Controlled Group Rules for Tax Exempt Organizations: A Brief Review
Corporate entities under common control are generally treated as a single employer for purposes of applying the core rules that govern employee benefit plans and executive compensation arrangements. For that reason, a complete and accurate controlled group analysis can be critical in determining and monitoring the legal compliance status of a benefit plan. For example, subject to a couple of exceptions, nondiscrimination testing typically must be performed on a controlled group basis. A controlled group analysis is needed to determine whether a retirement plan covering more than one employer is a single employer plan or a multiple employer, and whether a group health plan that covers more than one employer is a single employer plan or a multiple employer welfare arrangement (or MEWA). A controlled group analysis is also critical to identify which members of a group of related entities can be held jointly and severally liable for pension plan underfunding liabilities.
The controlled group rules should be considered any time there have been (or are expected to be) changes in the composition of the group, particularly if a new member organization is added. The rules that govern the determination of control relationships among organizations exempt from tax under Code Section 501(a) – "tax-exempt organizations" – are found in Treasury Regulations Section 1.414(c)-5. Given the pace of change in the tax-exempt world, particularly among local and regional health systems, we think these rules worth revisiting.
Control in the Absence of an Equity Interest
If an organization of any kind owns 80% or more of the outstanding stock of a for-profit corporation, those two entities will be members of a controlled group under the general rules that apply to controlled group determinations. However, among groups of tax-exempt organizations control is more likely to be structured and exercised by means of corporate governance. For that reason, Treasury Regulations Section 1.414(c)-5 provides that common control exists between an exempt organization and another exempt organization if at least 80% of the directors or trustees of one organization are either representatives of, or directly or indirectly controlled by, the other organization. For these purposes, 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. In addition, a trustee or director is considered to be controlled by another organization if the other organization has the general power to appoint and remove the trustee or director.
The power to remove or designate a trustee or director is determined based on facts and circumstances. The presence or absence of appointment and removal powers can generally be determined by reviewing the bylaws of the related organizations. It is not uncommon for health system bylaws to reserve a majority of board appointments to a single parent organization either outright or indirectly. Therefore, in instances where the ultimate parent may have direct authority to appoint less than 80% of the trustees of another exempt organization, it may be necessary to review the actual identities of the board members or other categories of board status to determine whether trustees or directors serving in those other categories may be treated as "representatives" of the parent organization.
Consider, for example, a tax-exempt health care provider with two classes of board members. Under the entity's bylaws, the parent organization of a health system has the authority to appoint all of the Class A members, and the Class A members comprise 70% of the board (i.e., a clear majority but less than the 80% threshold for control). The bylaws also require that at least half of the Class B members – who together comprise the remaining 30% of the board – must be employed clinical department chiefs of the parent entity or otherwise serve in a capacity by which they would be deemed to be "representatives" of the parent. Under those facts, the two organizations likely should be considered under common control even though no member has authority to appoint at least 80% of the board.
The foregoing rules apply in determining common control that is required to be found for purposes of applying the controlled group rules. Treasury Regulations Section 1.414(c)-5 also allows a group of related entities to treat themselves as members of a controlled group under certain circumstances. These "permissive aggregation" rules can be extremely helpful in cases where related entities may not be in a strict control relationship but where it is beneficial to allow the entities to be considered a single employer for employee benefit plan purposes. Specifically, if two or more exempt organizations wish to maintain a plan that covers employees from each organization, those organizations may treat themselves as being under common control (and, therefore, as a single employer) if each organization "regularly coordinates" its day-to-day exempt activities with the other organization. For example, consider an entity that provides a type of emergency relief in one geographic region and another exempt organization that provides the same type of emergency relief in another geographic region. If those two entities establish a single benefit plan covering employees of both entities, they may treat themselves as under common control. For another example take a tax-exempt hospital and a second exempt organization with which the hospital coordinates the delivery of medical services or medical research. Those two entities may treat themselves as being under common control if there is a single plan covering employees of the hospital and the employees of the second organization and the coordination between them is a regular part of their day-to-day exempt activities.
The regulations also permit the Commissioner of Internal Revenue to develop and publish guidance permitting other combinations of entities that include exempt organizations to elect to be treated as under common control if: (1) there are substantial business reasons for maintaining each entity in a separate trust, corporation or other forms; and (2) such treatment would be consistent with the anti-abuse standards of the regulations.
Permissive Disaggregation for Church Controlled Organizations
Importantly, the regulations include a special permissive disaggregation rule that applies to certain groups that include one or more qualified church controlled organizations. If a church controlled organization has within its related group a secondary school and several nursing homes, and the nursing homes receive more than 25% of their support from fees paid by residents, the nursing homes may treat themselves as being under common control with each other but not as being common control with the church and the school, even though the church and the school might be under common control.
The Anti-Abuse Rule
Finally, in part because significant benefits-related advantages can be realized by organizations seeking to be under common control and significant disadvantages can also follow from an unwanted application of the controlled group rules, the Treasury Regulations contain an anti-abuse rule. Specifically, in any case in which the Commissioner of Internal Revenue determines that the structure of one or more exempt organizations or the positions taken by those organizations has the effect of avoiding or evading any requirements imposed under Code Sections 401(a), 401(b) or 457(b) or any applicable section or other provision to which Section 414(c) applies, the Commissioner may treat an entity as under common control with the exempt organization. The regulations offer the following example of circumstances in which the anti-abuse rule could come into play: Organizations O and P are each tax-exempt organizations under Code Section 501(c)(3). Each organization maintains a qualified plan for it employees, but one of the plans would not satisfy the minimum coverage requirement (often referred to as the "70% test") of Code Section 410(b) if the organizations were under common control. The two organizations are closely related and, while the organizations have several trustees in common, the common trustees constitute fewer than 80% of the trustees of either organization. Organization O has the power to remove any of the trustees of P and to select the slate of replacement nominees. Given those facts, the IRS may seek to apply the anti-abuse rule in order treat organizations O and P as members of a controlled group.