BENEFIT PLAN COMPLIANCE AND CONTROLLED GROUPS

By George Kane, CPA, Mickelberry Communications Incorporated

Most of us know that the significant tax advantages, i.e., current deduction for employers and tax deferral or tax free treatment for employees, associated with certain employee benefit programs come with the cost of substantial compliance requirements. These requirements include limitations on the absolute and relative amounts of benefits that can be provided to individual employees or groups of employees. The rules are framed in the context of an employer/employee relationship and conjure up thoughts of a single business, company, or corporation as employer. Many of us, however, may not realize that the rules are designed to include, if applicable, groups of businesses, companies, or corporations to be treated, for compliance purposes, as one employer. Consequently the separate groups of employees of the aggregated businesses are treated as one set of employees for purposes of measuring observance with the rules.

Employer sponsored qualified retirement programs offer a prominent example for consideration. IRC Secs. 401 through 420 provide a full spectrum of requirements for employers and their employees. These include prohibitions against discriminating in favor of highly compensated employees, vesting requirements, and benefit limits. IRC Sec. 414(b) modifies many of these requirements by providing that all employees of all corporations that are members of a controlled group of corporations are treated as employed by a single employer.

The implication of this single-employer rule can be dramatic. At best it creates an administrative burden that can be substantial. At worst it can result in a plan disqualification.

Controlled Groups and
Affiliated Groups

The controlled group of corporations that concerns IRC Sec. 414(b) is defined in IRC Sec. 1563(a). The IRC Sec. 1563(a) controlled group is not to be confused with the IRC Sec. 1504(a) affiliated group of corporations that have the privilege of filing a consolidated income tax return. The controlled group definition casts a wider net and includes corporations and groups of corporations that would not be able to file a consolidated return. The major differences between the two groups are as follows:

* Affiliated groups are limited to parent-subsidiary relationships, i.e., where the ownership connection is effected entirely through corporate "chains." Controlled groups include not only parent-subsidiary groups but brother-sister groups and combined groups. Brother-sister groups unite otherwise unrelated corporations that share a level of common ownership by five or fewer individuals, estates, or trusts. Combined groups join certain parent-subsidiary and brother-sister groups where the parent of the parent-subsidiary group is also a member of a brother-sister group.
* Affiliated groups require an ownership of 80% in both voting power and value for inclusion. Controlled groups require an ownership of 80% in either voting power or value.

Clearly the controlled group, for purposes of monitoring compliance requirements for qualified retirement programs, can include corporations which are not included in the consolidated income tax return. Ignorance of this expanded group is potentially dangerous.

Practical Implications

What are some of the consequences of the single-employer rule? IRC Sec. 414(b) says that for purposes of IRC Secs. 401, 408(k), 410, 411, 415, and 416, all employees of all corporations that are members of a controlled group shall be treated as employed by a single employer. Section 401 includes a laundry-list of requirements for qualified retirement plans. The rule which is most affected by the single-employer mandate is IRC Sec. 401(a)(4) that requires that contributions or benefits cannot be provided under a plan in a manner which discriminates in favor of highly compensated employees. IRC Sec. 401(a)(4) works in tandem with IRC Sec. 410(b) which requires that the plan cover employees in a manner which does not discriminate in favor of highly compensated employees. Reg. Sec. 1.401(a)(4)-1 provides a coordinating link to the regulations under IRC Sec. 410(b). In combination, the regulations provide substantial testing requirements, mandatory disaggregation, and permitted aggregation of plans and safe harbors for these purposes. The requirements of IRC Secs. 401(a)(4) and 410(b) are beyond the scope of this article. The point to be made is that the single-employer rule cannot be ignored.

Does this mean that the controlled group can only have one retirement plan? No, it doesn't. Each member can have its own plan or plans. Each of the plans can provide different benefit structures. However, someone must keep track of all of the plans and benefits provided by all members of the group. This monitoring function requires profiles of the covered employee groups, including the compensation and benefit levels for each participant. This information enables the single employer, deemed to exist for the controlled group, to determine that the plans are not in compliance. This determination may be made by aggregating or disaggregating plans of different members or by treating certain members or parts of members as separate lines of business.

