Comments on proposed QSLOB regulations under section 414(r).

On January 31, 1991, the Internal Revenue Service issued proposed regulations under section 414(r) of the Internal Revenue Code, providing the exclusive rules for determining whether an employer operates qualified separate lines of business. The proposed regulations (EE-147-87) were published in the Federal Register on February 1, 1991 (56 Fed. Re3g. 4023) and in the March 4, 1991, issue of the Internal Revenue Bulletin (1991-9 I.R.B. 15). A public hearing on the proposed regulations was held on May 16, 1991. (1)

BACKGROUND

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,700 members represent more than 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promote the uniform and equitable enforcement of tax laws, and to reduce the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the separate line of business regulations.

OVERVIEW

The proposed qualified separate line of business (QSLOB) regulations are one of a series of regulatory projects interpreting the employee benefit provisions of the Tax Reform Act of 1986. Under sections 414(b) and 414(c) of the Internal Revenue Code, all employees of corporations that are members of the same controlled group of corporations and all employees of trades or businesses that are under common control are generally treated as employed by a single employer for purposes of the employee benefit provisions of the Code. Similarly, section 414(m) provides that all employees of members of an affiliated service group are treated as employed by a single employer. Consequently, all eomployees of a single employer (determined after the application of the foregoing provisions) are taken into account in applying the minimum coverage requirements of section 410(b) and the minimum participation requirements of section 401(a)(26) to a qualified retirement plan maintained by an employer.

Section 410(b)(5) provides an exception to this general rule for purposes of section 410(b) if the employer operates QSLOBs under section 414(4). If an employer operates QSLOBs, the employer may apply the minimum coverage requirements separately to the employees of each QSLOB. A similar exception is provided for purposes of the minimum participation requirements of section 401(a)(26) and the 55-percent average benefits test of section 129(d)(8).

According to the preamble, Congress was concerned about the economic disadvantage that employers could face if the average benefit percentage test were applied on an employer-wide basis in those situations where the level of benefits varied significantly among the employer's separate lines of business for competitive market reasons. (2) Congress did not intend, however,k to give employers a "bye" with respect to the nondiscrimination rules. Rather, under section 410(b)(5), all plans must satisfy a nondiscriminatory classification test on an employer-wide basis. Regrettably, in the QSLOB regulations the IRS took what was intended to be a facts-and-circumstances test (3) and transmutted it into several rigid "bright-line" tests that apply to all situations. The result is a set of regulatory hurdles so high that they deny relief to employers reasonably falling within the ambit of QSLOB rules.

In short, the facts-and-circumstances approach envisioned by Congress for implementing section 414(r) has not been adhered to by the IRS in crafting the proposed regulations. TEI believes that the regulations fail to appreciate the extent to which employers operate distinct, separate lines of business and the legitimate non-tax motivations for adopting disparate, independent benefit plans for each line. If the IRS wishes to use brightline tests for guidance, it should promulgate several flexible, optional tests to accommodate the "real world," market-driven judgments made by business managers when organizing operating units. A healthy dose of common sense will remedy many of the ills inherent in the definition of "separate lines of business."

We similarly believe that the recordkeeping requirements set forth in the regulations should be tempered. In their current form, the regulations will force taxpayers to redesign and reprogram information systems to capture data solely for the purposes of ensuring compliance with the QSLOB regulations. We submit that such a result is unnecessary and inappropriate.

In the comments that follow, TEI discusses its specific suggestions on how the IRS should amend the proposed regulations to make the QSLOB tests more workable by both adopting additional safe harbors and reducing certain data collection requirements. Our goal is to facilitate the promulgation of final regulations that expand the availability of section 410(b)(5) relief while fully serving congressional intent.

DETERMINATION OF SEPARATE

LINES OF BUSINESS

Prop. Reg. [section] 1.414(r)-3 states the general rule that a separate line of business (SLOB) is a line of business that is organized and operated separately from the remainder of the employer. Subsection (b) of Prop. Reg. [section] 1.414(r)-3 prescribes five requirements that must be satisfied to establish the "separateness" of a line business.

1. Prop. Reg. [section] 1.414(r)-3(b)(3):

Separate Financial

Accountability

Under Prop. Reg. [section] 1.414(r)-3(b)(3), a separate line of business must be a separate profit center and must maintain books and records providing separate revenue and expense information that is used in internal planning and control. The preamble defines separate financial accountability to include a profit-and-loss statement. (4) Without more guidance, however, an employer may be unsure which financial statements are necessary and what degree of detail will be required.

