Section 404 and 404(a)(7) Deduction Issues ASPPA Annual 2009

Kurt F. Piper, M.A.A.A., A.S.A., M.S.P.A.

Introduction

 This outline is meant to serve as a general guide with respect to many of the various issues which arise when determining the deductibility of contributions to combinations of DB and DC plans.

Introduction

 The opinions expressed are mine and not necessarily those of the sponsoring organizations.

Introduction

 Once the IRS issues guidance, the opinions expressed herein might not even reflect my own opinion.

Tax Deductions

 In order to claim a tax deduction, there must be a provision in the Internal Revenue Code (“the Code”) that allows it.

Tax Deductions

 Defined Benefit Pension Plans

TAX DEDUCTIONS

DB – 2006 & 2007

 The following were the rules for 2006 and 2007.  The rules changed for 2008.

 Tax deductions for pension plans are taken under IRC Section 404(a)(1).  The various methods of claiming a deduction are:

 TAX DEDUCTIONS

DB – 2006 & 2007

IRC Section 404(a)(1)(A)(i) – The amount required for minimum

funding purposes

 TAX DEDUCTIONS

DB – 2006 & 2007

IRC Section 404(a)(1)(A)(ii) – Funding benefits using a level dollar or level

percentage of compensation over future

service of each employee. If the remaining unfunded cost with respect to any 3 individuals is more than 50 percent of such remaining unfunded cost, the amount of such unfunded cost attributable to such individuals shall be distributed over a period of at least 5 taxable years.

 TAX DEDUCTIONS

DB – 2006 & 2007

IRC Section 404(a)(1)(A)(iii) – Normal cost plus past service amortization.

 TAX DEDUCTIONS

DB – 2006 & 2007

 IRC 404(a)(1)(D)(i) – 150% of Current

Liability less Assets

For plans with 100 or fewer participants, do not include the current liability for accrued benefits due to amendments made or effective in the prior two years.

 TAX DEDUCTIONS

DB – 2006 & 2007

IRC 404(a)(1)(D)(iv) – Unfunded Benefit Liabilities for plans covered by Title IV of ERISA (PBGC) which terminate during the plan year.

TAX DEDUCTIONS

DB – 2006 & 2007

 Notice 2007-28 has clarified that for purposes of applying the two year amendment rule in calculating 150% of current liability, the adoption of a new plan will be treated as a plan amendment only if the employer maintained another DB plan that covered any HCE covered by the new plan.

TAX DEDUCTIONS

DB – 2006 & 2007

 The prior IRS position was that the establishment of a new plan was the same as an amendment.

TAX DEDUCTIONS

DB – 2008

 PPA ’06 changed the minimum funding and deduction rules for 2008.

TAX DEDUCTIONS

DB – 2008

 Maximum deduction is the greater of:  430 minimum - 404(o)(1)(B)  404(o)(2) amount – 404(o)(1)(A)  Title IV Plans may still contribute and deduct the difference between Benefit Liabilities and assets in the year of plan termination – 404(o)(5)

TAX DEDUCTIONS

DB – 2008

 404(o)(2) amount – 404(o)(1)(A)/404(o)(2)(A)  Sum of:  Funding target plus  Target normal cost plus  Cushion amount less  Actuarial value of assets (unreduced by COB or PFB but reduced by un-deducted contributions).

TAX DEDUCTIONS

DB – 2008

 Cushion amount – 404(o)(3)  50% of funding target, plus  Increase in funding where future compensation increases are considered  If benefits not affected by future compensation (e.g. flat dollar) allow for expected increases based on the prior six (6) years of benefit increases  N/A for most cash balance/accumulation plans  404(l) compensation limit and 415 benefit limit taken into account

TAX DEDUCTIONS Example One  Example One – Facts     Target normal cost Funding target FT with salary scale Actuarial value of assets $100,000 200,000 250,000 200,000  2 year HCE lookback N/A  Minimum required contrib 100,000

TAX DEDUCTIONS Example One  50% Funding target  Increase due to sal scale  Cushion amount  Target normal cost  Funding target  Actuarial value of assets  Maximum deductible $100,000 50,000 150,000 100,000 200,000 (200,000) $250,000

TAX DEDUCTIONS

DB – 2008

 The cushion is meant to provide the plan sponsor with flexibility as to the amount of the contribution for the year; more in a good year; less in a bad year.

 Can a new plan be designed so as to provide a cushion, namely can the use of past service credits allow past service benefits to be allocated to funding target and, hence, create a cushion?

TAX DEDUCTIONS

DB – 2008

 The 2008 Graybook, Q&A #7, says that you add to funding target and cushion when amending an existing plan to crease past service credit.

 The implication is that such is possible for a new plan.

