Compensation measurement period tax year not plan year

Transcription

1 404 Deduction Rules for DB/DC Plans Tuesday, April 30, 2013 Kevin J. Donovan, CPA, MSPA Pinnacle Plan Design, LLC Defined Contribution Plans For defined contribution plans deduction limited to 25% of compensation paid to beneficiaries of the plan during tax year IRC 404(a)(3)(A)(i)(I) Compensation measurement period tax year not plan year 1

2 Defined Contribution Plans Reg (a)-9(b) further explains the compensation included in the 25% limit, as follows: the limitation shall be based on the compensation otherwise paid or accrued by the employer during such taxable year of the employer to the employees who, in such taxable year of the employer, are beneficiaries of the trust funds accumulated under the plan. Defined Contribution Plans Plan s definition of compensation not relevant (Revenue Ruling ) Example. Calendar year employer, calendar year plan. Employer maintains profit sharing plan using traditional dual entry system. Employees who enter the plan mid-year receive an allocation based only on their compensation earned while a participant. For purposes of the 25% deduction limit, the individual s compensation for full year is still included. 2

3 Defined Contribution Plans Example. An employer maintains a plan which defines compensation for allocation purposes as base compensation, therefore excluding overtime and bonuses. Nevertheless, for deduction purposes all compensation, including bonuses and overtime, is counted. Defined Contribution Plans Compensation includes elective deferrals IRC 404(a)(12) Compensation limited to $250,000 for 2012; $255,000 for 2013 IRC 404(l) Exclude compensation of participants not eligible for allocation (e.g. due to EOY employment requirement) they are not beneficiaries under the plan RR

4 Defined Contribution Plans Impact of elective deferrals (Post EGTRRA) IRC 404(n): Elective deferrals shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a), and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions. (emphasis added) e.g., post EGTRRA deferrals not employer contributions for deduction purposes Defined Contribution Plans 401(k) plan participants receiving no employer contributions (e.g., early entry for deferrals, last day requirement, etc.) Pre-EGTRRA -- IRS clear compensation counted in determining deduction limit IRS/ASPA # ; # Post EGTRRA (i.e. now that deferrals are not in the limit) are these participants beneficiaries under the plan for purposes of IRC 404(a)(3)(A)(i)(I)? 4

5 Defined Contribution Plans Use IRC 410(b) benefiting as guideline? Effectively done in Rev Rul Those eligible to defer considered to be benefiting for purposes of 401(k) portion of plan [Reg (b)-3(a)(2)(i)] Nothing in IRC 404 suggests need to disaggregate into separate plans But really Defined Contribution Plans My take look at 404(n) again Elective deferrals shall not be taken into account in applying any limitation to any contributions. All that should matter is whether employee received allocation of employer dollars If yes, count compensation If no, don t Deferring, not deferring, eligible to defer, etc. N/A BUT IRS Examination handbook; Page 9-18, next slide (Who knows when this was updated!!??) 5

6 Defined Contribution Plans Who is benefiting under the (401(k)) plan? Since the IRC 404 regulations do not define who is benefiting, the IRC 410 regulations governing coverage and how to determine which participant is considered benefiting should be used to make this determination. In general, in order to be considered benefiting an employee must share in the employer contribution... With a 401(k) plan, participants only have to be eligible to defer to be considered benefiting. Therefore participants who are eligible to make salary deferrals during the tax year (whether or not deferrals are actually made) are considered to be benefiting and their compensation is included in determining the limits under IRC 404(a)(3). See T.R (b)-3(a)(2). Let s recall this when we speak of combined plan limits and ½ employees in DB, ½ in DC but all deferring in 401k. Certainly we won t want the deferral only folks to be considered benefiting in the DC plan for that reason now will we!? Defined Contribution Plans Update PLR an employee who is treated as benefitting (for 410(b) purposes) under a section 401(k) plan for a plan year, but who is not eligible for any employer contributions other than elective deferrals, would not be considered a beneficiary of the trust for purposes of section 404(a)(3)(i)(l) since section 404(n) of the Code requires the limits on deductible contributions to be applied without regard to the existence or absence of elective deferrals Accordingly, the deductible limit under section 404(a)(3)(A) of the Code is determined based on compensation paid or accrued during the taxable year to all employees who are beneficiaries under the Plans during the taxable year taking into account only those employees who have allocations other than elective deferrals So at least one person at the IRS believes you must receive employer allocations to have your comp. included. 6

7 Defined Contribution Plans Multiple plans, IRC 404(a)(3)(A)(iv): If the contributions are made to 2 or more stock bonus or profit-sharing trusts, such trusts shall be considered a single trust for purposes of applying the limitations in this subparagraph. See PLRs and Defined Contribution Plans Example. Company X has 10 union employees. Total compensation of such employees is $400,000. It has only 2 non-union employees - owner and spouse - each of whom earn $40,000. Under collective bargaining agreement company X makes profit sharing contribution of 10% of compensation for union employees, for a total of $40,000. Separate plan exists for the non-union employees. Deduction limit for the plans is 25% of $480,000 or $120,000. With $40,000 to union plan there s room for $80,000 for PS plan for owner and spouse. As there are no other non-union employees, discrimination and coverage are not an issue. With 100% of comp. 415 limit, $40,000 can be allocated to each spouse. 7