Prop. Reg. [section] 1.414(r)-1(b)(2)(iii) defines a separate line of business to include "corporations, partnerships or divisions." Corporations and partnerships are juristic entities with legal rights and claims to assets and legal obligations represented by liabilities and capital. Financial accounting and reporting can, but need not, be rigorously limited and defined to represent such an entity. "Divisions," however, are more nebulous and amorphous operating units. A division may represent a part of a larger legal entity. Alternatively, a division may encompass a number of corporations or partnerships, or portions of either. Divisional profit-and-loss statements may have multiple formats within a single business line that crosses over multiple partnerships or corporations, some of which may not be controlled. As a result, the financial records created and maintained at the division level may be either more or less comprehensive than those created and maintained by a subsidiary or partnership.

More fundamentally, the level of detail in reporting income and expense will vary dramatically from division to division (or "business unit" to "business unit"), with the required level of detail depending on the scope of the business manager's accountability. For example, some business unit profit-and-loss statements will include corporate general and administrative (G & A) expense (overhead) allocations; other business unit profit-and-loss statements will exclude G & A expense and focus instead on direct costs of production, distribution, and marketing; still other business unit profit-and-loss statements will allocate some G & A expenses but not others. In sum, management devises its "business unit" or "divisional" profit-and-loss statements with a view to capturing the information deemed necessary to manage the line of business.

TEI recommends that the final regulations clarify the definition of profit-and-loss statements to provide that a pretax profit-and-loss statement (determined before interest income and expense and, at the election of the controlled group for each testing period, either before or after corporate overhead) will satisfy the requirements of separate financial accountability.

2. Prop. Reg. [subsection] 1.414(r)-3(b)(4)

and 1.414(r)-3(c)(2): Separate

Employee Workforce

In order for a line of business to be a "separate" line of business, Prop. Reg. [section] 1.414(r)-3(b)(4) requires that 90 percent of the employees who provide services to a line of business provide their services exclusively to that line of business. Prop. Reg. [section] 1.414(r)-3(c) requires the employer to ascertain whether employees provide services (exclusively or otherwise) to each line of business. Subparagraph (2)(ii) of Prop. Reg. [section] 1.414(r)-3(c) provides that if more than a negligible (5) portion of an employee's services are attributable to a line of business, then that employee's services are deemed to be provided to that line of business. An employee is deemed to provide services exclusively to a line of business only if no more than a negligible portion of his services are provided to any other line. As envisioned by the regulation, each employer will have to undertake a massive, annual survey of hundreds and perhaps thousands of employees to determine which lines of business they provided services to and the extent of those services. Such a survey, however, would be both costly and time consuming. A number of provisions already exist within the Code and regulations requiring collection of employee census data or allocation and apportionment of employee time and compensation expense (e.g., for purposes of sections 253A, 482, and 861 of the Code.) TEI objects to the imposition of yet another independent survey test for purposes of QSLOB relief. We were heartened by comments by Treasury and IRS representatives at the May 16 public hearing that every attempt was (and will) be made to minimize independent record creation for QSLOB testing. TEI submits that considerable room for improvement remains and, specifically, that there are less burdensome ways of determining a separate workforce than those prescribed in the regulations.

a. Headquarters Staff Allocation. Under the proposed regulations, headquarters staff (6) will generally be allocated to all lines of business, and this allocation will make it more likely that the employer will be unable to meet the 90-oercent threshold requirement (since headquarters staff would not be providing services exclusively to a line of business). Thus, an employer that internalizes staff functions is effectively penalized and placed at a competitive disadvantage compared with employers that contract out "staff" activities. Indeed, the trend in American business toward "right-sizing" of the workforce, while reducing the absolute size of corporate staff, will concomitantly increase the number of employees who serve multiple lines of business and, consequently, decrease the utility of the QSLOB rules. Nothiong in the legislative history of the QSLOB rules suggests that Congress intended such a result. TEI recommends that headquarters staff be eliminated from consideration in the determination of the "separate" workforce requirement. (7)