 And since the IRS has said that a new plan is not an amendment for purposes of the 2 year lookback limitation rule, this allows for the creation of cushions for one-man plans as well.

TAX DEDUCTIONS

DB – 2008

 However, note that the funding target created does not include the increase in the dollar limit due to COLA since that part of the benefit could not have been earned in the prior year.

TAX DEDUCTIONS

DB – 2008

 404(o)(2)(B) – “At-Risk”    If 430(i) (“At-Risk”) does not apply, the 404(o)(2) amount is not less than:    Funding target as if at risk, Target normal cost as if at risk, plus less Actuarial value of assets (unreduced by COB & PFB) Do the 4%/$700 loads apply? I don’t know.

So a plan sponsor should always be able to fund for the difference between “lump sum PVAB” and assets.

TAX DEDUCTIONS

Example Two

 One-man Plan  Accrued the IRC 415 dollar limit each year  End of year valuation date  PVAB on Plan assumptions$1,100,000  PVAB on 417(e) assumptions $1,200,000  Maximum lump sum under 415 $1,000,000  Value of Plan Assets $ 700,000  Maximum under 404(o)(2)(B) $ 300,000

TAX DEDUCTIONS

DB – 2008

 404(o)(1)(B) – minimum required contribution under 430  Does this “include interest”? By that I mean is the contribution tax deductible under 404(o)(1)(B) that, when adjusted for interest, satisfies the MRC?  The Code doesn’t seem to address this issue, but:  For most plans, if only the MRC amount is deductible, which is usually less than the contribution required to satisfy the MRC, then Congress meant that such plans could not deduct a required contribution.

TAX DEDUCTIONS

DB – 2008

 That would be a policy “FAIL” and stupid on it’s face.

 The IRS should interpret the Code to “interest adjust” this deductible limit so as to not require a contribution in excess of that which is deductible.

TAX DEDUCTIONS Example Three  One-man plan  End of year valuation  MRC as of valuation date is  Effective interest rate  Contribution made 9/15 following 6% $100,000 valuation date that when adjusted to the valuation date with the effective rate equals the MRC $104,214

TAX DEDUCTIONS

DB – Basis for Deduction

 One or more plan years form the basis for a tax deduction  Each tax year of the employer has a deductible limit  When the tax year coincides with a plan year, the deductible limit for the tax year is determined on the basis of that plan year

TAX DEDUCTIONS

DB – Basis for Deduction

 If not, one of three methods has been used to determine the deductible limit for the tax year  Limit determined on Plan year beginning within the tax year    Limit determined on Plan year ending within the tax year Weighted average of above based on the number of months of each plan year falling within the taxable year Regulation 1.404(a)-14(c)

TAX DEDUCTIONS

DB – Basis for Deduction

 Those were the rules for pre-2008 years.

 I believe they will be the rules for post-2007 years as well because of similarity in the language in the law pre and post PPA. I would be astounded if the IRS changed their interpretation without a clear instruction to do so by Congress.

TAX DEDUCTIONS

DB – Basis for Deduction

 There could be transition oddities  If the IRS were to say in regulations that the deductible limit for a tax year is based solely upon the plan year in which the tax year begins, then it is possible that two consecutive tax years might have their deductible limits determined based on the same plan year.

TAX DEDUCTIONS

DB – Basis for Deduction

  If the IRS were to say in regulations that the deductible limit for a tax year is based solely upon the plan year in which the tax year ends, then it is possible that a particular plan year will not have a tax year with a deductible limit based on that plan year.

That would be a problem, for example, for a tax year that ends 1/31 when the Plan year ends 12/31 and the Plan year uses an end of year valuation.

TAX DEDUCTIONS

DB – Basis for Deduction

 If the IRS were to mandate the pro-rata approach for all tax years or should the IRS mandate that then that would also be a problem, for example, for a tax year that ends 1/31 when the Plan year ends 12/31 and the Plan year uses an end of year valuation.

 Why change something that works?

TAX DEDUCTIONS Further notes on 2-Year Lookback  Many times the 404(o)(1)(A) amount is the maximum even with the two year restriction.

 So it is a good idea to always calculate this limit even if there has been a plan amendment within the prior two years.

TAX DEDUCTIONS Further notes on 2-Year Lookback  I recommend providing a caveat, if not a stern warning, in any actuarial report, letter, or email communicating the 404(o)(2)(A) amount.

 Sometimes the employer should only contribute the minimum (or some moderate amount) to avoid possible IRC section 415 problems, i.e. to avoid excess assets.