Legislative background to IRC Sec. 414(b) includes the following: "At the same time, however, the committee provision is not intended to mean that all pension plans of a controlled group of corporations...must be exactly alike, or that a controlled group could not have pension plans for some corporations but not others. Thus, where the corporation in question contains a fair cross section of high- and low-paid employees (compared to the employees of the controlled group as a whole), and where the plan coverage is nondiscriminatory with respect to the employees of the corporation in question, it is anticipated that the IRS would find that the plan met the antidiscrimination tests, even though other corporations in the controlled group had a less favorable retirement plan, or no plan at all." (House Ways and Means Committee General Explanation to P.L. 93-406, ERISA.)

Under the single-employer rule, individuals who are employed by more than one member of the group provide additional monitoring requirements. IRC Sec. 401(a)(17) limits the amount of annual compensation that can be taken into account for any employee under a plan to $150,000, plus an inflation adjustment. This limit applies to all compensation paid by any member of the group. Likewise the $7,000 (plus inflation) limit imposed on elective deferrals by IRC Secs. 401(a)(30) and 402(g)(3) includes elections for all plans for all members of the group.

IRC Sec. 401(a)(26) provides that a plan must benefit at least 50 employees or, if fewer, at least 40% of all employees of the employer. The single-employer rule will affect the application of this requirement. For example, it was noted above that members of controlled groups can have their own plans. However, a member with 50 or fewer employees cannot have its own plan if the number of employees of all members of the group exceeds 125 (since 40% of 125 equals 50).

IRC Sec. 411 supplies vesting requirements for qualified plans. Vesting is based on years of service with the employer, and the law and regulations provide a detailed regimen for counting those years. The counting process considers breaks-in-service and determines when service prior to a break must be included. Here again, the single-employer rule applies. Accordingly, for purposes of counting years of service, it would appear that service for any member of the controlled group should be included. The monitoring job may be daunting but should not be ignored.

Limits on the amount of benefits or contributions which can be provided for plan participants are specified in IRC Sec. 415. Under the single-employer concept, these limits apply to the controlled group. It should not be possible to exceed the benefit or contribution limits by including a participant in plans maintained by more than one member of the controlled group. Monitoring the limits, however, requires an analysis of the contributions and benefits of all members. Inadvertent violation of the cap for defined benefit plans, for example, could occur where a participant was employed by different members of the group at different periods in his or her career.

The "top-heavy" provisions of IRC Sec. 416 result in additional vesting and minimum benefit requirements when a plan is determined to be top-heavy. Top-heaviness is measured by the magnitude of benefits for certain owner and officer employees compared to the benefits of other employees. There are permitted and required aggregation rules for combining plans to determine top-heaviness. However, the IRC Sec. 414(b) single-employer rule for members of controlled groups applies as well. If the plans of each member of the group are not top-heavy, it's probably a good bet that they will not be top-heavy if you test them on a combined basis. Still, someone must make sure that each of the plans is not top-heavy. Also, if one of the plans maintained by a member of the group is top-heavy, then it would seem necessary to test for top-heaviness on a combined basis.

To recap, it's important to consider if any corporation which provides retirement benefits is a member of a controlled group. If it is, then compliance with various code sections will have to consider all members of the group. Finally, as if the preceding were not enough to worry about, the requirements of IRC Sec. 414(b) are in addition to the requirements of:

* IRC Sec. 414(c) which provides single-employer treatment for certain groups of partnerships and proprietorships under common control.

* IRC Sec. 414(m) which provides single-employer treatment for organizations that provide services for one another.

* IRC Sec. 414(t) which provides single-employer treatment for Sections 414(b), (c) and (m) groups for a number of code requirements applicable to nonretirement benefit programs. *

MAXIMIZING TAX DEPRECIATION WITH CAR ACQUISITIONS

By Scott Cheslowitz, CPA

Rothenberg & Peters, PLLC

Sport-utility vehicles have become extremely popular modes of transportation, despite their relatively hefty price. The tax laws in certain cases can subsidize the owner's cost through depreciation deductions that are higher than those allowed regular automobiles.

Depreciation deductions for passenger automobiles are allowed to the extent that the vehicles are used for business or investment purposes. However, under IRC Sec 280F, the annual deductions are capped. Automobiles placed in service in calendar year 1995 are subject to the following depreciation limitations:

* $3,060 for the first tax year,

* $4,900 for the second tax year,

* $2,950 for the third tax year, and

* $1,775 for each succeeding tax year.

Lessees of passenger autos can deduct the business/investment use portion of the lease cost but may be subject to the lease income inclusion that operates to provide somewhat of a parity with car owners.