8 Defined Contribution Plans Effect of overlapping Plan/Tax Year Recall 25% limit based on tax-year compensation Example Calendar plan-year June 30 tax-year Participant comp. June 30, 2013 = $400,000 Employer contribution for 2012 plan-year = $75,000 If timely, $25,000 of contribution for 2013 plan year could be deducted in tax-year-ended June 30, 2013 But not matching cont. on post 6/30/13 deferrals Revenue Rulings ; See later discussion re IRC 404(a)(6) and RR Defined Benefit Plans Maximum deduction greater of: 430 minimum [ 404(o)(1)(B)] Basically Target Normal Cost plus amortization (or less excess of assets over Funding Target) IRC 430(a) IRC 430(j)(2) requires adjustment for interest As this may require deposit greater than minimum is there reasonable basis for deducting full amount where maximum = minimum? Likely not issue for next few years with MAP (o)(2) amount [ 404(o)(1)(A)] 8

9 Defined Benefit Plans Target Normal cost present value of all benefits earned during the plan year IRC 430(b) ; Reg (d)-1(b)(1) Funding Target the present value of all benefits earned, or otherwise allocated to years of service prior to the first day of the plan year IRC 430(d)(1); Reg (d)-1(b)(2) New plan gets FT (and cushion) by crediting prior svc Defined Benefit Plans PVs determined by use of three funding segment rates prescribed by law First segment rate (S1) applied to payments projected to be made within 5 years of valuation date Second segment rate (S2) applied to payments projected to be made within next 15 years Third segment rate (S3) applied to payments projected to be made thereafter May use rates in effect for month of valuation date or up to 4-month lookback IRC 430(h)(2) 9

10 Defined Benefit Plans Deduction determined with respect to plan year ending with or within taxable year Similar language in 404(a)(1) pre PPA Plan Year Tax Year pre PPA Limit based on plan year beginning within tax year Limit based on plan year ending within tax year Weighted average of above based on number of months of each plan year falling within tax year Reg (a)-14(c) Is this still a valid reg post PPA 2006? Absent contrary guidance likely reasonable to assume yes Defined Benefit Plans Title IV (PBGC covered) plan may deduct contribution needed to fully fund benefit liabilities in termination year IRC 404(o)(5) What if termination process completed too late to make contribution deductible in termination year? What is termination year anyway? With separate 404 FT/TNC under MAP 21 stronger argument separate 404 FT/TNC continue to exist post termination-year? 10

11 Defined Benefit Plans 404(o)(2) amount = sum of: Target normal cost, Funding target, and Cushion amount, over Actuarial value assets 404(o)(2)(A) BE CAREFUL NOT TO OVER-FUND AND RUN AFOUL OF 415 LIMITS Defined Benefit Plans Cushion amount [IRC 404(o)(3)] sum of: 50% of Funding Target (FT), plus Increase in FT where future compensation increases considered Where benefits not effected by future compensation (e.g. flat dollar) allow for expected increases based on prior 6 years benefit increases N/A for accumulation/most cash balance plans 404(l) comp. limit and 415 benefit limit taken into account but PBGC plan may ignore 404(l) 11

12 Defined Benefit Plans When calculating 50% cushion, plans with less than 101 participants exclude from funding target any liability due to benefit increases for HCEs from amendments made or effective (whichever is later) in last 2 years IRC 404(o)(4) Defined Benefit Plans Plans NOT at-risk, IRC 404(o)(2) amount not less than: FT, as if plan at risk; plus TNC, as if plan at risk; less Actuarial value of assets IRC 404(o)(2)(B) At-risk status is from funding rules and relates to large (over 500 participants) plans that are under 80% funded. Such plans are subject to more stringent funding assumptions. Above rules allow use of such assumptions in determining maximum deductible amount for all plans Cash balance plans usually grant no past service. Such plans allowing for immediate LS should be able to use this rule to get deduction for full contribution in year 1 Example later in outline 12

13 Defined Benefit Plans At risk rules FT & TNC, determined in normal manner, but with additional assumptions (following slide), PLUS Load of $700 per participant added to FT Load of 4% of Non-at risk amt added to FT & TNC Loads only if at risk 2 of prev. 4 years Application of loads to 404(o)(2)(B) rule? likely reasonable to add loads absent contrary guidance IRC 430(i)(1)(A); 430(i)(1)(C); 430(i)(2) Reg 1.430(i)-1(c)(2) ; 1.430(i)-1(d)(2) Defined Benefit Plans Assumptions used for at-risk FT/TNC All employees eligible to commence distribution within 10 years after current year assumed to retire at earliest retirement date (ERD) and commence (most valuable form of) distribution at ERD ERD is earliest date participant may receive fully vested immediate distribution (Reg (a)-20 QA 17(b)) But not before end of current plan year IRC 430(i)(1)(B)(i) Reg 1.430(i)-1(c)(3)(ii)(C) / 1.430(i)-1(d)(2)(i) 13

14 Defined Benefit Plans MAP 21 In a moment we will show examples of the use of the cushion as well as use of the at-risk rules First however let s look at MAP-21 Defined Benefit Plans MAP 21 MAP 21 provides for modification of interest rates for purposes of funding beginning in 2012 (or 2013 if employer elects) Subjects segment rates for determining FT & TNC to floor and ceiling based on 25 year average As opposed to current 24 month average 25 year period ends 9/30 of prior calendar year So all rates for a calendar year subject to same limiting range of rates 14