TAX DEDUCTIONS Example Four  Example: The following is information about the initial plan adoption and an amendment Adoption Date Plan Am 1 12/31/2004 3/31/2006 Effective Date 1/1/2004 1/1/2006 IRC 412 Effective Date Benefit Formula in Plan/Amend 1/1/2002 5% of AAC x YOP 1/1/2006 7% of AAC x YOP

TAX DEDUCTIONS Example Four  Amendment number 1 is not taken into account in the 2008 valuation for the two year rule for HCE since it was adopted or effective in 2006.

TAX DEDUCTIONS Further notes on 2-Year Lookback  The IRS does not look at amendments adopted or effective in the prior 730 days (365 x 2). Rather, it looks at the amendments adopted or effective in the two

plan years

immediately preceding the current plan year (and also those adopted or effective in the current plan year) regardless of the valuation date.  I don’t know what the IRS would say if one of the prior plan years was a short plan year, possibly that a year is a year even if short.

TAX DEDUCTIONS Example Five  Example The following is information about the initial plan adoption and an amendment Adoption Date Plan Am 1 12/31/2004 3/15/2006 Effective Date 1/1/2004 1/1/2005 IRC Effective Date Benefit Formula in Plan/Amend 1/1/2004 5% of AAC x YOP 1/1/2005 7% of AAC x YOP

TAX DEDUCTIONS Example Five   Amendment number 1 is still not taken into account in the 2008 valuation for the two year rule for HCE since it was adopted or effective in 2006, despite being effective in 2005. In the past we may have made extensive use of IRC section 412(c )(8) (now 412(d)(2)) to adopt amendments after the end of the plan year. In the future we might want to adopt amendments increasing benefits before the end of the plan year. This might be best accompanied by the use of a beginning of year valuation so as to have reliable numbers before the end of the plan year.

TAX DEDUCTIONS Example Six  Example The following is information about the initial plan adoption and two amendments Adoption Date Effective Date IRC 412 Effective Date Benefit Formula in Plan/Amend Plan Am 1 Am 2 12/31/2004 3/15/2006 3/15/2007 1/1/2004 1/1/2005 3/31/2007 1/1/2004 5% of AAC x YOP 1/1/2005 7% of AAC x YOP 1/1/2006 4% of AAC x YOP

TAX DEDUCTIONS Example Six   Amendment number 1 is still not taken into account in the 2008 valuation for the two year rule for HCE since it was adopted or effective in 2006. Amendment number 2 is taken into account since it does not increase accrued benefits but, rather, it decreases them. So here we should use the benefits under the original formula as limited by Amendment number 2. Namely, ignore that amendment number 1 ever existed when calculating current liability for this purpose.

TAX DEDUCTIONS Example Six  So here we should use the benefits under the original formula as limited by Amendment number 2.  In this example, ignore that amendment number 1 ever existed when calculating current liability for this purpose.

 In the general case, you must research the benefit structure used for HCE.

TAX DEDUCTIONS Further notes on 2-Year Lookback  What if an amendment has some provisions that increase benefits and some that decrease benefits?

 In my opinion, you look at the net result  This could mean different results for different HCE

TAX DEDUCTIONS Further notes on 2-Year Lookback  You might hear that the amendment should be bifurcated, with the “increase” part of the amendment treated as a separate amendment from the “decreasing” part of the amendment.

 I respectfully disagree.

Tax Deductions

 Defined Contribution Plans

TAX DEDUCTIONS

Defined Contribution Plans

 Tax deductions for stock bonus plans, money purchase pension plans, and profit sharing plans, including 401(k) plans, are taken under IRC Section 404(a)(3), but can be limited by IRC Section 404(a)(7).

TAX DEDUCTIONS

Defined Contribution Plans

 The basic maximum deduction is 25% of the compensation paid or accrued during the tax year of the employer to the “beneficiaries” under the plan.

TAX DEDUCTIONS

Defined Contribution Plans

 Some related issues are:

TAX DEDUCTIONS

Defined Contribution Plans

 The Code says, “if such taxable year ends within or with a taxable year of the trust with respect to which the trust is exempt under section 501(a)”.

TAX DEDUCTIONS

Defined Contribution Plans

 The Code is not creating a linkage of the contribution direction between the tax year of the employer and the Plan, i.e. the contribution for a tax year does not always have to be allocated in the Plan year in which the tax year ends.

TAX DEDUCTIONS

Defined Contribution Plans

 The Code is saying that the Trust must be tax qualified (as opposed to disqualified or nonqualified) for the Plan year in which the taxable year of the employer ends if it wants to take a deduction for such taxable year.

 TAX DEDUCTIONS

Defined Contribution Plans

The carryover rules have changed a lot since ERISA. Now, excess contributions can be carried over, but such carryovers do not increase the tax deduction in a later year.