IRC Sec. 280F(d)(5) defines a passenger automobile as a four-wheeled vehicle built primarily for use on public roads and which is rated at 6,000 pounds unloaded gross vehicle weight or less. (In the case of a truck or van, gross vehicle weight is used instead.) As a result, certain heavy sport utility vehicles may be able to escape the depreciation dollar caps. Not only does this allow for potentially larger MACRS deductions, but it opens up the possibility of the full Section 179 expensing allowance.

The Case of John Smith

During 1995, John Smith, a self-employed doctor, bought a $40,000 sport utility vehicle which has a gross vehicle weight of over 6,000 pounds. The vehicle is used 75% for business and 25% for personal purposes. Assuming that all expensing conditions are met and the mid-year convention applies, Dr. Smith can deduct $20,000 of the cost of the vehicle, as follows:

Cost $40,000

Business portion @ 75% 30,000

(a) Sec. 179 deduction 17,500

Remaining business cost 12,500

(b) First year MACRS at 20% 2,500

1995 depreciation ((a)+(b)) $20,000

In contrast, depreciation under the luxury automobile limitations for 1995 would have been only $2,295 (i.e., $3,060 x 75%).

It should be noted that the IRC Sec. 179 expense is allowed in full regardless of when the asset is placed in service--it is not subject to proration. Regardless of whether the asset is placed in service on January 1 or 31, 1995, the allowable deduction under IRC Sec. 179 is still $17,500. One other point to remember: Sport utility vehicles are considered listed property. This is so regardless of their weight. Based on this fact, none of the cost can be expensed under IRC Sec. 179 if the asset is not used more than 50% for business purposes. Additionally, if the trade or business use drops below 50 percent in a later year, part of the expense deduction may have to be recaptured. *

CO-OP HOUSING CO NOT TAXED
ON INTEREST INCOME UNDER TRUMP VILLAGE CASE

By Stewart Berger, CPA,
Martin Leventhal & Company, LLP

In Trump Village Section 3, Inc., TCM 1995-281, the Tax Court held that the taxpayer, a cooperative housing corporation, was not a membership organization subject to IRC Sec. 277 of the IRC. Accordingly, the taxpayer was allowed to offset its interest income by losses attributable to residential apartments.

The taxpayer was a limited profit housing company, formed and operated under New York's Mitchell Lama law, that qualified as a cooperative housing corporation under IRC Sec. 216. Trump Village maintained escrow and reserve funds, administrative funds, and a mortgage escrow fund. Interest income was generated by the fund's investments. Trump Village reported net losses each year--the IRS, stating that IRC Sec. 277 applied, attempted to tax the interest income as "nonmembership income."

IRC Sec. 277 generally applies to nonexempt membership organizations, including social clubs, that operate primarily to furnish goods or services to members. Deductions related to transactions with members are limited to the income derived from transactions with members; excess deductions can be carried over to the succeeding year. The IRS asserted that the interest earned on Trump Village's reserve funds was nonmembership income, which could not be offset by excess membership deductions.

The Tax Court found that Trump Village qualified under IRC Sec. 1381 as a nonexempt cooperative taxable under Subchapter T. The criteria that the court used in making its decision were 1) there was subordination of capital as tenant-members owned stock with limited benefits, 2) there was democratic control by the members, and 3) allocations were made among the members in proportion to each tenant's contribution. Since the taxpayer properly qualified under Subchapter T, the court held that IRC Sec. 277 did not apply; accordingly the taxpayer could offset its interest income by its operating losses.

It should be noted that a nonexempt cooperative taxable under Subchapter T must separate its income arising from business with patrons, or patronage-sourced income, from nonpatronage-sourced income. Nonpatronage-sourced income is potentially subject to double taxation at the cooperative level and again, when distributed, at the patron level. Patronage-sourced income is generally taxable only at the patron level. Interest income is patron sourced if it is integrally related to the cooperative's business.

In 1995 a bill was sponsored in the House that would make it clear that Subchapter T and not IRC Sec. 277 would apply to cooperative housing corporations as defined in IRC Sec. 216. This proposal has been shelved at the present time and is not part of the revenue reconciliation act currently being considered. *

Editor:

Edwin B. Morris, CPA

Rosenberg, Neuwirth & Kuchner

Contributing Editors:

Richard M. Barth, CPA

Anthony R. Castellanos, CPA

Price Waterhouse LLP

Stephen P. Valenti, CPA