15 Defined Benefit Plans MAP 21 For plan years beginning in corridor % 2013 corridor % 2014 corridor % 2015 corridor % 2016 (and later) corridor % Of the 25-year average Defined Benefit Plans MAP 21 1/1/12 Adjusted Segment Rates (zero look back month) as follows: Unadjusted 1.98 / 5.07 / year avg 6.15 / 7.61 / % floor 5.54 / 6.85 / 7.52 These rates will apply for all valuation dates for plan years beginning in 2012 (unless election out) IRS Notice

16 Defined Benefit Plans MAP 21 Change effective for Funding (2012 optional) AFTAP (2012 optional) Change not effective for Deduction limits under Section 404(o) PBGC variable rate premiums PBGC reportable events 417(e) and 415 Defined Benefit Plans MAP 21 EXAMPLE: End of year valuation One participant plan effective in 2012 No prior service; 2012 Comp = $250K EOY Age 58, NRA 62 Accrued Benefit EOY = $1, Full/Immediate vesting Plan Actuarial Equivalence Pre retirement interest 5%, mortality - none Post retirement int. 5.5%, (e) table 16

17 Defined Benefit Plans MAP S1 = 1.75%; S2 = 4.62%; S3 = 5.72% Sept 2012 rates using 4 th month prior 430 S1 = 5.54%; S2 = 6.85%; S3 = 7.52% Per Notice $ limit 62 (NRA) $1, $ limit 58 (AA) $1, APR 62 = ; APR 58 = Max LS NRA = $248,033; AA = $203,157 With immediate vesting latter = at risk TNC Defined Benefit Plans MAP TNC = MRC LS NRA 430 rates 417(e) table - $216,370 Obtained by running 430 rates through 417(e) table LS NRA Plan rates - $248, * LS NRA 415 max - $248, * TNC $248,033/1.0554^4 = $199,913 Greater of first two (417(e) or plan), limited to last (415), discounted back at MAP adjusted S1 17

18 Defined Benefit Plans MAP TNC LS NRA 404 rates 417(e) table- $257,477 Obtained by running 404 rates through 417(e) table LS NRA Plan rates - $248, * LS NRA 415 max - $248, * TNC $248,033/1.0175^4 = $231,405 Greater of first two (417(e) or plan), limited to last (415), discounted back at unadjusted S1 Defined Benefit Plans MAP 21 First plan year and no prior service granted so no FT and no cushion Maximum deductible contribution therefore greater of 404 TNC ($231,405) or At-risk amount ($213,113) At risk = $203,157 (at-risk TNC from above) + $700 + (231,405 *.04) Latter two pieces loads discussed previously Min / max range = $199,913 -> $231,405 18

19 Defined Benefit Plans Use of Cushion Example One Big Hit trial lawyer Age 58 at 1/1/13, 15 years prior svc No other employees Reg (a)(4)-5(a)(3) N/A Wants to retire 12/31/2017 at age 62 Consistently earned $250K annually 2013 will earn $550K Likely back to $250K in 2014 And he needs it all to live Wants to shelter the $300K excess But with no future obligation Defined Benefit Plans Use of Cushion One Big Hit trial lawyer (cont) Adopts DB plan Normal retirement age 62 Monthly benefit $100 per year of service Benefit at 1/1/13 effective date $1,500 Annual accrual thereafter $100 Total benefit at retirement $2,000 Assume lump sum, 5% (e) table B.O.Y. valuation January 2013 unadjusted S1-1.62% 19

20 Defined Benefit Plans Use of Cushion One Big Hit trial lawyer (cont) FT = $215,996 1,500 * * ^ (-5) TNC = $14, * * ^ (-5) Max deduction = $338,394 FT + Cushion (50% FT) + TNC (215,996) + (215,996 *.5) + 14,400 Defined Benefit Plans Use of Cushion One Big Hit trial lawyer (cont) Deposit of $300,000 will be enough to cover all 20 years of benefits Assuming deposit 12/31/2013 & ROR of at least ~~ 1% No future funding requirement 20

21 Defined Benefit Plans Use of Cushion i.e. benefit at age 62 will be $2,000 Value (liability) at age 62 (assuming current table) will be $312,090 (2,000 * ) At 1% ROR assets will grow to $312,181 Greater growth fine Maximum lump sum under IRC 415 at age 62 with 5 years in plan exceeds $1.25 million We did this in 2012 with an author who had first big seller Defined Benefit Plans Use of At Risk Rules Cash bal example: First year theoretical contribution = $100,000; Assume employee will take payment at NRA 13 years from retirement so use S2 for discounting Interest crediting rate 4% Future value at 4% = $166,507 Present value at 4.67% = $91, % = Aug 2012, unadjusted second segment rate (S2) Unadjusted S1 = 1.77% (used on next slide) Represents 404 TNC and in year 1 would = minimum required cont. (MRC) for deduction purposes (post MAP) 21

22 Defined Benefit Plans Use of At Risk Rules At risk rules Assume full vesting end of year 3 (i.e., 2 years from EOY val date) This becomes earliest retirement date and is date used to determine at risk TNC and FT TNC with additional assumptions = $104,430 $100K * (1.04 ^ 2) / ( ^ 2) TNC Load = $3,680 (4% * 91,991) FT load = $700 (one participant) + (4% * 0) Maximum deduction = $108,810 At-risk TNC + At-risk FT - assets ($104, ,680) + ( ) 0 Full $100K contribution credit therefore deductible Defined Benefit Plans Post-year end amendments Often a plan fails coverage or nondiscrimination testing and a plan amendment is made after year-end to correct Reg. Section 1.401(a)(4)-11(g) allows such an amendment to be considered for testing if, among other requirements, such amendment is non-discriminatory on a standalone basis The regulation specifically says that the amendment is not considered for purposes of the funding or deduction rules So absent some other provision, contributions made per corrective amendments not deductible in year for which they are made 22