TAX DEDUCTIONS

Defined Contribution Plans

 So, the carryover will reduce the new deductible contributions for the year in which the carryover is deducted. (IRC 404(a)(3)(A)(ii).)  This does allow some flexibility as to which Plan year a contribution is allocated and in which tax year it is deducted.

TAX DEDUCTIONS

Defined Contribution Plans

  For example, say that only the owner is eligible for a contribution in 2008 but 5 employees become eligible in 2009.

If the employer contributes $46,000 after the employer’s 2008 tax return due date but within 30 days, the contribution can be designated for 2008, allocated in 2008 to the owner, and deducted in 2009 provided there is enough deduction limit available in 2009. (More on what this deductible limit is later.)

 TAX DEDUCTIONS

Defined Contribution Plans

Plans which are not defined contribution plans are those “designed to provide benefits upon retirement and covering a period of years (and) if under the plan the amounts to be contributed by the employer can be determined actuarially as provided in paragraph (1)”, then the plan is a defined benefit pension plan.

 TAX DEDUCTIONS

Defined Contribution Plans

Two or more defined contribution plans of the employer are combined for purposes of the deduction limit.

TAX DEDUCTIONS

Defined Contribution Plans

 This aggregation does not apply to members of an affiliated service group (IRC Section 404(a)(3)(B)). Members of an affiliated service group must separately deduct the contributions to their plans and, for example, cannot aggregate compensation with respect to meeting the 25% of compensation deduction limit or the 6% rule.

 TAX DEDUCTIONS

Defined Contribution Plans

Money purchase pension plans, including target benefit pension plans, shall be treated like profit sharing plans except that the Secretary of the Treasury can provide exceptions.

TAX DEDUCTIONS

Defined Contribution Plans

 One such exception might be created for when a required contribution cannot be deducted in the current year solely to the 25% of compensation limit.  Perhaps the IRS will issue guidance to allow it to be deducted anyway due to being required by IRC section 412.

TAX DEDUCTIONS

Defined Contribution Plans

 I suspect there will be some strings attached to prevent abuse.  Note that there is no such current exception (beware flip-flops!)

TAX DEDUCTIONS

Defined Contribution Plans

 Contributions which are deductible for a taxable year are those the employer either makes by the last day of the tax year or those made by the tax return due date of the employer (with extensions) and which the employer elects to deduct in such prior tax year.

TAX DEDUCTIONS

Defined Contribution Plans

 Deduction of a contribution on the employer’s tax return counts as the election but does not have to be the only form of election.  A board resolution is OK, for example, and was a common method pre-ERISA.

 A contribution shown on a Schedule SB is not an employer election regarding the tax year the contribution is deducted, in my opinion.

  TAX DEDUCTIONS

Defined Contribution Plans

Only the compensation of “beneficiaries” counts towards the deduction limit. What does “beneficiary” mean in this case?

 TAX DEDUCTIONS

Defined Contribution Plans

Surely not the “beneficiary” of a death benefit of a plan participant since they are not usually employees with compensation.

   TAX DEDUCTIONS

Defined Contribution Plans

The pre-ERISA regulation, 1.404(a)-13, defined such as the “beneficiaries of the trust funds accumulated under the plan”. Somebody from Mars who suddenly found himself on Earth might think that this would mean “any employee with an account balance”. Nice Barsoomian try.

 TAX DEDUCTIONS

Defined Contribution Plans

This regulation was interpreted by Revenue ruling 65-295 to mean “those employees who

participate in the allocation of the employer's contribution

to the plan in the year for which such contribution is made”.

  TAX DEDUCTIONS

Defined Contribution Plans

The revenue ruling explicitly excludes employees who terminated employment during the year and for whom no allocation of contribution is being made. Thus, the regulation, as interpreted by the revenue ruling, almost anticipates the term of art “benefiting” as defined in the regulations under IRC Section 410(b).

  TAX DEDUCTIONS

Defined Contribution Plans

The only difference seems to be that an employee must get a share of the employer contribution to have his compensation counted in the deduction limit; One IRS employee has said that receiving only a share of forfeitures makes an employee a beneficiary since the source of the forfeitures is from employer contributions.

  TAX DEDUCTIONS

Defined Contribution Plans

Is only receiving a 401(k) salary deferral (or eligibility to defer) good enough to make the recipient a “beneficiary”?

It is true such contributions are no longer subject to the 25% of pay deduction limit even though they are technically employer contributions due to Code section 404(n).

TAX DEDUCTIONS

Defined Contribution Plans

 Q&A 10 from the 2007 Gray Book from the Enrolled Actuaries Meeting says an employee who only makes a 401(k) deferral is said to be a beneficiary but not if he was eligible but didn’t.

