Chapter 7 LIMITATIONS ON QUALIFIED DEFINED BENEFIT AND DEFINED CONTRIBUTION PLANS

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1 0001 [ST: 145] [ED: ] [REL: 2] (Beg Group) osed: Mon Aug 22 13:22:29 EDT 2011 VER: [LS Master:03 Dec 10 02:10][MX-SECNDARY: 11 Feb 11 06:55][TT-: 27 Oct 10 08:00 loc=usa unit=03208-ch0007casebk] 35 Chapter 7 LIMITATIONS ON QUALIFIED DEFINED BENEFIT AND DEFINED CONTRIBUTION PLANS General Topics: Maximum Limitations on Benefits/Contributions under Qualified Plans and the Determination of ensation IRC: 401(a)(4), 401(a)(16), and 415; EGTRRA (a) and (b); PPA (a) and (b) IRS Regulations: Treas. Regs (c) and 1.415(a)-(j) (2007). Additional References: I,R.S. Alert Guidelines Limitations on Contributions and Benefits, available at (June 8, 2005) 7.01 GENERAL REQUIREMENTS Internal Revenue Code 401(a)(16) provides that a plan shall not be qualified nor its trust exempt unless the plan provides that benefits or contributions will not be in excess of the limitations set forth in Code 415. In the case of a defined benefit pension plan, the plan must limit the maximum amount of annual benefits that may be paid to a participant from the plan. 1 This maximum is subject to two limitations: a dollar limitation and a percentage of compensation limitation. The initial dollar limit for defined benefit plans was set at an annual amount of $75,000 and the percentage of compensation limitation was set at 100% of 3-year final average pay. In the case of a defined contribution plan (including a money purchase pension plan), the plan must limit the maximum contributions and other additions that may be allocated annually on behalf of a participant. 2 This maximum is subject to two limitations: a dollar limitation and a percentage of compensation limitation. The 1 I.R.C. 415(b). Treas. Regs through -10 were issued in Since then, changes have been made to I.R.C. 415 by Pub. L. No (ERTA 81); Pub. L. No (TEFRA 82); Pub. L. No (DEFRA); Pub. L. No (TRA 86); Pub. L. No (Technical and Miscellaneous Revenue Act of 1988; Pub. L. No (GATT); Pub. L. No (SBJPA 96); Pub. L. No (EGTRRA 01); Pub. L. No (JCWWA); Pub. L. No (PFEA); and Pub. L. No (WFTRA) 04). The Service issued proposed regulations to provide comprehensive guidance regarding the limitations of I.R.C. 415, including updates to the regulations for statutory changes since See 70 Fed. Reg. 31,214 (May 31, 2005). Since then, the IRS finalized the regulations in 2007, adopting and expanding much of the 2005 proposal, incorporating the legislative changes made by PPA 06, and designating 1.415(j)-1. See 72 Fed. Reg. 16,878 (April 5, 2007). 2 I.R.C. 415(c). 145

2 0002 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:29 EDT LIMITATIONS ON PLANS CH. 7 initial dollar limit for defined contribution plans was set at an annual amount of $25,000 and the percentage of compensation limitation was set at 25% of current pay. There is a further limitation on the growth of an account balance under a defined contribution plan. As a result of these initial formulations, if one were to compare the defined benefit limitation with the defined contribution limitation, the two initial dollar limitations bore a 1:3 relationship ($25,000 compared to $75,000), whereas the two initial compensation limitations bore a 1:4 relationship (25% of pay compared to 100% of pay). 3 Such relationship between the two dollar limitations could not be expected to be retained as both were subject to cost of living adjustments. The percentage of compensation limitations would, of course continue at 1:4 relationship unless changed by Congress. Prior to 2000, there was a third limitation such that an individual covered under both an employer s defined benefit plan and defined contribution plan could not achieve the full maximum levels in both sets of plans. 4 In effect, such individual could not receive the full maximum benefit under the defined benefit limitation in addition to the full maximum allocation under the defined contribution limitations. Thus, one of the plans would be designated as the cut back plan and reductions would be made to benefits or allocation to that plan consistent with the rules of this third limitation. This limitation expired in As a result of the repeal of this limitation, small employers interested in maximizing their deductions for qualified plan contributions may consider implementing both a defined benefit and defined contribution plan in order to take advantage of both maximum limits. In an effort to defeat undermining these limitations, the Code requires that all defined contribution plans (maintained by the same employer) must be aggregated and all defined benefit plans (maintained by the same employer) must be aggregated for purposes of applying the annual tests. 6 As such, if plans with different plan years have to be aggregated, the limitations of Code 415 are to be tested on a common limitation year basis. For purposes of Code 415, employer includes not only the employer who sponsors the plan, but also all other members of the controlled group of employers (within the meaning of Code 414 (b) and (c)) and all members of an affiliated service group (within the meaning of Code 414(m)), whether or not such employer participates in the plan. 7 A plan s limitation year is presumed to be the calendar year unless the terms of the plan provide for an alternate period. 8 Generally, in the case of a single plan, 3 See Section 7.09, infra, the limitations by year. 4 I.R.C. 415(e). Pub. L. No , 1452 (SBJPA 96), repealed I.R.C. 415(e), effective for the year Id. 6 I.R.C. 415(f). 7 I.R.C. 414(b)-(c), 414(m)(4)(B), 414(n)(3)(B), 414(o). Note for purposes of applying the test for controlled group members, the 80% threshold test under I.R.C is reduced to 50%. See I.R.C. 415(h). 8 Treas. Reg (j)-1.