We recommend that a separate-line-of-business payroll be adopted as a more workable alternative to the 90-percent exclusive services test. Thus, if an employee is carried on a separate-line-of-business payroll and is entitled to the same pension benefits as all employees in that line of business, the employee should be treated as providing services exclusively to that line of business. The separate-line-of-business payroll can be defined as the compensation expense (whether reported as part of cost of goods or "below the line") included by management in its divisional or business unit profit-and-loss statements. Given the substantial non-tax management purposes served by such profit and loss statements, it is unlikely an employer would manipulate its compensation expense simply for purposes of the test. (8)

A second alternative is a variation of the "dominant line of business" approach of Prop. Reg. [section] 1.414(r)-7(c)(2)(ii), under which residual shared employees (e.g., legal, tax, executive administration, purchasing, and employee benefits) -- that is to say, headquarters staff -- are assigned to the employer's dominant line of business. Assigning shared employees to the dominant line of business will minimize the administrative burdens of Prop. Reg. [section] 1.414(r)-3(c)(2)(ii)'s survey requirements since these "residual" departments must, by functions or legal requirements, perform services that involve the entire controlled group.

Another approach is to adopt a de minimis test, which would provide that if employees in common support functions comprise less than, say, five percent of the total controlled group workforce, they should not be counted as providing services to any line of business.

Finally, the regulations could focus on either (1) the revenues generated by each separate-line-of business employee count compared with the controlled group employee count. Under this approach, the support staff would be allocated among the various separate lines of business, with fractionalization of support staff being permitted.

In summary, a number of alternatives can be developed to prevent the allocation of headquarters staff from defeating the separate-line-of-business relief Congress intended to provide to employers competing in multiple markets. We urge the IRS to adopt one or more of them.

b. Prop. Reg. [section] 1.414(4)-3(c)(2)(iv) -- Nonresident Aliens. Prop. Reg. [section] 1.414(r)-3(c)(2)(iv) provides that for purposes of the separate employee workforce determination, an employer may exclude nonresident aliens who receive no earned income from the employer that constitutes income from sources within the United States. The employer may not, however, exclude any nonresident alien who does not provide services exclusively to any line of business. TEI submits that the second rule is at odds with the statute. Section 414(q)(11) specifically excludes such nonresident aliens from QSLOB testing. Furthermore, other testing requirements under sections 410(b) and 401(a)(26) have never required the inclusion of nonresident aliens.

Even assuming, arguendo, the IRS's statutory authority to include nonresident aliens within the scope of the QSLOB rules, there are practical reasons for not doing so. Indeed, the regulations would impose an impractical data collection burden on employers. Specifically, since the Code's testing rules have never required the inclusion of nonresident aliens, the proposed regulations would impose a new and independent data collection and recordkeeping burden on employers. TEI recommends that this nonresident alien rule be eliminated. If the rule is retained, the administrative burdens should be ameliorated by adopting the separate-payroll recommendation discussed in item 2.a., which would minimize data-gathering responsibilities in respect of foreign subsidiaries, while still requiring the allocation of a foreign-owned multinational parent's corporate staff function. (9)

3. Prop. Reg. [subsection] 1.414(r)-3(b)(5)

and 1.414(r)-3(c)(3):

Determination of Separate

Management

Prop. Reg. [section] 1.414(r)-3(b)(5) requires a line of business to have separate management to qualify as a separate line of business. A line of business will be treated as having its own separate management only if 90 percent of the top-paid employees providing services to the line of business provide their services exclusively to that line. Prop. Reg. [section] 1.414(f)-3(c)(3) defines "top-paid" employees as the 10-percent most highly compensated employees providing services (exclusively) or otherwise) to the line of business.

TEI believes that the definition of separate management in the proposed regulations is unrealistically narrow. Specifically, defining management of a line of business based solely on the compensation of employees providing any services of the line of business -- regardless of whether the employee is truly vested with discretionary, decision-making authority -- is a crude and arbitrary measure of separate management. The interaction of this definition with the 90-percent exclusive-services requirement means that if the highly paid corporate headquarters staff allocated to a line of business exceeds one percent (10) of all employees providing services to the line of business. This is an unduly stringent result. We know of no principle of business organization dictating that a business is not separate if the number of highly paid corporate staff providing services to the business exceeds one percent of the workforce.