TAX DEDUCTIONS

Defined Contribution Plans

 Either way you slice it, the Q&A is wrong.

 If benefiting is the criteria, then whether the participant defers or not is irrelevant since those who are eligible to defer are considered benefiting.

 If 404(n) applies, which mandates that elective deferrals shall not be taken into account in applying any limitation to any contributions, then without contributions other than elective deferrals, the participant would not be a beneficiary.

TAX DEDUCTIONS

Defined Contribution Plans

 For now I am being conservative and not including these “deferral only” participants.  Others are including them, either to the limited extent of the IRS Q&A (i.e. if the participant deferred) or, else, to the aggressive extent of including all who are eligible to defer as beneficiaries.

Tax Deductions

 DB/DC Combos

TAX DEDUCTIONS

DB/DC Combos

 IRC 404(a)(7)(A) provides the general rule: the deduction is the greater of  25% of compensation or  the contribution required by IRC Section 412 to the defined benefit pension plan(s).

TAX DEDUCTIONS

DB/DC Combos

 There are important exceptions to the general rule.  First the following is the Code language.

 (Then, what it means)

TAX DEDUCTIONS

DB/DC Combos

 The Beneficiary Test: “This paragraph shall not have the effect of reducing the amount otherwise deductible under paragraphs (1), (2), and (3), if no employee is a beneficiary under more than 1 trust or under a trust and an annuity plan.”

TAX DEDUCTIONS

DB/DC Combos

 Elective Deferrals: “If, in connection with 1 or more defined contribution plans and 1 or more defined benefit plans, no amounts (other than elective deferrals (as defined in section 402(g)(3))) are contributed to any of the defined contribution plans for the taxable year, then subparagraph (A) shall not apply with respect to any of such defined contribution plans and defined benefit plans.”

 TAX DEDUCTIONS

DB/DC Combos

Six Percent Rule: “In the case of employer contributions to 1 or more defined contribution plans, this paragraph shall only apply to the extent that such contributions exceed 6 percent of the compensation otherwise paid or accrued during the taxable year to the beneficiaries under such plans.

TAX DEDUCTIONS

DB/DC Combos

For purposes of this clause, amounts carried over from preceding taxable years under subparagraph (B) shall be treated as employer contributions to 1 or more defined contributions to the extent attributable to employer contributions to such plans in such preceding taxable years.”

TAX DEDUCTIONS

DB/DC Combos

 IRC Section 404(n): “Elective deferrals (as defined in section 402(g)(3)) shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a) or paragraph (1)(C) of subsection (h), and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions.”

TAX DEDUCTIONS

DB/DC Combos

 DB plans covered by Title IV of ERISA (PBGC) shall not be subject to 404(a)(7) effective for years beginning in 2008.

TAX DEDUCTIONS

DB/DC Combos

 These Code sections mean the following:

TAX DEDUCTIONS

DB/DC Combos

 If no individual employee is a beneficiary under one or more defined benefit plans 404(a)(7) limit.

and

one or more defined contribution plans for a year, then the plans are not subject to the IRC Section

TAX DEDUCTIONS

DB/DC Combos

  The fact that an employee who is a beneficiary under the defined benefit pension plan made 401(k) salary deferrals does not result in the application of the IRC Section 404(a)(7) deduction limit solely because of the 401(k) deferrals.

Q&A 7 of Notice 2007-28 makes this clear when it says “However, pursuant to section 404(n), elective deferrals are not taken into account.”

TAX DEDUCTIONS

DB/DC Combos

 It was once suggested that if an employee who is a beneficiary under the defined benefit pension plan and who had a non-zero account balance under the defined contribution plan other than a 401(k) account, then regulation 1.404(a)-13 would consider that person as being one of the “beneficiaries of the funds accumulated” and, thus, cause the limits of IRC Section 404(a)(7) to apply.

TAX DEDUCTIONS

DB/DC Combos

 This interpretation was completely incorrect. Revenue ruling 65-295, referenced earlier with respect to the regulations under IRC Section 404(a)(3), interprets the the year.

exact same words

used in the regulation under IRC Section 404(a)(7) to mean employees who receive contributions for

TAX DEDUCTIONS

DB/DC Combos

 It is extremely doubtful that a Federal judge would let the IRS say “blue means blue” in 404(a)(3) and “blue means red” in 404(a)(7) when the language is the same and the subjects are so closely related.

TAX DEDUCTIONS

DB/DC Combos

 Again, the purpose of the language of the Code, regulation, and revenue ruling is to exclude from the deduction limit calculation those employees for whom the employer does not make contributions for both 404(a)(3) and 404(a)(7).

 Revenue Ruling 65-295 was not being nice, it was being restrictive.

 It also cannot be read both ways.

