505). o Continuation of coverage requirements in Code section 4980B. Note: The COBRA rules are inapplicable to church plans. • Medicare Secondary Payor Rules (“MSP”) – Medicare is primary for Medicare-eligible employees working for employers with fewer than 20 employees. The MSP rules include their own employer aggregation rule that provides that all employers treated as a single employer under Code section 52 are considered a single employer for purposes of the “under 20 employees” rule. However, the MSP Manual, published by the Centers for Medicare and Medicaid Services provides that religious organizations are not aggregated for MSP purposes. “Incorporated parishes and churches that are part of a churchwide organization, such as a diocese or synod, are considered to be individual employers.”12 • MEWA definition in ERISA applies a “control group” rule.13 Note: This definition would be applicable only to those church plans making the election 11 A “church plan maintained for church employees” is exempt from the group term life insurance nondiscrimination rules. Code § 79(d)(7)(A). However, under Code section 72(d)(7)(B), the definition of “church employee” does not include employees of educational institutions above the secondary school level (except for schools for religious training) or employees of any organization, the principal purpose of which is providing medical or hospital care. Code § 170(b)(1)(A)(ii). Thus, the exemption from the Code § 79 nondiscrimination provisions generally is not applicable to many non-QCCOs (including church-related universities, hospitals and nursing homes). 12 Medicare Secondary Payer Manual, Chapter 1, § 60. 13 The MEWA definition in ERISA applies the controlled group rules of ERISA section 4001(b). ERISA section 4001(b), in turn, cross-references the controlled group rules in Code section 414(c). 6 provided to nonprofit employers under Code section 410(d) to be subject to ERISA. 8. Other Legal Requirements Where Controlled Group Rules May Apply • FMLA. The Family and Medical Leave Act requires employers to provide employees with up to 12 weeks of unpaid leave to care for a newborn or a family member with a serious health condition (or the employee’s own serious health condition). The FMLA applies to employers with 50 or more employees within a 75-mile radius of the worksite. The FMLA does not specifically refer to Code section 414(c), nor does it apply any controlled group-type concept in determining which employers are covered under its provisions. However, Department of Labor regulations under the FMLA provide that separate entities will be deemed to be part of a single employer if they meet the "integrated employer" test. This test basically involves a facts and circumstances determination, based on the following four factors: (1) common management; (2) interrelation between operations; (3) de-centralized control of labor relations; and (4) degree of common ownership/financial control.14 • ADEA. The Age Discrimination in Employment Act applies to employers with 20 or more individuals and prevents employment-related discrimination based on age. The ADEA also does not refer to Code section 414(c) or make any reference to a controlled group concept in its definition of covered employer. However, there is some case law that suggests that the DOL “integrated employer” test applied under the FMLA may be applicable. • ADA. The Americans with Disabilities Act, which prohibits disability-based discrimination in employment, applies to employers with 15 or more employees. The ADA also does not use a controlled group concept in its definition of covered employer. However, as in the case of the ADEA, there is some case law that suggests that the DOL “integrated employer” test applied under the FMLA may be applicable. 14 The DOL regulations do not provide any additional guidance on the definition of any of these four factors. However, it appears that a mere parent-subsidiary relationship is not sufficient to establish that two employing entities should be viewed as one single employer. Rather, there needs to be some true interrelationship of operations. 7