The failure of the proposed regulations to provide meaningful criteria for the identification of management employees undermines the usefulness of the separate-management test. The proposed definition will produce anomalous results depending upon the nature of the businesses in which the taxpayer is engaged and the relative sizes of the separate businesses. Labor intensive service businesses (e.g., restaurants) may have non-highly compensated, unskilled employees who become "management" under this definition causing a failure to qualify as a SLOB. Likewise, union employees of certain manufacturers may be deemed to be "management" under the proposed definition.

The separate-management test may, in some circumstances, discourage larger employers with large corporate staffs from developing new business opportunities on a small-scale, start-up basis. The allocation of corporate staff to an entrepreneurial venture during its early stages could necessitate a very expensive benefit structure completely out of line with its business needs in terms of attracting employees or competing with established businesses. Such an uncompetitive benefit cost structure could cause the venture to die aborning.

The separate-management test effectively penalizes employers for developing corporate staff functions that provide services to all lines of business even where there is no discernible connection between staff duties and the traditional functions of management. In addition, the separate management test imposes substantial administrative burdens. For example, the possible inclusion of union employees with in the management group, besides being counter-intuitive, will create problems in collecting, analyzing, and projecting compensation. Union employees may well be included in the top-paid employee group, especially in smaller divisions or subsidiaries. For example, assume a large manufacturing firm has a small unionized subsidiary with 200 employees, of which 150 are represented by a union. The 10-percent test will require the employer to count the 20 highest-paid employees as the separate management. In such an employee population, 10 of those employees could reasonably be non-union management personnel, with the other 10 employees being either line supervisors or highly paid union employees. Thus, the employer will constantly have the projecting union wages that will include overtime, bonuses, and incentives. (11) Further, the compensation of the top-paid group could fluctuate because of union layoffs and job "bumping" during economic downturns. Such fluctuations might be significant enough to render the averaging rules under Prop. Reg. [section] 1.414(r)-11(c) unseless, since Prop. Reg. [section] 1.414(f)-11(c)(3) permits only a 10-percent variation factor. Therefore, if the separate-management test is retained, some other noncompensation-driven test should be developed to define the management group.

In summary, TEI questions why another "top-paid" employee group must be tested under the QSLOB rules, especially since the test can result in the combination of union and non-union employees. In some industries, separate union and non-union computarized payrolls are maintained to facilitate the tracking and correlating of information unique to the distinct employee groups; such segregation makes application of the test difficult. for the foregoing reasons, TEI recommends that the IRS reconsider the separate management test. If the test is retained, the IRS should provide a rule such that union employees are excluded from management.

and 1.414(r)-3(c)(4):

Separate Tangible Assets 

Under Prop. Reg. [subsection] 1.414(r)-3(b)(6) and 1.414(r)-3(c)(4), a qualified separate line of business must have its own assets and at least 90 percent of its assets must be used exclusively by the line of business. A tangible asset that is not used by any line of business (e.g., a corporate headquarters facility) is deemed to be used by every line of business.

The separate-tangible-asset test may be one of the most onerous burdens placed on the taxpayer by the QSLOB regulations, and may well be the decisive factor in an employer's electing not to use section 414(r). Currently a corporate taxpayer must maintain at least four fixed-asset ledgers to determine federal tax depreciation (Book, Tax, AMT, and ACE), as well as those required for state tax purposes. The proposed regulations may require a new and arguably more burdensome fixed-asset analysis, which might well require the purchase and maintenance of a special recordkeeping computer program. Under this text, a taxpayer must analyze ezch asset to determine whether it si shared and reprogram the fixed-asset ledger to reflect this new distribution of assets.

Smaller divisions and subsidiaries that are neither asset intensive nor have highly valued assets may not pass this test because the mandated allocation to each line of business of expensive assets that are shared throughout the controlled group (such as computer systems in order to report financial, pension, tax, and other information.) TEI recommends that this test be eliminated as unnecessary and burdensome. If the IRS retains this requirement, the 90-percent standard should be reduced to 50 percent. In addition, the asset test should be based on asset values as of the year end preceding the testing year. Furthermore, the regulations should permit the use of reasonable estimates rather than detailed analyses of the fixed-asset ledger.

Prop. Reg. [section] 1.414(r)-3(c)(4) sets forth a special rule for shared buildings. Specifically, if only a portion of a building is used exclusively by a line of business, the employer is permitted, but not required, to treat the portion so used as if it were a separate tangible asset that is used exclusively by the line of business. Although we applaud the intended liberalization of the separate-asset rule, we regret that a company's building utilization may not always fit easily into this rule. For example, some buildings are used during regular office hours by one line of business and at night by a different line of business. the proposed regulations should be amended to clarify that the use of the same space, but at different times, by two different lines of business permits each line of business to claim the space as its separate tangible asset.