TAX DEDUCTIONS

DB/DC Combos

 There is an ambiguity as to who “receives contributions” under a defined benefit plan.

 One might think that this ought to include those participants who benefit.

 However, it might include participants with frozen accrued benefits (and so not benefitting) in underfunded plans because the funding for those benefits is continuing.

TAX DEDUCTIONS

DB/DC Combos

 It would include one and only one of the following:  A participant with a frozen accrued benefit when the plan is not underfunded but there are contributions, or  A participant who is continuing to accrue benefits but there are no contributions to the defined benefit plan due to the full funding limit.

 Both cannot be considered as “beneficiaries”.

TAX DEDUCTIONS

DB/DC Combos

  I’ve decided that it depends solely on whether the employer is making a contribution to the defined benefit pension plan and not on whether anyone benefits in the DB plan. This sounds odd to a generation accustomed to the 410(b) and 401(a)(4) regulations, but remember that under Code section 404 Congress is talking only about tax deductible contributions and not benefit accruals.

TAX DEDUCTIONS

DB/DC Combos



The Six Percent Solution

TAX DEDUCTIONS

DB/DC Combos

 “Six percent” has been an historical number.  In the really old days, employee contributions not in excess of six percent of pay were not considered against the annual addition limit.  Those days are, of course, long gone.

TAX DEDUCTIONS

DB/DC Combos

   Then before PPA ’06, there was an explicit instruction in the law that only non-deductible defined contributions in excess of six percent of pay were subject to the 10% excise tax. Thus if the DB contribution was 30% of pay and the DC contribution was 6% of pay, there was no excise tax at all. Of course the 6% of pay DC contribution was not deductible in the current year

TAX DEDUCTIONS

DB/DC Combos

 Many of us thought that the PPA six percent rule would work in a similar manner.  Namely, if the DC contribution were 6% of pay or less, then there would be no effect on the DB deduction.  That is not what Notice 2007-28 said.

TAX DEDUCTIONS

DB/DC Combos

 The position in Notice 2007-28 is now irrelevant since Congress enacted WRERA ‘08.  So, if the DC contribution is more than 6% of pay, the 404(a)(7) limit is 31% of pay.

 And the DC deduction limit is never less than 6% of pay no matter how much is contributed to the DB plan.

TAX DEDUCTIONS

DB/DC Combos

 A side note: keep in mind that the contribution to the defined benefit pension plan as limited by IRC section 404(a)(7) still cannot be greater than the IRC section 404(a)(1) limit (404(o)).

 The plan sponsor can take the lesser amount as a tax deduction, not the greater.



Example

TAX DEDUCTIONS Example Seven XYZ Company 401(k) Plan for 2008 Employee Group Eligible but no contributions 401(k) deferrals only Receives deferrals and match Number 50 100 500 Compensation $1,000,000 500,000 10,000,000 Compensation for beneficiaries = $10,000,000. The compensation of the 401(k) deferral only employees doesn’t count due to IRC section 404(n) and those who receive no contributions don’t count because they do not receive any employer contributions or forfeitures.

TAX DEDUCTIONS

Example Seven

 Example DEF Company 401(k) Plan and Defined Benefit Pension Plan for 2008  DEF Company makes profit sharing contributions for Division A and provides defined benefits for Division B.  Nobody is in both divisions so nobody gets both PS & DB.  All employees are eligible to make 401(k) deferrals and some in each division do defer.

TAX DEDUCTIONS

DB/DC Combos

 The deduction limit for the defined benefit plan is limited solely by 404(a)(1), the deduction limit for the profit sharing contribution of the 401(k) plan is limited solely by 404(a)(3), and the limits of 404(a)(7) do not apply to either.

TAX DEDUCTIONS

Example Eight



Example

GHI Company 401(k) Plan and Defined Benefit Pension Plan for 2008   GHI Company makes profit sharing contributions for Division A and provides defined benefits for Division B. Nobody is in both divisions so nobody gets both DB and DC. All employees are eligible to make 401(k) deferrals and some in each division do defer. All who defer receive a 10% match.

TAX DEDUCTIONS

DB/DC Combos

 The deduction limit for the defined benefit plan is limited by 404(a)(1), the deduction limit for the profit sharing contribution of the 401(k) plan is limited by 404(a)(3), and the limits of 404(a)(7) apply to both because of the match.