23 Defined Benefit Plans Post-year end amendments For pension plans that other provision is Code Section 412(d)(2): For purposes of this section, any amendment applying to a plan year which (A) is adopted after the close of such plan year but no later than 2 1/2 months after the close of the plan year, (B) does not reduce the accrued benefit of any participant determined as of the beginning of the first plan year to which the amendment applies, and (C) does not reduce the accrued benefit of any participant determined as of the time of adoption, shall, at the election of the plan administrator, be deemed to have been made on the first day of such plan year. Defined Benefit Plans Post-year end amendments Note that this provision has been used to increase deductions even for DB plans that were not failing any testing E.g. owner only or safe harbor formula plans looking to increase contribution and therefore increased benefits (within 2 ½ months of) post year-end to get there Until the IRS made a comment at the 2011 EA meeting it was generally accepted that this was permissible MAYBE BECAUSE THE LAW CLEARLY ALLOWS IT!!?? The following 9 slides trace through some regulation sections and the actual IRS comment at the EA meeting We will not go through them at this point, but they are there for your later review if you care Further comments from the IRS are expected on this issue 23

24 Defined Benefit Plans Post-year end amendments Reg (d)-1(d)(1)(i) Plan provisions adopted by valuation date. Except as otherwise provided in this paragraph (d), a plan s funding target and target normal cost for a plan year are determined based on plan provisions that are adopted no later than the valuation date for the plan year and that take effect on or before the last day of the plan year. Defined Benefit Plans Post-year end amendments Reg (d)-1(d)(1)(ii) Plan provisions adopted after valuation date. If a plan administrator makes the election described in section 412(d)(2) the plan amendment is treated as having been adopted on the first day of the plan year for purposes of this paragraph (d). Section 412(d)(2) applies to any plan amendment adopted no later than 2-1/2 months after the close of the plan year, including an amendment adopted during the plan year. Thus, if an amendment is adopted after the valuation date for a plan year but takes effect by the last day of the plan year, the amendment is taken into account in determining the plan s funding target and target normal cost for the plan year 24

25 Defined Benefit Plans Post-year end amendments Reg (d)-1(d)(1)(iii) Determination of when an amendment takes effect. For purposes of this paragraph (d)(1), the determination of whether an amendment that increases benefits takes effect and when it takes effect is determined in accordance with the rules of section 436(c) and (c)(5) the determination of when an amendment takes effect is unaffected by an election under section 412(d)(2). Defined Benefit Plans Post-year end amendments Reg (c)(5) Rule for determining when an amendment takes effect. For purposes of section 436(c)... in the case of an amendment that increases benefits, the amendment takes effect under a plan on the first date on which any individual would obtain a legal right to the increased benefit if the individual were on that date to satisfy the applicable requirements for entitlement to the benefit 25

26 Defined Benefit Plans Post-year end amendments Preamble to Reg (c)(5)... if an amendment is adopted to provide increased benefits retroactively with respect to a prior year, but no participant's benefits are increased until the amendment is adopted, the amendment takes effect at the time of adoption and must satisfy the requirements of section 436(c) for the plan year the amendment is adopted. Defined Benefit Plans Post-year end amendments 2011 Graybook Q&A 4 - QUESTION The final 430 regulations provide that a plan amendment is reflected in FT and TNC if adopted no later than the valuation date for the plan year. In the case of an amendment adopted after the valuation date, the amendment is reflected in FT and TNC if the plan administrator makes the election in 412(d)(2). 26

27 Defined Benefit Plans Post-year end amendments 2011 Graybook Q&A 4 QUESTION (cont) However, in both cases, the amendment is taken into account only if it takes effect on or before the last day of the plan year. Assume a discretionary amendment (i.e., an amendment that is neither required for qualification nor integral to an amendment that is required for qualification) is adopted within the 412(d)(2) period of 2 ½ months after the end of the prior plan year to increase the benefit formula for prior service for all participants that worked at any time during the prior plan year. If the plan administrator makes the 412(d)(2) election, can the amendment be reflected in FT and TNC? Does the answer depend on whether a 436 contribution is required? On whether plan operations had actually reflected the amendment in the prior year? On whether the amendment is reflected for coverage and nondiscrimination purposes? Defined Benefit Plans Post-year end amendments 2011 Graybook Q&A 4 - RESPONSE In this situation the amendment is only reflected if it is adopted and takes effect by the end of the prior plan year. In general, if a discretionary amendment is adopted after the plan year that provides for increases in the prior year, there is no legal right to the increased benefits until adoption. Such an amendment takes effect when adopted (assuming 436 permits), and could be taken into account for the adoption year if a 412(d)(2) election is made for that year. 27

28 Defined Benefit Plans Post-year end amendments 2011 Graybook Q&A 4 RESPONSE (cont) If a discretionary amendment is implemented operationally during a plan year (thus creating a legal right in the plan year) adoption is required by the end of that plan year [see Rev. Proc ]. Any corrective amendment that meets the requirements of 1.401(a)(4)- 11(g) that is adopted after the end of the plan year is treated as being effective in the year preceding the year the amendment is adopted for purposes of coverage and nondiscrimination, but that treatment will not apply for minimum funding (or deductions) as noted above. [note last phrase is consistent with 1.401(a)(4)-11(g)(5)] Combined Plan Deduction Limits Applies where employer contributes to both DB and DC plan for same tax year [IRC 404(a)(7)(A)]; AND At least one employee is a beneficiary in both plans [IRC 404(a)(7)(C)(i)] 28