3 0003 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:29 EDT GENERAL REQUIREMENTS 147 employers will choose the plan s plan year as the limitation year; however, in the case of related plans, the employer may choose a common limitation year for use by all such plans. 9 Parts of the limitation of Code 415 are expressed in terms of an employee s compensation (these are referred to as the compensation limits). The term compensation is defined in Code 415 and generally includes all types of compensation received by the employee from the employer within a given limitation year. 10 There are, however, certain permitted exceptions (e.g., amounts paid by the employer to a plan of deferred compensation that are not includible in gross income; amounts which received special tax benefits such as premiums for group term life insurance; etc.) to this definition of compensation: 11 Prior to 1998, it was important to know whether the employer also had a Code 125 cafeteria plan and/or Code 401(k) plan. Initially, compensation for purposes of the Code 415 limits did not include amounts deferred and not includible in gross income under Code 125, 401(k) or 408(k). 12 As a result of the legislative changes of SBJPA 96, compensation for purposes of the Code 415 limit does include amounts deferred but not includible in gross income under Code 125 and 401(k), as well as elective contributions and deferrals pursuant to Code 403(b) and 457 plans. 13 Hence, the compensation limits of Code 415 apply to an employee s gross compensation, as opposed to the net taxable compensation. The final regulations limit the amount of compensation that may be considered after a participant severs employment. 14 Generally severance pay, parachute payments and deferred compensation triggered by severance are not includable in compensation For purposes of Code 415, compensation limits are imposed to limit the amount of benefits and allocations under qualified plans. TRA 86 imposed an annual compensation ceiling on the amount of compensation any qualified plan could take into account in determining benefit accruals under a defined benefit plan or allocations under a defined contribution plan. 15 However, when TRA 86 added this 9 Id. Treas. Reg (b)(3); Prop. Treas. Reg (j)-1(c). See Rev. Rul. 79-5, C.B. 165, in which the Service permits different limitation years for the two plans maintained by the same employer. 10 I.R.C. 415(c)(3). 11 Treas. Reg (d)(3); Prop. Treas. Reg (c)-2(c). The proposed regulations clarify that post-severance compensation may be included as compensation for purpose of I.R.C. 415(c)(3) if paid within 2½ months after separation from service and only if it would have been paid if the participant continued in employment or for bona fide sick, vacation or other leave. 12 Treas. Reg (d)(3)(i), which was adopted on December 30, 1980, and thus does not reflect subsequent legislative changes. See Pub. L. No , 1434(a) (SBJPA 96), effective for plan years beginning after December 31, Pub. L. No , 1434(a) (SBJPA 96), effective for plan years beginning after December. 14 Treas. Reg (c) Pub. L. No , 1106(d)(1) (TRA 86), (adding subsection (17) to I.R.C. 401(a). Pub. L. No.

4 0004 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS ON PLANS CH. 7 compensation ceiling in Code 401(a)(17), it failed to cross-reference the compensation limitations under Code 415. The proposed regulations interpreted Code 415 to incorporate the compensation limit of Code 401(a)(17). 16 The end result is that the dollar limitations of Code 415 have become increasingly more important than the compensation limitations. Example: The normal retirement benefit (NRB) of a plan equals 100% final average earnings (FAE)/65/life only or J&S, subject to the limitations of Code 401(a)(17) and 415. An unmarried participant is retiring in 2005 at age 65 with FAE of compensation at $250,000. FAE is limited to $210,000, but the plan may not distribute a NRB of 100% $210,000/65/life due only to the dollar limitation of Code 415(b) of $170, LIMITATIONS FOR DEFINED BENEFIT PLANS This limitation is generally relevant only when benefits actually commence under a defined benefit plan; prior to payment any accrual of benefits is always subject to the limitations of Code 415(b) and thus the accrual does not exceed the limitation. Under Code 415(b), the annual retirement benefit that is paid to a participant during a limitation year from a qualified defined benefit plan may not at any time exceed the lesser of: A dollar limit of $160,000 (adjusted for inflation in $5,000 increments to reflect cost-of-living increases), subject to a 10-year-phase-in rule; or A compensation limit of 100% of the participant s average total compensation for the highest 3 consecutive years of service, also subject to a different 10-year-phase-in rule. 17 According to the final regulations, the defined benefit plan s provisions must preclude the possibility that any annual benefit accrued (regardless of whether it is vested) and the annual benefit payable exceed the limitations of Code 415(b). 18 Such annual benefit does not include amounts attributable to employee contributions 19 or rollover contributions. Under the final regulations, the annual benefit does not include: Survivor benefits payable to a surviving spouse under a qualified joint and survivor annuity (as defined by Code 417(b)) to the extent that the survivor benefits would not be payable if the participant s benefits was not being paid as a qualified joint and survivor annuity. 20 A Social Security supplement , (OBRA 93) reduced the $200,000 compensation ceiling to $150,000, and readjusted the method by which the new compensation) ceiling would increase). 16 Prop. Treas. Reg (c)(2)(f). 17 I.R.C. 414(b)(1). 18 Treas. Reg (a)-1(d). 19 Treas. Reg (d)(2) (such amounts are treated as allocations to a separate defined contribution plan for purposes of applying the limitations of Code 415). 20 Under the final regulations, if benefits are paid partially in the form of a joint and survivor annuity and partially in some other form (e.g., lump sum), the new rule would continue the exception on the portion of the benefit paid in the form of the joint and survivor annuity, rather than the current rule