5. Prop. Reg. [section] 1.414(r)-3(c)(5):

Optional Rule

for Vertically Integrated

Lines of Business

Under Prop. Reg. [section} 1.414(r)-3(c)(5), if a vertically integrated business meets certain requirements, an employee whose services for an upstream line of business contribute to providing property or services from the upstream line to the downstream line is not treated as providing services to the downstream line. A parallel rule precludes the allocation of assets from the upstream to downstream line. The principal requirements of the rule are that the upstream business provide 50 percent of its production of services to external parties and that the downstream business either consumes or modifies the same property or provides the same property to a different level of market.

TEI is concerned that the limitations on the availability of this optional rule effectively penalize an employer that internalizes business functions, in the same manner that the separate-management and employee-workforce tests penalize employers for internalizing staff legal, tax, and other functions. TEI suggests that the 50-percent external sales or services tests be eliminated if the taxpayer can demonstrate that competitors can demonstrate that competitors of the downstream line of business purchase semilar products or services from unrelated suppliers (i.e., outside the controlled group.)

TEI recommends that the 50-percent rule be eliminated in cases where one employer has two operations that are vertically integrated but are traditionally operated by unrelated entities. Where the lines are not traditionally operated by unrelated entities or where competitors do not purchase similar products from unrelated suppliers, the 50-percent requirements should be reduced to 25 percent.

QUALIFIED SEPARATE LINES

OF BUSINESS

1. Prop. Reg. [section] 1.414(r)-(4)(c):

Notice Requirement

Section 414(r)(2)(B) requires the employer to notify the Secretary when the employer treats itself as operating QSLOBs. The preamble anticipates that a standard notice will be incorporated into the Form 5300 (Application for Determination for Employee Benefit Plan) or Form 5310 (Application for Determination Upon Termination; Notice of Merger, Consolidation or Transfer of Plan Assets or Liabilities; Notice of Intent to Terminate). (12) Since neither of the forms is normally filed annually, however, TEI recommends that Form 550 (Annual Return/Report of Employee Benefits Plan) be the vehicle to notify the Secretary of a QSLOB election. Line 22 of the present Form 5500 can be expanded to include any information related to QSLOB testing that is not currently required. Requiring an annual election would force employers to review this election each year for new developments in corporate structure, plan changes, and personnel shifts. TEI questions whether a one-time election (as contemplated in the proposed regulations) would best serve either the IRS or the employer.

Prop. Reg. [section] 1.414(r)-4(c)(2) provides that once the employer has provided the notice for a testing year and the time for filing that notice has expired, the employer is deemed to have irrevocably elected the separate-line-of-business sections of the Code. TEI recommends that the regulations accord employers an opportunity to change its election upon audit or its first return in which the QSLOB rules have significance. Since an employer cannot forsee how the IRS will interpret the myriad post-1986 Act regulations that govern qualified employee benefit plans, it would be unfair to lock the employer into an election that may not be reviewed until four of five years into the future. Prop. Reg. [section] 1.414(r)-4(c) provides 20/20 hindsight to the IRS upon audit, but none to the employer.

2. Prop. Reg. [section] 1.414(r)-5(c):

Safe Harbor for Separate

Line of Business in

Different Industries

Under section 414(r)(2)(c), a separate line of business must pass "administrative scruitiny," which is done in one of two ways: (1) the separate rate line of business may satisfy one of the safe harbors set forth in the statute or Prop. Reg. [section] 1.414(f)-5, or (2) the employer may request an individual determination from the Commissioner. Prop. Reg. [section] 1.414(r)-5(c) sets forth one of the administrative-scrutiny safe harbors. It provides that a separate line of business is eligible for safe-harbors treatment if it is in a different industry or industries from every other separate line of business of the employer. The regulations provide that the Commissioner will issue a revenue proedure or other guidance of general applicability that establishes industry categories that will be considered separate. A proposed revenue procedure based on the two-digit Standard Industrial Classification ("SIC") code system was published as an appendix to the proposed regulations. (13)

TEI recommends that the current two-digit SIC code-based rule be expanded to use the four-digit SIC codes. The proposed rules are too broad and can throw diverse companies (e.g., restaurants and grocery stores) into a single line of business. The preamble intimates that "inappropriate" disaggregation of plants may occur under a mechanical application of SIC codes to determine QSLOBs. (14) Notwithstanding the discussion, we believe four-digit SIC codes offer the level of refinement necessary to distinguish the way companies run their businesses. At a minimum, the IRS should provide further guidance on its theory of "inappropriate" disaggregation, define when and how it arises, and provide examples of "inappropriate" disaggregation. In addition, to prevent any perceived abuse, the IRS might retain the right to decide on audit what other SIC code combinations require aggregation because of violation of "inappropriateness" standards.