29 Combined Plan Deduction Limits Deduction limited to greater of 25% of compensation paid to beneficiaries of the plans during the tax year; or Contributions to DB plan to extent not in excess of minimum funding requirement Not less than funding target over assets IRS has indicated that MAP does apply for this purpose (IRS phone forum) i.e. new (higher) rates used resulting in lower FT No big deal as rarely if ever used IRC 404(a)(7)(A) Combined Plan Deduction Limits Limit does not apply - To extent employer contributions to DC plan do not exceed 6% of compensation (of DC plan beneficiaries ) IRC 404(a)(7)(C)(iii) To multiemployer plans IRC 404(a)(7)(C)(v) To PBGC plans IRC 404(a)(7)(C)(iv) 29

30 Combined Plan Deduction Limits IRS Notice Q&A 8 - where DC contributions exceed 6% of comp, only DC contributions over 6% considered in determining 25% limit Effectively translates to 31% limit BUT, only consider compensation of DC beneficiaries in determining the 6% 6% is aggregate number i.e., individual participants may get greater than 6% Combined Plan Deduction Limits DB Plans exempt from PBGC coverage Plans of professional group if plan never covered more than 25 active participants Physicians, dentists, D.O.s, O.D.s, lawyers, CPAs, P.E.s, architects, actuaries, others where license requires advanced study Not APAs, QPAs, RIAs, real estate prof, etc. ERISA Title IV 4021(b)(13), 4021(c)(2) 30

31 Combined Plan Deduction Limits DB Plans exempt from PBGC coverage Plans covering only substantial owners A substantial owner is an individual who (at any time during the prior 60-months) owns: the entire interest in a sole proprietorship more than 10% of either a capital or profits interest in a partnership, or more than 10% in value of either the voting or all stock of a corporation ERISA Title IV 4021(b)(9), 4021(d) Combined Plan Deduction Limits Attribution rules of IRC 1563 and 414(c) apply in determining ownership Under IRC 1563(e) An individual shall be considered as owning stock owned by his children who have not attained the age of 21 years, and, if the individual has not attained the age of 21 years, the stock owned by his parents Children not deemed to own the stock of their parents via above rules are not substantial owners and therefore could cause coverage 60-month rule basically requires child to be age 26 for this rule to cause coverage 31

32 Simple DB/DC using PBGC coverage to our advantage 2012 Comp. AAC BOY AAC EOY YOS EOY Age Owner $ 250,000 $211,667 $223, Son 32,000 31,929 31, NHCE 1 100, NHCE 2 30, Total $ 412,000 Simple DB/DC using PBGC coverage to our advantage 2012 very big year so looking for large deduction; unsure about future DC plan is PS only, no 401(k) Historically has contributed maximum PS for owner plus 5-10% for employees 2012 contributions to DC plan Maximize Owner 0% to son $7,500 each to NHCEs 32

33 Simple DB/DC using PBGC coverage to our advantage In 2012 add a DB plan Owner benefit = 2% X AAC X YOS first 5 years, 1% thereafter (recall 5 prior years of service) Son benefit =.5% X AAC X YOS Exclude Non-key employees NRA 62; QJSA 50% Act. eq. 5% pre / 5.5% (e) table post For funding, beginning accrued benefits determine FT while increase used for TNC Though for testing full year-end amount considered Simple DB/DC using PBGC coverage to our advantage DB (monthly) benefits beginning of year 1: Owner- AAC * benefit/year * YOS 12 $211,667 * 2% * 5 12 = $1, Limited by IRC 415 to $1, $200,000/12 = $16, One year of participation so limit to 1/10th Son $31,929 *.5% * 1 12 = $

34 Simple DB/DC using PBGC coverage to our advantage DB (monthly) benefits end of year 1: Owner- Limited by IRC 415 to $1, SO NO INCREASE > BOY benefit = EOY benefit THEREFORE no Target Normal Cost for owner Son $31,965 *.5% * 2 12 = $26.64 Increase = = $13.34 Simple DB/DC using PBGC coverage to our advantage S1-1.77%; S2-4.67%; S3-5.78% Showing max only so using unadjusted rates (for August month lookback) Funding Target: Owner (NRA 62, AA 60) - AB * APR / (1+S1)^(NRA-AA) $1, * / ^2 = $239,481 Son (NRA 62, AA 26) * / ^36 = $262 Target Normal Cost (Son only): * / ^36 = $263 34

35 Simple DB/DC using PBGC coverage to our advantage DB maximum TNC + FT + cushion assets Cushion = 50% of FT (we re ignoring increase in FT from compensation increases as owner at max) $263 + ($239,481+$262)*1.5 0 = $359,878 Should cover owner accruals through NRA $223,167 * [(2%*5)+(1%*3)] 12= $2, $2, * = $359,793 (owner LS at NRA) Since DB covered by PBGC combined plan deduction not limited to 25%/31% Simple DB/DC using PBGC coverage to our advantage 2012 Comp. PS DB Total Owner $ 250,000 $50,000 $239,481 $289,481 Son 32, NHCE 1 100,000 7,500 7,500 NHCE 2 30,000 7,500 7,500 Cushion 119, ,872 Total $ 412,000 $65,000 $359,878 $424,878 35