5 0005 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS FOR DEFINED BENEFIT PLANS 149 (described in Code 411(a)(9) and Treas. Reg (a)-7(c)(4)(ii)) is included in the participant s annual benefit. 21 Ancillary benefits unrelated to the retirement benefits (e.g., disability benefits, incidental death benefits, post-retirement medical benefits). [A] Changes in the Dollar Limit The defined benefit dollar limit has undergone numerous changes. It was initially $75,000 when ERISA was passed (1:3 relationship with defined contribution dollar limit of $25,000), and increased with cost of living adjustments to a level of $136,425 in Congress reduced the defined benefit dollar limit to $90,000 (again reverting to a 1:3 ratio with the new defined contribution dollar amount of $30,000). 22 Congress then froze the defined contribution dollar limit at $30,000 until the defined benefit dollar limit reached $120,000 (in order to achieve a 1:4 ratio between the two dollar limits just for that particular year). At that point, both dollar limits would bear a 1:4 ratio to each other, just like the compensation limits. Of course, such result would not continue as cost of living adjustments to the defined benefit and defined contribution dollar limits would not move in a similar 1:4 ratio. By 2001, the adjusted defined benefit dollar limit was $140,000. In 2001, Congress increased the defined benefit dollar limit for years 2002 until The dollar limit would be $160,000 beginning in 2002, subject to cost of living increments in multiples of $5, The cost-of-living adjustments were made a permanent addition to the Code by PPA 06, which repealed the sunset provisions of EGTRRA, which would have eliminated them beginning in Also the changes in the Code 415 limitations may have implications for employers nonqualified executive compensation plans that supplement benefits not otherwise provided through the qualified plans. If Treasury increases the dollar limit for a given calendar year and the plan s limitation year is not the calendar year, then the plan is to use the dollar limit announced by Treasury on January 1st for the limitation year which ends on or after that January 1st. 24 The defined benefit compensation limitation is determined using the average of the participant s three highest consecutive years of compensation. The proposed regulations took the position that only years of participation were counted for this purpose. 25 However, PPA 06 explicitly provided that all years of service could be considered in determining the high three years of which has no exception. Treas. Reg (b)-1(c)(4)(i)(A). 21 Treas. Reg (b)-1(c)(4)(ii)(A). 22 See Pub. L. No , 235(g)(4) (TEFRA 82), for transitional relief for participants who had accrued benefits in excess of the new $90,000 limit but met the prior $136,425 dollar limit. ERISA also prescribed transitional relief for participants with accrued benefits in excess of the revised I.R.C. 415 limits. See Pub. L. No , 235(e)(4). 23 See Pub. L. No , 611(a) (EGTRRA 01), made permanent by Pub. L. No , 811 (PPA 06). 24 I.R.C. 415(b)(2)(A). See Treas. Reg (d)-1(a)(3). 25 Prop Treas. Reg (b)-1(a)(5).

6 0006 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS ON PLANS CH. 7 compensation. 26 This compensation limit is not limited by the annual compensation ceiling of Code 401(a)(17); however, the plan s benefit formula is limited by such compensation ceiling. [B] Various Adjustments to the Dollar Limit Just as a participant s benefit under a defined benefit plan is premised on three factors (1) the amount of the benefit, (2) the normal age at which benefits will commence, and (3) the form of benefits the Code 415 defined benefit limit is likewise expressed in terms of three factors. While the first factor of the Code 415 defined benefit limit was discussed above (the dollar limit and the compensation limit), the Code likewise defines the other two factors. [C] Adjustment to the Dollar Limit for Commencement of Benefits Initially, the Code 415 defined benefit limits were expressed in terms of an annual benefit commencing at age 65; however, there was no adjustment to the dollar limit for early commencement of benefits between ages 62 and 65. Thus, only if benefits commenced prior to age 62 or after age 65 was an actuarial adjustment needed to the defined benefit dollar limit. While there was an actuarial adjustment for early commencement prior to age 62, there was a statutory floor of a $75,000 dollar limit imposed at age 55. Example: If the applicable Code 415 dollar limit was $75,000 but the participant s benefit was to commence at age 55, the actuarially adjusted Code 415 dollar limit would be $38, The statutory floor of $75,000 imposed at age 55 represents a considerable savings to the employee and make early commencement a more valuable feature. TRA 86 revised the Code 415 dollar limit so that it is expressed as an annual benefit commencing at the participant s Social Security retirement age. 28 Thus, if a plan s actual annual benefit commenced before or after this age, the Code 415 dollar limit was to be actuarially adjusted to reflect an earlier or later commencement of benefits. 29 Actual benefits paid from the plan are then 26 Pub. L. No , 832(a) (PPA 06). 27 See S. Rep. No. on H.R. 3838, p Pub. L. No , 1106(b)(1)(A)(i) and (ii) (TRA 86), amending I.R.C. 415(b)(2)(C), effective after December 31, For purposes of the Social Security Act, its retirement age is scheduled to increase to age 67 from age 65 over a period of 20 years. The Social Security retirement age for an individual who attains age 62 before the year 2000 (which is equivalent to an individual who is born before 1938) is age 65. For an individual who attains age 62 after December 31, 1999, the retirement age increases, in increments, to age 67. Thus, for all individuals born after 1954, their retirement age will be age 67. For those born between 1938 and 1955, the retirement age increases from age 65 based on certain increments. Those born in 1939, their retirement age is age months; those born in 1940, age months; those born in 1941, age months; etc. 29 Treas. Reg (c)(1). Notice 87-1, C.B. 458 stated that the adjustment used for early commencement of benefits between the Social Security Retirement Age and age 65 is 5/12 of 1% per month; for months between age 65 and age 62, the adjustment factor used is 5/9 of 1% per month; and for months between age 62 and actual commencement, the actuarial equivalent valued is used, using an