3. Prop. Reg. [section] 1.414(r)-5(d):

Safe Harbor for Separate

Lines of Business Reported

as Industry Segments

under FAS 14

Under Prop. Reg. [section] 1.414(r)-5(d), an employer will fall within a safe harbor for administrative scrutiny under section 414(r)(2)(c) if the employer is required to report the separate line of business as one of more reportable industry segments on an annual report filed in conformity with Form 10-K and if the employer timely files the report with the Securities and Exchange Commission (SEC). Prop. Reg. [section] 1.414(r)-5(d)(3) states a Form 10-K is timely filed with the SEC if it is filed within the required period (90 days including the 15-day extension) without regard to any further extensions or amendments.

At issue is whether an employer is entitled to use this safe harbor where the Form 10-K is filed after the 90-day period. Since the SEC has its own penalties for late filing, it should not be necessary to require the employer's employee benefits or tax department toKsupervise the filing of the Form 10-K to preserve the availability of the safe harbor. Mandating a timely filed Form 10-K without extensions satisfies no reasonable tax purpose, especially since that Form 10-K deadline is March 30 -- before the filing of the Form 5500 and before most data is collected to make QSLOB determinations. TEI recommends that the proposed regulations allow a Form 10-K, or any amendment thereto, be considered timely filed if it is filed within the required period, including extensions, as set forth under the application SEC regulations.

4. Prop. Reg. [section] 1.414(r)-5(b)(ii):

Statutory Safe

Harbor -- Determination

Based on Preceding

Testing Year

Prop. Reg. [section] 1.414(r)-5(b)(5)(ii) endeavor to mitigate the employer's testing burden by allowing the employer to use the preceding year's employee count. This prior-year rule, however, is limited to situations where the employer's turnover rate is five percent or lower. Since the regulation seeks to test various lines of businesses within a single controlled group, it is unrealistic to set a single turnover rate limit to apply to diverse lines of business. For example, an employer may have two lines of business: retailing, where turnover may exceed the five percent limit; and heavy manufacturing, where turnover may average five percent or less.

TEI recommends that the turnover limitations be dropped in its entirety because it is unworkable. In the alternative, we believe that a different turnover rate should be assigned to each industry category enumerated in the contemplated revenue procedure for safe-harbor industry categories. This will more accurately reflect the variations in turnover rates experienced by the many employer groups.

5. Prop. Reg. [section] 1.414(r)-5(e):

Safe Harbor for Separate

Lines of Business that

Provide Minimum or

Maximum Benefits

This safe harbor under the administrative-scrutiny requirement tests minimum and maximum benefits. It is intended to ensure that benefits provided by an employer in a separate line of business do not unduly disadvantage non-highly compensated employees or unduly advantage highly compensated employees regardless of the concentration of highly compensated employees in the separate line of business. (15) TEI is concerned that the proposed regulations can be interpreted as requiring a minimum allocation to a defined contribution profit-sharing plan even where the separate line of business is not profitable and the plan document does not require the allocation. The concern arises from the following language in Prop. Reg. [section] 1.414(r)-5(e)(2)(ii)(b):

Each nonhighly compensated employee of the separate line of business who benefits under a plan accrues a benefit for the plan year that equals or exceeds either the definied benefit minimum in paragraph (e)(2)(iii) of this section or the defined contribution minimum in paragraph (e)(2)(iv) of this section .... (Emphasis added.) The referenced paragraph (e)(2)(iv) provides that the defined contribution minimum is an allocation rate equal to three percent of the employee's compensation for the plan year. It is unclear, however, whether the regulations require a minimum benefit floor of three percent anytime the employer decides to grant a benefit.