TAX DEDUCTIONS

Example Nine

 Counting only the beneficiaries: Division A compensation = Division B compensation = $2,000,000 $1,000,000 Total compensation = $3,000,000 Compensation of Division B employees who get matches = $ 500,000

TAX DEDUCTIONS

Example Nine

 DB Valuation Date  Assets:  404(o)(1)(B) Minimum:  404(o)(1)(A) Maximum:  TNC+FT+Cushion:  limited by 2 yr rule: 12/31/2008 $10,000,000 $ 300,000 $ 350,000 $10,400,000 $10,000,000

TAX DEDUCTIONS

Example Nine

 404(o)(1)(D)(i) Maximum :  $10,000,000 x 1.5 - $10,000,000 = $5,000,000 Unfunded current liability w/o 2 year rule $10,400,000 - $10,000,000 = $ 400,000

TAX DEDUCTIONS

Example Nine

 Profit Sharing contribution  Matching contribution  Total DC contributions $350,000 $100,000 $450,000

TAX DEDUCTIONS

Example Nine

 6% of DC compensation 6% x ($2,000,000 + $500,000) = $150,000 Since DC contributions exceed 6% of DC compensation, we do not use the Q&A 9 rule, we use the Q&A 8 rule.

TAX DEDUCTIONS

DB/DC Combos

 Maximum DB = The lesser of regular DB maximum or 25% of Total compensation - DC contribution + 6% of DC compensation, = lesser of $5,000,000 or 750,000 - $450,000 + 150,000 = lesser of $5,000,000 or $450,000, = $450,000

TAX DEDUCTIONS

DB/DC Combos

 You must look at the possibilities.  You have to determine the 25% limit,  the minimum funding amount,  the regular DB maximum deductible amount,  the 6% of DC participants’ compensation amount,  etc. and reach a conclusion.

TAX DEDUCTIONS

Example Ten



Example Nine

 Affiliated Service Group: Doctor A, Inc., Doctor B, Inc., and AB Medical Partnership. All three sponsor a defined benefit pension plan and a 401(k) Plan.

 Doctor A compensation  Doctor B compensation  Employees’ compensation $225,000 $225,000 $200,000

TAX DEDUCTIONS

Example Ten

 Required Contributions to defined benefit pension plan by Doctor A, Inc.

of AAC x YOP $200,000 Doctor B, Inc.

of AAC x YOP AB Medical Partnership $150,000 $ 20,000 5% 5% ½% of AAC x YOP

TAX DEDUCTIONS

Example Ten

 Profit Sharing & QNEC Contributions to 401(k) plan by Doctor A, Inc.

of pay $13,500 6% Doctor B, Inc.

of pay AB Medical Partnership $13,500 $15,000 6% 7-1/2% of pay

TAX DEDUCTIONS

Example Ten

 For Doctor A, Inc. the DC does not exceed 6% of pay so the minimum DB contribution is deductible.  Ditto for Doctor B, Inc.

 For AB Medical Partnership, 25% of pay is $50,000. The sum of the DB minimum of $20,000 and the DC of $15,000 is $35,000 so there’s no problem with 404(a)(7).

TAX DEDUCTIONS

Example Ten

 Note that Doctor A and Doctor B cannot dip into the left over deduction limit of the AB Medical Partnership because they are employees of the corporations and not the partnership.

TAX DEDUCTIONS

Example Eleven



Example

 ZZZ Company 401(k) Plan and Defined Benefit Pension Plan for 2008 Owner Compensation $220,000 DB contribution $200,000 DC contribution $ 1 Employee $10,000 $ 500 $10,000

TAX DEDUCTIONS

Example Eleven

 Note that the 6% of pay limit is 6% of ($220,000 + $10,000) = $13,800, so $10,001 is OK.  There is no “meaningful” contribution test for a DC plan, so the $1 for the Owner includes the owner for 404(a)(3), 404(a)(7), 410(b), and 401(a)(4) purposes.

TAX DEDUCTIONS

DB/DC Combos

 This is a useful tool in designing DB/DC combos.  The idea is to provide ½% of pay in the DB plan for the NHCE to meet the meaningful benefits test of 401(a)(26) and provide their real benefits in the DC plan; the HCE get something in the DC plan so that their compensation can count towards the 6% of DC pay.

TAX DEDUCTIONS

DB/DC Combos

 If this works (i.e. fits the allowable deductions), you avoid providing expensive defined benefits to a select few NHCE alienating the other NHCE, avoid DB Gateway problems, and provide more stability with respect to 401(a)(26) and 401(a)(4).

TAX DEDUCTIONS

DB/DC Combos

 The major problem is fitting all DC contributions within the 6% of pay limit and the DB deduction limits from the IRS Six Percent Solution.

TAX DEDUCTIONS

Example Twelve

      

Example

AAA Company Profit Sharing Plan and Defined Benefit Pension Plan for 2008. Every employee is in both plans.