7 0007 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS FOR DEFINED BENEFIT PLANS 151 subject to this revised Code 415 dollar limit. 30 The $75,000 floor at age 55 was also removed, thereby permitting the Code 415 dollar limit to be fully decreased to its actuarial equivalence. The following table illustrates the dramatic difference in the applicable dollar limit before and immediately after the passage of TRA 86: 31 Retirement Age Limit Prior to the 1986 Act New Limit (Born Before 1938) New Limit (Born After 1954) 65 $90,000 $90,000 $78, ,000 83,970 72, ,000 78,030 67, ,000 72,000 63, ,170 65,736 57, ,240 60,192 52, ,000 55,224 48, ,000 50,760 44, ,000 46,728 40, ,000 43,128 37, ,000 39,888 34,902 With the passage of EGTRAA 01, Congress reverted back to the original rule of age 65 and specified that distribution of benefits between ages 62 and 65 would not result in any adjustment to the Code 415 defined benefit dollar limit. 32 interest rate that is not less than the greater of 5% or the rate specified in the plan for purposes of determining early commencement of benefits. The interest rate adjustment used for commencement of benefits after the Social Security Retirement Age could not be less than the lesser of 5% or the rate specified in the plan. GATT retained the prior rule under I.R.C. 415(b)(1)(E) for limitations years beginning in 1995, but required the interest rate on 30- year Treasury securities to be substituted for the 5% rate if the benefit was payable in a lump sum subject to I.R.C. 417(e)(3). For plan years beginning in 2004 and 2005, Pub. L. No , 101(b)(4) (PFEA 04) substituted 5.5% for 5% for benefits payable in a lump sum subject to I.R.C. 417(e)(3). 30 I.R.C. 415(b)(2)(D). 31 Reprinted from EMPLOYEE BENEFITS HANDBOOK, 20-4 (Jeffrey Mamorsky, ed., 3d ed). The new limits vary as an individual s Social Security Age is determined on the basis of his/her year of birth; thus those born before 1938 have a Social Security retirement age of age 65 whereas those born after 1954 have a Social Security retirement age of 67. The table shows the two extremes those born before 1938, whose Social Security retirement age is age 65 and those born after 1954, whose Social Security retirement age is age 67. Employers are not expected to compute the number of months in the phase up from age 65 to 67 for purposes of computing the Social Security retirement age. S. REP. NO (Pub. L. No ), p I.R.C. 415(b)(2)(E). Pre-EGTRRA 01, the adjustment to use for earlier commencement of benefits between age 62 and the employee s Social Security Retirement Age (SSRA) is the same adjustment factor of 5/9 of 1% per month as used for computing the reduction under Social Security for early commencement. After EGTRRA, for adjustment for earlier commencement of benefits before age 62, an interest used in the actuarial equivalency cannot be less than the greater of (i) 5% or (2) the rate that is not more than 105% of the benefit that would be provided if the applicable interest rate defined by Code 417(e)(3) were used or (3) the rate specified in the plan for this purpose.

8 0008 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS ON PLANS CH. 7 Therefore, there is no longer a comparison of the participant s Social Security Retirement Age with the age of benefit commencement. 33 Given the increase in the defined benefit dollar limit to $160,000 (from $140,000) for 2002, this affords a dramatic increase in the Code 415 dollar limit used for early commencement of benefits. To illustrate these increases, the following chart affords a quick comparison at various ages a participant s retirement benefit was paid at the maximum level in 2001 versus paid at the new maximum levels in 2002: 34 Age 415 Limit 415 Limit Difference % Increase for 2001 for $1,446,420 $1,653,050 $206, % 62 1,153,970 2,066, , % 60 1,038,330 1,874, , % ,090 1,468, , % The substantial increase in benefits through a revised Code 415 dollar limit affords significant planning opportunities for small businesses with owners that are close to retirement age. [D] Adjustment to the Dollar Limit for Forms of Payment The annual benefit described in the Code 415 limits is defined as an annual benefit payable at age 65 in the form of a straight life annuity (or a qualified joint and survivor annuity, if applicable), exclusive of benefits attributable to employee contributions, rollover contributions and benefits from assets transferred from The interest rate used in the actuarial equivalency for commencement of benefits prior to age 65 may not be less than the greater of 5% or the rate specified in the plan; for commencement of benefits after age 65, the interest rate may not be greater than the lesser of 5% or the rate specified in the plan. For plan years beginning in 2004 and 2005, Pub. L. No , 101(b)(4) (PFEA 04) substituted 5.5% for 5%. See I.R.B. 879, Notice for question and answer guidance under PFEA, provided by the Service for distributions with annuity starting dates beginning in 2004 or See Prop. Treas. Reg (b)(1) (permitting the Service to issue guidance setting forth simplified methods for making these actuarial equivalencies). 33 Pub. L. No , 611(a) (EGTRRA 01), effective for limitation years beginning in 2002, and made permanent by Pub. L. No , 811 (PPA 06). 34 The value of the lump sum amounts assumes a 7% GATT (Pub. L. No ) rate in effect at the time of distribution. For example, an age 65 participant retiring in 2001 could only receive the maximum dollar benefit of $140,000/65/life only or J&S, valued here at $1,446,420; whereas an age 65 participant retiring in 2002 could receive a maximum dollar benefit of $160,000/65/life only or J&S, valued here at $1,653,050. The increase is magnified for participants retiring before age 65. In 2001, a participant age 62 could only receive the maximum dollar benefit of $140,000/65/life only or J&S, reduced by a 20% actuarial factor (to reflect the spread between his/her Social Security retirement age of months and early retirement age of 62), valued here at $1,153,970; whereas a participant age 62 in 2002 could receive the maximum dollar benefit of $160,000/65/life only or J&S, with no actuarial reduction (since the benefit is paid age 62), valued here at $2,066,300. Participants retiring at age 60 in 2001 could only receive the maximum dollar benefit of $140,000/65/life only or J&S, reduced by a 38% actuarial factor (to reflect the spread between his/her Social Security retirement age of age monthsandearly retirement age of 60), valued here at $1,039,330; whereas participants retiring at age 60 in 2001 could receive the maximum dollar benefit of $160,000/65/life only or J&S, reduced by a 13% actuarial factor (to reflect the spread between age 62 and age 60), valued here at $1,874,200.