36 Simple DB/DC using PBGC coverage to our advantage Select DB/DC test results ignoring PD and MVAR - Owner Normal Accrual Rate = 10.78% DB: 1,667 * 12 / 250,000 = 8.00% DC: 50,000 * 1.085^2 / / 250,000 = 2.78% 8.5% = standard interest rate 2 = Years from attained age (AA) to testing age (TA) = Testing APR based on 71GAM 8.5% age 62 NHC 2 Normal Accrual Rate = 11.8% DC only: 7,500 * 1.085^17 / / 30,000 = 11.8% IRC 401(a)(26) passed as 2 of 4 persons covered Combined Plan Limits Beneficiaries under plan Beneficiaries under the plan Recall from above combined plan limits only apply if at least one employee benefiting in both DB & DC RR and IRS position in DC plan arena consistent with notion of benefiting under 410(b) In DB arena maintenance of accrued benefit even if frozen appears to suffice 2005 greybook Q&A 15 Logical as DB funding really considers all benefits and not just those accruing in particular year 36

37 Combined Plan Limits Beneficiaries under plan Consider carve out DB & 401(k) trying to avoid combined deduction limit while allowing everyone to defer Recall IRC 404(n): Elective deferrals shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a) and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions. (emphasis added) Combined Plan Limits Beneficiaries under plan Employer sponsors DB plan & 401(k) PS plan Employees in DB plan eligible for deferrals only in 401(k) Others in 401(k) PS plan receive PS contributions (but are not in DB plan) i.e., absent deferrals no one benefits in both plans 2005 IRS/ASPPA Q&A #21 IRS indicated that the combined plan limit did not apply Of course it doesn t 404(n) controls BUT this requires conclusion that deferral only participants are NOT beneficiaries in DC plan And therefore comp. not considered in DC limit 37

38 Cash Balance/401(k) Combo Compensation Age HCE 1 owner $ 255, HCE 2 non owner 255, NHCE 1 30, NHCE 2 30, NHCE 3 30, NHCE 4 30, NHCE 5 30, NHCE 6 30, Total $ 690,000 Cash Balance/401(k) Combo Ex.1 DC over 6% Components of Design DC plan 3% non-elective safe harbor 401(k)/PS Maximize Owner 3% total to non-owner HCE Additional 4% PS to NHCEs (7% with SH) Suggest no safe harbor to HCEs HCEs defer max, NHCEs do not defer Same for all examples 38

39 Cash Balance/401(k) Combo Ex.1 DC over 6% Components of Design DC plan For PS allocation each participant in own group for flexibility & gateway requirements No last day or hour requirement for PS allocation If not 401(k) SH possibly use 501 hours or last day Combo designs generally require loss of requirements such as 1,000 hours and last day for PS allocation Gateway must go to any NHC receiving allocation of employer DC or accrual in DB (more later) 5% Top-Heavy in profit sharing plan Cash Balance/401(k) Combo Ex.1 DC over 6% Components of Design DB plan Cash balance plan with pay credits as follows: Owner - 61% of compensation (exclude non-owner HCE) NHCEs 2.5% of compensation Interest crediting rate = 5% (same for all examples) Plan AE = 5%, (e) table (same for all) QJSA = 50% J&S (same for all) 39

40 Cash Balance/401(k) Combo Ex.1 DC over 6% Components of Design DB plan (same for all) NRA later age 65 / 5 th anniv. participation Should be same as DC Though likely fine if DC earlier Require 1,000 hours to receive pay credit May not have an EOY requirement in a DB plan Would violate DOL requirement that year of service with 1,000 or more hours may not be ignored for benefit accrual DOL Reg ; Cash Balance/401(k) Combo Ex.1 DC over 6% PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 33,500 $155,550 $ 189,050 $ 23,000 $ 212,050 HCE 2 7, ,650 17,500 25,150 NHCE 1 2, ,850 2,850 NHCE 2 2, ,850 2,850 NHCE 3 2, ,850 2,850 NHCE 4 2, ,850 2,850 NHCE 5 2, ,850 2,850 NHCE 6 2, ,850 2,850 Total $ 53,750 $160,050 $213,800 $ 40,500 $ 254,300 40

41 Cash Balance/401(k) Combo Ex.1 DC over 6% Employer deduction total $213,800 less than 31% of compensation $690,000 * 31% = $213,900 Cash Balance/401(k) Combo Ex.2 DC not over 6% Components of Design DC plan 3% non-elective safe harbor 401(k)/PS $21,150 Owner 3% total to non-owner HCE Additional 4% PS to NHCEs (7% with SH) Components of Design DB plan Cash balance plan with contribution credits as follows: Owner - 76% of compensation (exclude non-owner HCE) NHCEs 2.5% of compensation 41

42 Cash Balance/401(k) Combo Ex.2 DC not over 6% PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 21,150 $193,800 $ 214,950 $ 23,000 $ 237,950 HCE 2 7, ,650 17,500 25,150 NHCE 1 2, ,850 2,850 NHCE 2 2, ,850 2,850 NHCE 3 2, ,850 2,850 NHCE 4 2, ,850 2,850 NHCE 5 2, ,850 2,850 NHCE 6 2, ,850 2,850 Total $ 41,400 $198,300 $239,700 $ 40,500 $ 280,200 Cash Balance/401(k) Combo Ex.2 DC not over 6% Employer deduction total $239,700 Greater than 31% of comp But DC not in excess of 6% of comp 6% * $690,000 = $41,400 = Employer DC 25%/31% limit therefore not applicable Important that HCEs receive employer $$s in DC to use comp. in applying 6% limit 42

