Anti-abuse pension regulations.

Since the beginning of the private pension system in the U.S., many taxpayers, including closely held companies, have spent a great deal of time and effort trying to build significant pensions for deserving highly compensated employees and officers. Sometimes, however, there is an impediment to doing so in the form of cost. The greatest cost to most pension programs is the cost of providing pensions to rank-and-file employees. Just by the sheer number of these employees, the additional costs involved in maintaining a qualified plan can be very significant. While no one questions the desirability of providing qualified plan benefits to all employees, tax law changes throughout the 1980s have made it significantly more expensive and complex, and have caused many private employers to discontinue their pension programs entirely.

Among the techniques used by some employers to reduce the cost of maintaining a qualified plan is to provide pension benefits for only one division or one of several related companies. However, small employers have recently found it extremely difficult to do this because of the myriad of rules on plan qualification, including those in Sec. 401(a)(26) restricting the use of multiple comparable plans in one employer or group of related employers.

For related entities, the basic rule has been that controlled groups of employers are aggregated under Sec. 414(b) or (c) for coverage and other purposes. However, after the tax cases of Kiddie, 69 TC 1055 (1978), and Garland, 73 TC 5 (1979), in which two physicians found a way around the controlled group rules by setting up affiliated service groups to exclude their rank-and-file employees, the rules have been toughened up. Those cases caused the enactment of Sec. 414(m), which combats the affiliated service group and management company practices that many firms used (and still use for good business reasons), but also may result in a perceived discrimination in the pension arena.

Treasury apparently felt that these new rules were still not enough to counter perceived abuses, particularly in the small, closely held arena. As such, in 1987, regulations under Sec. 414(o) were promulgated. Sec. 414(o) is an anti-abuse statute that gives the IRS authority to promulgate regulations to combat abuses not thought of in other Code sections enacted by Congress. These types of general anti-abuse statutes are becoming more and more prevalent in all areas of tax law. The problem with them is that the Service is sometimes overzealous, causing not only tremendous additional complexity, but also tax law that causes problems for very legitimate arrangements.

The regulations under Sec. 414(o) suffer from such criticism. In fact, a good portion of those regulations was subsequently retracted retroactively in its entirety. Prop. Regs. Sec. 1.414(o)-1 still exists, however, and can cause problems for closely held businesses in the area of "leased owners" and "leased directors." Because of their breadth, it is extremely easy to stumble into these regulations, and although there are no cases or rulings to date construing them, they do exist and must be dealt with. The easiest way to illustrate these problems is by example.

Example: X,Y and Z are three unrelated companies (insofar as they are not a controlled group or affiliated service or management organization), all in manufacturing. Individual I owns 50% each of X and Y. The third company, Z, is entirely unrelated, but all three companies work joint ventures to some extent. Because they are related in what they do and there is one owner who owns some percentage of each of two companies, there is some overlap of business and activity. I is a key, talented management individual who performs services for both of the companies in which he has an ownership interest. X and Y are located in different geographical areas and have entirely separate work forces. Because of the overlap in the management team and particularly with respect to this one individual, one of the companies will pay the other a management fee for management services relative to I's work for that company. However, none of the companies are management companies, since each has significant sales to separate outside customer bases.

This situation does not fall within the affiliated service group rules or the management company rules of Sec. 414(m). However, the IRS believes this is an abusive situation, and that it would not be fair for the common employee (I) to participate in a richer pension plan in one of these companies than the pension he could get had he been in the other (recipient) company. As a consequence, when an employee owns at least 5% of the recipient, he will be deemed to be a leased owner and, under the regulations, his participation in the richer plan of the second company will jeopardize the qualified status of any plan maintained by the recipient company or the leasing company. Thus, for example, if the recipient company has a Sec. 401(k) plan in which this leased owner does not participate and all other coverage rules are met, the fact that this leased owner participates in another pension plan maintained by the second company could cause the disqualification of the Sec. 401(k) plan or the leasing company plan even when the second company stands on its own as an operating business. While there is a de minimis rule that will help certain arrangements, it is not an easy one to meet and many common arrangements will be caught under these regulations. Since the result is extremely harsh, taxpayers need to be aware of them.

The fact that there have been no cases or rulings on these regulations in almost 10 years is indicative of the fact that they are either too complex to understand or there are no such abuses. In any event, if faced with an attack on this subject, taxpayers should know that because the regulations are very controversial, the Service may be reluctant to have them tested in court.