9 0009 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS FOR DEFINED BENEFIT PLANS 153 another plan. 35 Thus, an adjustment must be made to the limit if the actual benefit paid from the plan is in a form other than a life annuity or joint and survivor annuity (e.g., 10-year certain and life annuity or lump sum payment). 36 In such cases, the applicable Code 415 limit must be adjusted actuarially to the desired form of payment and then the benefit may be tested against the altered Code 415 limits. 37 No adjustment is required if the participant received ancillary benefits that are not directly related to retirement benefits (e.g., pre-retirement death or disability benefits). 38 Example: If the applicable Code 415 dollar limit was $165,000 as a life annuity, but the participant elected the 15 certain and life annuity form, the actuarially adjusted Code 415 dollar limit would be $124,904. [E] Other Adjustments or No Adjustments Prior to TRA 86, the dollar limit and the compensation limit of Code 415 were reduced by a fraction, if the participant had less than ten years of service at the commencement of benefits. 39 The fraction was the employee s actual years of service divided by ten. Hence, there was a pro rata reduction to both limits for less than ten years of service. TRA 86 adjusted the dollar limit only and made the adjustment for a participant with less than ten years of plan participation. 40 The compensation limit was adjusted in accordance with the prior rule. The practical effect was to deny the full dollar limits under Code 415 unless the highly compensated executive had a full ten years of plan participation. Code 415(b) provides a de minimis rule whereby a participant may receive an annual benefit (derived from employer contributions) of $10,000 regardless of the age at commencement or the form of payment. However, an adjustment is required if the participant has less than 10 years of service (not participation). In order to qualify for this de minimis rule, $10,000 must be the maximum benefit payable to the employee from all defined benefit plans from this employer (for the plan year and any prior plan year) and there can be no defined contribution plan covering such individual from such employer Treas. Reg (b); Treas. Reg (b)-1(b)(2), (3). 36 I.R.C. 415(b)(1)(E). In determining actuarial equivalencies, the interest rate for forms of payment other than lump sum shall not be less than the greater of 5% or the rate specified in the plan. For lump sum payments, the interest rate is specified in I.R.C. 417(e)(3). 37 Treas. Reg (c)(1). Pre-EGTRRA 01, the adjustment to use for earlier commencement of benefits between age 62 and the employee s Social Security Retirement Age (SSRA) is the same adjustment factor of 5/9 of 1% per month, as used for computing the reduction under Social Security for early commencement. For further adjustment for earlier commencement of benefits before age 62, an interest rate used in the actuarial equivalency cannot be less than the greater of 5% or the rate specified in the plan for this purpose. But see Prop. Treas. Reg (b)-1(c)(2) & (3) whereby actuarial equivalences are to be used in determining early and late commencement of benefits. 38 I.R.C. 415(b)(2)(B). See Treas. Reg (b)-1(c)(4)(B). 39 Treas. Reg (g)(1), which were adopted on December 30, 1980, and thus do not reflect subsequent legislative changes. 40 Pub. L. No , 1106(f) (TRA 86), amending I.R.C. 415(b)(5)(B). 41 I.R.C. 415(b)(4). See Treas. Reg (b) 1(f)(1)(i).