43 Cash Balance/401(k) Combo Ex.3 DB PBGC Covered Components of Design DC plan 3% non-elective safe harbor 401(k)/PS Maximize Owner 3% total to non-owner HCE 4% PS to NHCEs Components of Design DB plan Cash balance plan with contribution credits as follows: Owner - 76% of compensation (exclude non-owner HCE) NHCEs 2.5% of compensation Cash Balance/401(k) Combo Ex.3 DB PBGC Covered PS/SH Cash Balance Total Employer 401(k) Total HCE 1 $ 33,500 $193,800 $ 227,300 $ 23,000 $ 250,300 HCE 2 7, ,650 17,500 25,150 NHCE 1 2, ,850 2,850 NHCE 2 2, ,850 2,850 NHCE 3 2, ,850 2,850 NHCE 4 2, ,850 2,850 NHCE 5 2, ,850 2,850 NHCE 6 2, ,850 2,850 Total $ 53,750 $198,300 $252,050 $ 40,500 $ 292,550 43

44 Cash Balance/401(k) Combo Ex.3 DB PBGC Covered Employer deduction exceeds 31% of comp. AND DC exceeds 6% of comp. So requires PBGC coverage Therefore assumes not Dr/Professional as under 25 active participants ERISA 4021(b)(13) Run any of these scenario through your testing software and you ll see they pass all testing Plan must be in existence Engineered Timber Sales, Inc. v. Comr., 74 T.C. 808 (July 22, 1980) Tax court ruled plan must be in existence & executed prior to end of employer s tax year in order for a deduction to be taken IRS reiterated this in Rev. Rul

45 Plan must be in existence So using fiscal year plan where plan year begins in tax year, ends after tax year, and executing plan before end of plan year but after end of tax year does not result in deduction in prior tax year Plan year 4/1/12-3/31/13 Tax year 1/1/12-12/31/12 Plan signed 3/31/13 cannot take deduction in 2012 irrespective of fact that it s signed before end of plan year that begins in tax year Plan must be in existence The Service also ruled in that if, under local law, a valid trust has been created by the end of the taxable year except for the existence of corpus, the trust will be deemed to be in effect if the corpus is furnished no later than the due date (including extensions) of the employer's tax return. Accordingly, it is not necessary to open an account for the trust prior to the end of the tax year. It is simply necessary that plan documents are properly executed. 45

46 Self-employed deduction limit IRC 404(a)(8)(C) Limits deduction on behalf of SE person to earned income Can preclude deduction for minimum funding required for defined benefit plan IRC 4972(c)(4) Provides for exception to excise tax on nondeductible contributions for amounts required by 412 but not deductible due to above Self-employed s Earned Income Earned income = net earnings from selfemployment (NESE) less: Deduction for employer contributions for owner But not elective deferrals ½ SE tax For SE persons earned income = compensation only with respect to a trade or business in which personal services of the taxpayer are a material income-producing factor IRC 401(c)(2) / 1402(a) 46

47 Self-employed s Earned Income When determining net earnings from SE (and therefore SE tax) Contribution for owner not deductible GCM Laflamme v. Comr, TCM /6/2012 Gale v. U.S., DC-Northern Ill., 6/27/91 Contribution for employees is deductible Self-employed s Earned Income Calculation of deduction for ½ SE Tax First multiply NESE by 92.35% For 2012, tax is calculated as 10.4% up to the Social Security taxable wage base (TWB) for the year ($110,100 for 2012) plus 2.9% of all NESE Outside W-2 income serves to reduce SE tax Deduction for ½ SE tax is 10.4% portion X 59.6% plus 2.9% portion X 50% Basically same as 6.2% of amount subject to full tax plus 1.45% of amount subject to 2.9% only 47

48 Sole-prop Example For 2012 individual has W-2 income of $60,000 from regular employer Also has Schedule C income of $120,000 from outside consulting No other employees Wishes to maximize contribution to solo 401(k) plan Sole-prop Example Net earnings from SE $ 120,000 Multiply by ,820 Lesser this amount or TWB 110,100 Outside wages 60,000 Amount to tax at 10.4% 50,100 50,100 X 10.4% 5, ,820 X 2.9% 3,214 1/2 SE tax deduction 5,210 X.596 = 3,105 3,214 X.50 = 1,607 $ 4,712 48

49 Sole-prop Example Net Earnings from Self Employment $120,000 ½ SE tax 4,712 Pre-pension Earned Income 115,288 Maximum PS (20% of pre-contribution net) 23,058 Add 401(k) deferral 17,000 Total 40,058 Check PS deduction: $120,000 4,712 - $23,058 = $92,230 (comp.) $ 92,230 x 25% = $23,058 Partnerships Reg (e)- 1A(f)(1) in the case of a defined contribution plan, a partner's distributive share of deductions allowed the partnership under section 404 for contributions on behalf of a self-employed individual is that portion of the deduction which is attributable to contributions made on his behalf i.e., if DC plan, partner deducts on personal tax return amounts contributed on his/her behalf 49