If the separate line of business has a profit-sharing lplan, a required allocation under the proposed regulations will effectively remove the advantage of a profit-sharing plan when business slips and a three-percent allocation will severely impair the company. Nothing in the legislative history of the QSLOB rules suggests that Congress intended ot discourage the use of profit-sharing plans in order to use section 414(r). TEI recommendes that instead of requiring a fixed allocation, the proposed regulations should mandate that the same allocation rate be used in respect of the non-highly compensated employee as is used in respect of the highly compensated employee. Thus, an employer whose profits justify a one-percent allocation will not be forced to borrow in order to fund the plan at three percent merely to maintain its eligibility for the separate-line-of-business safe harbor. Without this change, an employer may choose not to fund the plan, a result clearly not envisioned by Congress in enacting section 414(r).

TEI also is concerned with the requirement in Prop. Reg. [section] 1.414(r)-5(e)(2)(iii)(c) that the allocation be based on compensation as defined in section 415(c)(3). This requirement effectively overides an individual plan definition of compensation which may permissibly be different from the section 415(c)(3) definition. Thus, each defined contribution plan will have to be amended to account for the required portion of the allocation based on one definition of compensation and the remainder based on another definition. To avoid unnecessary plan amendments and confusion, TEI recommends that the mandated allocation be based on compensation as defined in the plan.

DOMINANT-LINE-OF-BUSINESS

METHOD OF ALLOCATING

RESIDUAL SHARED EMPLOYEES

Prop. Ref. $S 1.414(r)-7(c)(2)(ii) provides that residual shared employees may be allocated to the employer's dominant line of business. A dominant line of business is defined as a qualified separate line of business to which at least 55 percent of all substantial service employees are assigned under this section. TEI recommends that the definition of dominant line of business should be modified in three ways.

First, the definition should be expanded to include alternative methods of determination other than strictly head count. Examples of alternative standards include gross receipts, revenues, expenses, gross or net profits, or net worth. By focusing solely on employee count, the proposed regulations ignore other pertinent indicia of business size. In particular, the proposed rule fails to distinguish between capital and labor intensive lines of business. As proposed, the rule forces the allocation of residual shared employees to the labor intensive lines. Under the particular facts of an employer with a labor intensive service line and a capital intensive manufacturing line, the virtually mandatory allocation of residual employees to the labor intensive line of business prevents an employer that derives the greatest proportion of revenues and profits from the manufacturing line from using the dominant-line-of-business-allocation method.

Second, to assist in determining what is a dominant line of business, TEI suggests that the regulations be modified to permit a determination of a dominant line of business when no one of the lines of business constitutes a clearly dominant line. A 55-percent threshold (or even 45-percent under Prop. Reg. $S 1.414(r)-7(c)(2)(iii)) is simply too high for employers maintaining more than two lines of business. For example, assume an employer has five lines of business and that the lines of business have exclusive (and substantial) service employees to which 33, 25, 25, 10, and 7 percent of the employer's workforce are dedicated; assume further that one of the lines of business consistently delivers 50 percent of the controlled group's revenues. Common sense suggests that the line of business providing 50 percent of the group's revenue be deemed the dominant line. Nonetheless, under the proposed regulations there will not be a dominant line of business. TEI recommends that the regulations provide alternatives and "tie-breaker" rules that allow an employer in this circumstance to use a dominant line of business approach for allocation of residual shared employees. We suggest that the employer be allowed to designate a dominant line of business based on its facts and circumstances including the historical evolution of the business.

Finally, if the dominant line of business 55-percent test is retained, then the determination should be based on all employees including union employees. Prop. Reg. $S 1.414(r)-5(b)(3) states that the employees of the separate line of business are determined by applying Prop. Reg. $S 1.414(r)-7 to the employees taken into account under the statutory safe harbor. The reference to section 410(b) (excluding union employees) in the proposed regulations may distort the determination of the dominant line when some lines are unionized.

ALL-OR-NOTHING APPROACH

TO TESTING AND SANCTIONS 

Under Prop. Reg. $S 1.414(r)-1(b)(1), if an employer elects to treat one line of business as a qualified separate line of business, it must treat all of its lines as qualified separate lines of business. TEI maintains that the imposition of this "all-or-nothing" rule is beyond the scope of the statute. If an employer elects to use the separate line of business rules for one or more of its plans, there is no justification for requiring this approach for the other plans that may satisfy the minimum-coverage test on an employer-wide basis. TEI recommends that this requirement be eliminated.