10 0010 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS ON PLANS CH LIMITATIONS FOR DEFINED CONTRIBUTION PLANS In contrast to defined benefit plans, Code 415 imposes limitations on annual inputs to a participant s account. However, not all inputs are subject to limitation; hence the term annual addition defines what input items will be subject to limitation. Under Code 415(c), those items which count as annual additions made to a participant s account under a qualified defined contribution plan for a limitation year are limited by the lesser of: A dollar limit of initially $25,000 (or higher amount as adjusted for cost-ofliving increases). TRA 86 froze the defined contribution dollar limit at $30,000 in order to parallel the defined contribution limit of $30,000 with the defined benefit limit of $120,000 with a1to4ratio. 42 Thereafter, the defined contribution limit was to be adjusted to become 25% of the defined benefit limit. GATT changed this adjustment by providing that both dollar limits would be adjusted only in $5,000 increments and that such changes would be tied to cost-of-living adjustments. 43 Thus, the defined contribution limit would next change to $35,000 whenever the COLA increase was sufficient to put it at or above this level (which did not occur by 2000). EGTRRA 01 increased the defined contribution limit to $40,000 for 2001, adjusted for inflation (in $1,000 increments) in the future. 44 The compensation limit was originally 25% of the participant s total compensation from the employer for the limitation year. ensation is defined similarly as in computing the defined benefit compensation limit, discussed above. EGTRRA 01 increased the 25% limit to 100%. 45 TRA 86 redefined the term annual addition 46 to include the sum of the following for any limitation year: employer contributions allocated to the employee s account; 47 any forfeitures allocated to the employee s account balance; and all employee contributions made during the limitation year. Prior to TRA 86, only a portion of the employee s own contributions were counted as part 42 I.R.C. 415(c)(2), as amended by Pub. L. No , 1106 (TRA 86). 43 Pub. L. No , 732(b)(1) (GATT 94). 44 Pub. L. No , 611(a)(4)(A)-(B) and (b)(2)(a)-(b) (EGTRRA 01) increased both the defined benefit and defined contribution limits in excess of their expected levels. This change was made permanent by Pub. L. No , 811 (PPA 06). 45 See Pub. L. No , 611(c) (EGTRRA 01), effective for 2002 through 2010, subsequently made permanent by Pub. L. No , 811 (PPA 06). 46 I.R.C. 415(c)(2), as amended by Pub. L. No , 1106(e)(2) (TRA 86), effective for years beginning after There are certain exclusions permitted: catch-up contributions made by participants age 50 and over; employer contributions to restore previously forfeited account balances pursuant to I.R.C. 411(a)(7)(C) upon the participant s repayment of the prior distribution; and restorative payments stemming from plan losses attributable to a breach of fiduciary duty of care. See Treas. Reg (c)-1(b)(2)(ii).

11 0011 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS FOR DEFINED CONTRIBUTION PLANS 155 of his/her annual addition (i.e., the lesser of all employee contributions over 6% of compensation or one-half of all employee contributions). 48 Hence, employee contributions of up to 6% of compensation could be made without jeopardizing what additional allocations could be made to the participant s account balance. Now, for participants at risk of hitting the annual defined contribution limit, employee contributions are limited so to avoid any possible cutback in employer allocations. Employee contributions made pursuant to Code 401(k) elections are deemed to be employer contributions for purposes of the annual addition computation. 49 This rule, as well, as the above treatment of all employee contributions to be considered annual additions, has effectively penalized those employees making contributions to defined contribution plans, as they risk using up their Code 415 limits with their own money before any allocation from employer contributions. There is a time schedule applicable for determining when a given contribution may be counted as an annual addition. A contribution is deemed to be an annual addition for a particular limitation year if, under the plan, it is allocated to the account as of any date within the year. For purposes of being credited within a given limitation year, employer contributions must be actually made within thirty days after the date the employer s federal income tax return is due (including extensions) for the taxable year coincident with or within which the limitation year ends. 50 In contrast, mandatory or voluntary employee contributions must be actually made within thirty days after the end of the limitation year in order to be considered current year additions. 51 The proposed regulations envisioned that excess annual additions could be credited to a participant s account causing a violation of the limits of Code 415. Hence, if an excess addition would be generated due to reasonable error in estimating a participant s annual compensation, or as a result of the allocation of forfeitures, or under other limited facts and circumstances, the excess amount is not considered as an annual addition for the limitation year provided it is handled under the plan by one of the following methods: 52 The excess is allocated/reallocated to other participants; The excess is used to reduce employer contributions for the next limitation year for that particular participant; The excess is held in a suspense account for the limitation year and then 48 Treas. Reg (b)(ii). 49 The following items are not treated as annual additions: repayments of participant loans; rollover contributions and plan-to-plan transfers; repayment of previously cashed-out balances in order to restore prior years of service under I.R.C. 411(a)(7)(C); and employee contributions to a qualified cost of living arrangement as described in I.R.C. 415(k)(2). See Reg (c)-1(b)(3). 50 Treas. Reg (c)-1(b)(6), For tax-exempt employers, the tax return (Form 990) deadline is the 15th day of the sixth month following the end of the tax year. Under the recently issued proposed regulations, contributions could be made as late as the 15th day of the tenth month following the end of the tax year and still included in annual limitations for the limitation year. See id. 51 Treas. Reg (b)(6)(c). 52 I.R.C. 415(c)(2)(B). See Treas. Reg (b)(6); Prop. Treas. Reg (c)-1.