50 Partnerships Reg (e)- 1A(f)(2) In the case of a defined benefit plan, a partner's distributive share of contributions on behalf of selfemployed individuals and his distributive share of deductions allowed the partnership under section 404 for such contributions is determined in the same manner as his distributive share of partnership taxable income. See section 704, relating to the determination of the distributive share and the regulations thereunder. (emphasis added) Partnerships IRS/ASPA Q. Field Service Advice indicates that 1.404(e)- 1A(f)(2), which requires allocations of defined benefit plan deductions to be made in accordance with each partner's profits interest, is still valid. Is this true? Assume a partnership has three equal partners, two of whom are covered under the partnership s DB plan at a cost of $75,000 each. There are no other employees. The 404 reg appears to say that each partner is responsible for funding (and deducting) $50,000. A. Absent a special allocation in the partnership agreement we agree with the above result. A special allocation in the partnership agreement could result in the deduction being allocated to the two covered employees. 50

51 Year Deductible Plan contribution deemed made on last day of preceding taxable year if payment on account of such taxable year and made not later than due date for filing tax return for such taxable year (including extensions) 404(a)(6) Year Deductible In order for 404(a)(6) to apply (allowing deduction in tax year prior to year of deposit): Contribution must be treated as a contribution actually received on last day of tax year would be treated; and No later than due date of tax return, employer either: designates payment in writing (to PA or trustee) as on account of employer s preceding taxable year ; or claims payment as deduction on tax return for preceding taxable year Revenue Ruling

52 Year Deductible Note from above Contribution must be treated as a contribution actually received on last day of tax year would be treated This would seem to disallow prior year deduction for amounts contributed pursuant to post yearend corrective amendment under Reg (a)(4)-11(g) Further, from 1.401(a)(4)-11(g)(5) the amendment is not given retroactive effect for purposes of section 404 Year Deductible A payment may be designated as on account of preceding taxable year (as provided above) at any time on or before the due date (including extensions) of tax return for such year SO, where return first filed without taking deduction, amended return may be filed claiming deduction if filed before (extended) due date CONVERSELY, if deduction claimed on preceding year return for post year-end deposit, employer may not amend return to push deduction to current year 52

53 Year Deductible Presume that: payment made within 8 ½ months after year-end treated as prior year deposit for 412 (minimum funding) not deducted on prior year tax return, and nothing in writing designates contribution is on account of prior tax year How about deposit made 10/15 (within 404(a)(6) period for Sole Prop) for calendar year plan? Can contribution be on account of one year for minimum funding purposes and another year for deduction purposes? Year Deductible Revenue Ruling Taxpayer allowed to take deduction in 1975 for contribution made within 404(a)(6) period, but count for 412 (minimum funding) in 1976 ( 412 did not apply until years beginning after 1975) Service cited following language in Temp. Reg (c)-12(c)(2) (allowing 8½ month post yearend period to satisfy minimum funding in case of pension plans other than single employer DB plans): 53

54 Year Deductible The rules of this section relating to the time a contribution is deemed made for purposes of section 412 are independent from the rules contained in section 404(a)(6) relating to the time a contribution is deemed made for purposes of claiming a deduction for such contribution under section 404. [Temp. Reg (c)-12(c)(2)] (emphasis added) Year Deductible PLR : For 1988 company maintained three plans a money purchase plan, a PS plan and a DB plan Contributions to 3 plans exceeded 404(a)(7) limit Company wished to treat certain contributions to DB plan made after year-end but prior to extended due date of tax return (and minimum funding deadline) as 1988 contributions for 412 but as 1989 for 404 Citing Temp. Reg (c)-12(c)(2) and RR 77-82, Service allowed taxpayer to treat contributions in above manner 54

55 Year Deductible Note that with contribution considered 404 contribution for subsequent year, limits of 404 for following year will apply and they will apply to all amounts designated as being on account of such subsequent year i.e., contribution is not added to following year s limit - it becomes deductible within such limit (Presumably) Reg (a)-14(d)(2)(i) will require that contribution be excluded from assets when determining deductible amounts for subsequent year Year Deductible 2011 Greybook Q&A 7 A company has a calendar taxable year and sponsors a pension plan with a calendar plan year. Which of the following combinations are acceptable for a contribution made during the contribution grace period (January 1, 2011 to September 15, 2011)? a) Deduct in 2010, reflect on 2010 Sched SB? b) Deduct in 2010, reflect on 2011 Sched SB? c) Deduct in 2011, reflect on 2010 Sched SB? d) Deduct in 2011, reflect on 2011 Sched SB? 55

56 Year Deductible 2011 Greybook Q&A 7 (cont) RESPONSE a), c), and d) are acceptable. IRC 404(a)(6) deems a contribution made after the last day of a taxable year to be made on the last day of a taxable year if the payment is made on account of such taxable year. A contribution is considered to be on account of the 2011 plan year when reported on the 2011 Schedule SB and thus cannot be deducted on the sponsor s 2010 tax return COMMENTARY TO FOLLOW Year Deductible I respectfully disagree that (b) is not acceptable IRC 404(a)(6) and do not require contribution to be on account of preceding plan year They require it to be on account of preceding tax year As detailed above, there is plenty of authority (e.g. RR 77-82) providing that they can be different e.g. as in (c) where on 2010 SB but 2011 tax return If a contribution is within deductible limit for preceding year, and is made by due date of preceding year tax return, it should be deductible in preceding year irrespective of treatment for funding purposes 56

57 Year Deductible Effect of Extension. If a company files its tax return prior to the original due date, but after obtaining an extension of time for filing, the due date under 404(a)(6) is the extended due date. Revenue Ruling , affirmed by Revenue Ruling (see also 2002 IRS/ASPA Q&A #47) Important to understand that due date of contribution is due date of return, NOT prior to filing return Conversely, an extension is not valid where the return is filed prior to the original due date and prior to filing for the extension. PLR