Under Prop. Reg. $S 1.414(r)-8(d)(5), if a plan is tested under the separate line of business rules and it fails one or more of the nondiscrimination rules, that plan and all other plans of which it is a portion will be disqualified under section 401(a) of the Code. TEI objects to the imposition of such a draconian penalty without regard to the nature or magnitude of the employer's offense. A more balanced approach would permit alternative testing methods to maintain the plan's overall qualification. The "death penalty" for employee benefit plans should be reserved for truly capital offenses of obvious and egregious abuse. It should not be imposed when an employer attempts to comply in good faith with the arcane and complex minutiae inherent in the benefits area and there has been no attempt to deliver a qualified "top-hat" plan to highly compensated employees.

In summary, TEI believes that flexibility and proportionality are the keys to successful implementation of the QSLOB regulations. An all-or-nothing approach to SLOB relief and sanctions for failing the requirements for SLOB plan qualification is not appropriate.

CONCLUSION

Tax Executives Institute appreciates the opportunity to present its views relating to the proposed regulations on qualified separate lines of business under section 414(r) of the Code. If you should have any questions about our comments, or if you wish for us to elaborate on our views, please do not hesitate to call Lester D. Ezrati, chair of the Institute's Federal Tax Committee at [phone]; David L. Klausman, chair of the Institute's Employee Benefits Subcommittee, at [phone]; or Jeffery P. Rasmussen of the Institute's professional tax staff, at [phone].

(1) For simplicity's sake, the proposed regulations are generally referred to as "the proposed regulations" and specific provisions are cited as "Prop. Reg. $S." References to page numbers are to the proposed regulations (an preamble) as published in the Internal Revenue Bulletin.

(2) 1991-9 I.R.B. at 17.

(3) See H.R. Rep. No. 841, 99th Cong., 2d Sess. II-523 (1986)(Conference Report).

(4) 1991-9 I.R.B. at 18.

(5) One may infer from Example 9 of Prop. Reg. $S 1.414(r)-3(c)(2)(iv) that services in excess of one week per year are "more than negligible." The "more than negligible" standard is too stringent. If the recommendations in the text are not adopted, the regulations ought to allow employees to provide up to 25 percent of their services to a line of business before being included in the line's workforce. Such a standard mirrors the 500 hours of service required for "material participation" under the passive activity loss rules.

(6) Section 414(r)(6) dictates that the Secretary prescribe rules for the allocation of headquarters personnel. "Headquarters personnel" is not defined by the regulations but the employees covered by the sobriquet "headquarters staff" fall within the definition of "residual shared employees."

(7) Although the IRS must allocate headquarters staff to address the statutory requirements of section 414(r)(6)(A), we do not believe it is a necessary component of the threshold inquiry whether a "separate" line of business exists. The allocation of staff employees unnecessarily complicates the testing.

(8) To safeguard against abuse, the IRS could retain authority to challenge on examination the use of management fees, chargebacks, and allocations that result in a segregation of the accounting payroll expense reporting from the lines of business served by the employee.

(9) If the rule is intended to place foreign-owned multinationals on the same competitive level as domestic multinationals, the rule should be modified to address this issue directly thereby avoiding an overbroad, all-encompassing data collection rule.

(10) To meet the separate management test, ninety percent of the ten percent most highly compensated employees providing services to a line of business must provide services exclusively to the line. Thus, if ten percent of the ten percent most highly compensated employees allocated to a line of business also provide service to another line, the line of business fails the separate management test.

(11) Employers who provide section 401(k) plans use projections throughout the testing year to monitor the Actual Deferral Percentage and the Actual Contribution Percentage to maintain the plan's qualified status. Employers who do not maintain section 401(k) plans, but wish to avail themselves of SLOB relief, face the burden of modifying their EDP systems and data-collection methods to monitor compensation as though a section 401(k) plan were in effect. Furthermore, relatively few employees covered by collective bargaining agreements are also covered by section 401(k) plans. Employers providing 401(k) plans to non-union personnel and other plans to union personnel face a similar burden in modifying existing systems to implement the compensation test for SLOB relief.

(12) 1991-9 I.R.B. at 20.

(13) 1991-9 I.R.B. at 52-53

(14) 1991-9 I.R.B. at 21.

(15) 1991-9 I.R.B. at 22.