12 0012 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:30 EDT LIMITATIONS ON PLANS CH. 7 allocated/reallocated to all participants in subsequent years; or The plan permits employee contributions be returned to the extent necessary to use up the excess amount. The plan had to specify which method will govern the treatment of excess annual additions. 53 Under the final regulations, plan sponsors are directed to use the IRS correction program (known as EPCRS) for correction of these operational failures. In the event the employer elects to change the 12-month period to be used as the plan s limitation year (e.g., changes from a calendar period to the plan year period), there will be a short limitation year during the year of transition. The defined contribution dollar limit for this short limitation year must be adjusted by a fraction, the numerator of which is the number of months in the short limitation year and the denominator for which is twelve. 54 In order for the plan and trust to remain qualified, Code 401(a)(16) requires the maximum limitations of Code 415 not to be exceeded. Code 404 disallows an employer s deduction to fund benefits in excess of the defined benefit limits or allocations in excess of defined contribution limits. 55 Because the definition of an annual addition includes forfeitures and employee contributions, an employer may lose a deduction even though its own contributions are calculated within the maximum limitations. Cost of living adjustments in the dollar limitations of Code 415 may not be anticipated by the plan s actuary for purposes of funding or deductibility PRE-TERMINATION RESTRICTIONS FOR DEFINED BENEFITS PAYABLE TO THE HCES Prior to the 1993 finalized regulations under Code 401(a)(4), Treas. Reg (c) set forth conditional limitations that applied to benefits payable to certain highly paid employees in the event of an early plan termination. The rule was fashioned as a qualification rule and designed to prohibit an employer from establishing and funding a defined benefit plan whereby older and highly paid employees would be eligible for the plan s normal retirement benefit, while younger employees would never become eligible for those benefits as the plan would be prematurely terminated. To permit the establishment and maintenance of such a plan would unduly discriminate in favor of the highly paid. While Congress could have accomplished the same result by prohibiting employers from terminating plans within a fixed period of time (e.g., 10 years), this alternative was not utilized. 53 Under the proposed regulations, these methods would be eliminated; instead any excess annual additions would be corrected pursuant to the Service s correction program (Employee Plans liance Resolution System EPCRS ), discussed in Chapter 15. Prop. Reg (b)(6). 54 Treas. Reg (b)(4); Prop. Treas. Reg (j)-1(d)(2). 55 I.R.C. 404(j)(1). 56 Treas. Reg (c)(3)-1; 1.404(a)-14 and ; Rev. Rul , C.B. 104; Notice 83-10, F-1, C.B. 536.

13 0013 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:31 EDT PRE-TERMINATION RESTRICTIONS FOR DEFINED BENEFITS 157 The 1993 final regulations under Code 401(a)(4) substantially altered these rules but affirmed the practice of restricting benefits to highly compensated employees (HCEs) (limited to the group of the 25 most highly compensated employees and former employees of the employer) prior to plan termination. The new rules are no longer conditional in nature but apply at any time distributions are made to an HCE prior to a plan termination. 57 There are exemptions from these rules; however, they are only available for fully funded plans and for circumstances where the distribution is not a significant portion of plan liabilities. [A] Distribution Limitations Under the 1993 regulations, limitations must be imposed on the payment of benefits to the 25 highest-paid HCEs. 58 The amount of the limitation equals (1) the amount that would be paid under a straight life annuity that is the actuarial equivalent of the participant s accrued benefit and other benefits to which the employee is entitled under the plan (other than a Social Security supplement); and (2) the amount the employee is entitled to receive under a Social Security supplement. 59 The new limitation also applies to all benefit payments, including death benefits. 60 Unlike the prior time sensitive rules, the new limitation applies regardless of when the plan was established or amended to increase benefits. There are exemptions to these limitations available in the event any one of the following conditions can be satisfied with respect to a restricted participant: After payment to the participant of all benefits payable from the plan, the value of plan assets would be at least 110% of the value of current liabilities; The present value of the benefits payable to the participant is less than 1% of the value of current liabilities prior to distribution; or The present value of the benefits payable to the participant does not exceed $5, The new distribution limitations apply to all qualified defined benefit plans 62 and to qualified money purchase plans which have an accumulated funding deficiency. [B] Use of Escrow The pre-1993 regulations did not prevent the distribution of lump-sum payments to the affected employees, provided adequate security (e.g. escrow, bond) had been given by the employee to the plan. While the 1993 regulations were silent on this issue, the Service has issued a revenue ruling 63 which affirmed the use of escrows 57 Treas. Reg (a)(4)-5(b)(1)-(2). 58 Id. Such determination must be made on an employer-wide basis. 59 Treas. Reg (a)(4)-5(b)(3)(i)(A)-(B). 60 Treas. Reg (a)(4)-5(b)(3)(iii). 61 Treas. Reg (a)(4)-5(b)(3)(iv)(A)-(C). 62 Treas. Reg (a)(4)-5(b)(4). 63 Rev. Rul , C.B. 76.

14 0014 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:31 EDT LIMITATIONS ON PLANS CH. 7 and bonds when lump-sum payments are distributed to one of the affected employees and an exemption does not apply DEFINITION OF COMPENSATION FOR THE QUALIFICATION REQUIREMENTS Since defined contribution allocations or defined benefit accruals are generally dependent upon a participant s compensation, the qualification rules of Code 401(a) affirmed that a participant s compensation may be utilized in determining his/her benefits and in determining employer contributions. Thus, any limitations associated with compensation limits under the Code would have to define compensation. Leaving such discretion to an employer for purposes of qualification testing would undermine the Code s nondiscrimination requirements. Thus, while the qualification rules permit the employer to define compensation for plan purposes in any way it chooses, the Code requirements set forth specific definitions of compensation to evaluate whether a given section has been satisfied. Prior to ERISA, there had been court cases that determined whether pension benefits were gratuitous promises from the employer or contractual arrangements that provided deferred compensation for the employee. ERISA certainly solidified the notion that employer promises for benefits outside the normal payment of compensation were contractual and would require payment. As the Code prescribed nondiscrimination requirements on a variety of employee benefits as a precursor for the present tax-exempt treatment of such benefit, issues arose as to whether the benefits inured unduly to the advantage of the highly paid and thus whether such tax-exempt treatment should be denied. In the determination of who is highly paid, the Code and the Service have always looked to the compensation level of the affected participants. With the other codifications of TRA 86, Congress decided to formulate a definition of a highly paid employee in terms of compensation and also to codify the definition of compensation for a variety of purposes. A specific definition of compensation, as set forth in Code 414(s), is applicable in a variety of situations for employee benefits purposes. Such definition applies only if a specific Code section is referenced. For example, for purposes of applying nondiscrimination tests to Code 401(k) plans, the definition of compensation found in Code 414(s) applies. 64 For purposes of the accrued benefit rules under Code 411(b), such definition does not apply, because Code 411 does not make specific reference to Code 414(s) COMPENSATION IN GENERAL Under Code 414(s), compensation is defined as compensation by reference to Code 415(c)(3) ( 415 compensation ). Regulations under Code 415 define compensation in general as all wages, salary, commission, bonuses, tips, etc., including items such as moving expenses, certain stock options, etc., and excluding deferred compensation. Code 415 compensation is used in determining the compensation limits for defined benefit and defined contribution plans under 64 See I.R.C. 401(k)(9).