$ 300,000 Compensation: DB Valuation Date: 12/31/2008 Assets: MRC: Maximum deductible: $2,000,000 $ 500,000 $1,000,000

TAX DEDUCTIONS

Example Twelve

  Profit Sharing contribution 25% of total compensation $75,000 25% x $300,000 = $75,000  6% of DC compensation 6% x ($300,000) =$18,000

TAX DEDUCTIONS

Example Twelve

 Since DC contributions exceed 6% of DC compensation, we do not use the Q&A 9 rule, we use the Q&A 8 rule.

Tax Deductions Title IV Terminating Plans

 IRC section 404(o)(5):Title IV Plans may still contribute and deduct the difference between Benefit Liabilities and assets in the year of plan termination

Tax Deductions Title IV Terminating Plans

 This means, for example, that if a Plan covered by Title IV or ERISA terminates in 2009, and the difference between Benefit Liabilities and assets exceeds the otherwise deductible maximum deduction under 404(o), the amount under 404(o)(5) is the maximum deductible contribution.

 This is not a change from prior law.

Tax Deductions Title IV Terminating Plans

 What happens if the plan sponsor does not know by the due date of the 2009 tax return what the full 404(o)(5) contribution is?

 Remember that the Plan will not satisfy the criteria for a Standard Plan Termination unless the full 404(o)(5) amount is contributed or, else, one or more Majority Owners eat dirt.

Tax Deductions Title IV Terminating Plans

 One theory is that the amount not contributed by the Plan sponsor’s 2009 tax return is not deductible.

 Another theory is that the amount not contributed by the Plan sponsor’s 2009 tax return is deductible over some amortization period.

 Horse feathers.

Tax Deductions Title IV Terminating Plans

 There are only two real-World possibilities  Ask the PBGC to change the Plan Termination Date without incurring additional benefits to avoid a problem with the IRS– the IRS being a Federal Agency that would not be required to come up with the extra money to fund the participant’s benefits if the plan sponsor were to say “Up Yours IRS” and go into bankruptcy.

Tax Deductions Title IV Terminating Plans

 Contribute and claim the full contribution required to satisfy the criteria for a Standard Plan Termination and let the IRS disallow some or all of the contribution. Then scream like a stuck pig to Congress.

Tax Deductions Title IV Terminating Plans

 Choosing not to claim a tax deduction only makes sense if the plan sponsor pays no taxes.

 Choosing to amortize the amount could possibly lose a portion if the IRS take a liberal interpretation later. This is because if the tax year of the contribution is beyond the statute of limitations, the IRS will not let the plan sponsor go back and amend the return to increase the tax deduction.

Tax Deductions Title IV Terminating Plans

 So, either deducting all of the contribution ASAP or, else, getting the PBGC to let the Plan Termination Date slide into another tax year, are the best alternatives.

 However, the choice can only be made by the plan sponsor with advice from the tax advisor.

Tax Deductions Self Employed Individuals

 IRC section 404(a)(8)(C)  Limits deduction on behalf of self employed to earned income (after subtraction of ½ FICA)  This can preclude the deduction for minimum funding for a DB plan

Tax Deductions Self Employed Individuals

 IRC section 4972(c)(4)  Exception to excise tax on non-deductible contributions for amounts required by 412 but not deductible due to 404(a)(8)(C).

Tax Deductions Self Employed Individuals

 Is the carry over deductible in the following years on an FIFD basis, amortized, or never deductible?

 I think FIFD (first in, first deducted), but that’s up to the taxpayer and tax advisor.

Tax Deductions Partnerships

 Reg section 1.404(e)-1A(f)(1) allows a partner to deduct DC contributions the partnership contributes on his behalf.

Tax Deductions Partnerships

 Reg section 1.404(e)-1A(f)(2) says a partner’s deductible share of a DB contribution is determined in the same manner as his distributive share of partnership taxable income.

 Clearly partnership agreements should probably have a special allocation section when there are DB plans involved.

Tax Deductions Partnerships

  Would such language in the partnership agreement constitute “separate plans” under the 401(a)(26) regulations?

No. That would be inconsistent with Reg section 1.401(a)(26)-2(d)(1)(iii) that allows an exception to the separate plan prohibition when the cost of funding is allocated based on the allocation among partners in proportion to their partnership interests. Of course such interest must be spelled out in the partnership agreement.

404 Pool

 When will the proposed 404 regulations be issued?

 2009  2010  2011  2012  After President Sarah Palin takes office in 2013  When Heck freezes over, if after 2013.

404 Pool

 To enter the pool:  Complete Form 999666, “Form to report illegal gambling including office football pools”. File by running it through the shredder.

 Place your pool entry of $100 in small unmarked bills in the small brown box labeled “Alms for Actuaries who need a drink” at the rear of the meeting room under the brown table.

 Winners meet me in the bar in the year 2015.

Thank you!