15 0015 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:31 EDT COMPENSATION IN GENERAL 159 Section 415, as well as for testing for compliance with the top-heavy rules. 65 Under the final regulations, compensation required to be reported under Code 6041, 6051 and 6052 for income tax withholding (so called W-2 earnings) now satisfy the definition of compensation under Code Therefore, such wages can be used for purposes of Code 414(s). For plan years beginning after 1991, current compensation (not accrued) must be used. 67 Also, an employer may elect to calculate compensation based on the plan year or the calendar year ending within the plan year. [A] Alternative Definitions of ensation Under the regulations, the employer may elect to use one of the following safe harbor alternative definitions of compensation: Reduction Safe Harbor. Code 415 compensation, reduced by reimbursements or other expense allowances, fringe benefits, moving expenses, deferred compensation, and welfare benefits. 68 Supplemental Safe Harbor. Either the Code 415 compensation or the reduction safe harbor compensation, increased by deferred contributions under a Code 401(k) plan, SEP, Code 403(b) annuity, or Code 457 deferred compensation plan or by governmental plan contributions under Code 414(h)(2). 69 HCE Exclusions Safe Harbor. Code 415 compensation, reduction safe harbor compensation, or supplemental safe harbor compensation, modified to exclude certain items consistently from the compensation of HCEs. 70 An employer may use any other alternative definition of compensation if it is reasonable, does not favor HCEs in form, and meets a special nondiscrimination requirement. 71 The determination of whether an alternative definition of compensation is reasonable is based on facts and circumstances. The regulations under Code 414(s) illustrate a number of compensation definition features that would or would not be considered reasonable Under the recently issued proposed regulations, compensation in excess of the I.R.C. 401(a)(17) limit cannot be considered for purposes of applying the limits of I.R.C See Prop. Reg (c) Treas. Reg (d)(4). 67 Treas. Reg (k)-1(g)(2), 1.401(m)-1(f)(2). For purposes of running the special nondiscrimination rules applicable under Code 401(k) and 401(m), compensation is limited to compensation earned while an employee is a participant, rather than all compensation. 68 Treas. Reg (s)-1(c)(3). For purposes of Code 415(c)(3), all salary deferral contributions made pursuant to a salary reduction agreement and not includible in the employee s gross income under I.R.C. 125 are automatically included in this definition for limitation years beginning after December 31, See I.R.C. 415(c)(3)(D). 69 Treas. Reg (s)-1(c)(4)(i)-(iii). 70 Treas. Reg (s)-1(c)(5). 71 See generally Treas. Reg (s)-1(d). 72 Treas. Reg (s)-1(d)(3)(v).

16 0016 [ST: 145] [ED: ] [REL: 2] osed: Mon Aug 22 13:22:31 EDT LIMITATIONS ON PLANS CH. 7 The alternative definition of compensation must not discriminate in favor of HCEs in its design. 73 For example, a definition that includes bonus amounts but excludes overtime would not be permissible because the design includes a feature more likely to be part of an HCE s compensation and excludes a feature more likely to be part of a NHCE s compensation. The average percentage of total compensation under the alternative definition for HCEs must not exceed by more than a de minimis amount the average percentage of total compensation under the alternative definition for NHCEs. Average percentage is calculated either by dividing the alternative compensation by Code 415 compensation or by dividing the aggregate alternative compensation by the aggregate Code 415 compensation. 74 For purposes of the Code 414(s) definition, the employer may elect to include or exclude all salary deferral contributions but may elect to include only a portion of salary deferral contributions if the definition of compensation would satisfy the nondiscrimination requirements taking all deferred compensation into account. 75 Many employers include salary deferral contributions as it would penalize participants utilizing those arrangements. [B] Uses of ensation ensation is used to determine the following: Code 415 limitations on compensation Determination of who is an HCE under Code 414(q) The level of top-heavy minimum contributions under Code 416(c) Employer s deduction ceiling under Code 404(a)(12) Nondiscrimination testing under Code 401(a)(4). ensation as defined by Code 414(s) and 415(c)(3) may be different for each of the above items or the plan may elect a uniform definition. For purposes of the first four items, use of the Code 415 definition of compensation is mandatory; whereas nondiscrimination testing may use the Code 415 definition of compensation, but is permitted to use the Code 414(s) definition LIMITATIONS ON COMPENSATION Under Code 401(a)(17), annual compensation taken into account under a plan for any plan year could not exceed $200,000 (indexed for inflation). This is important for two reasons: A plan may calculate contributions or benefits only on the basis of compensation at or below the compensation ceiling, and 73 Treas. Reg (s)-1(d)(1). 74 Treas. Reg (s)-1(d)(2)(ii). 75 See I.R.C. 414(s)(2)-(3).