Workshop #53: Deduction Limits for Defined Benefit and Combo Plans Michael B. Preston, FSPA Preston Actuarial Services, Inc. Angela Barclay, EA Pension Benefits Unlimited, Inc.
Overview of Presentation Deduction Limits and exemptions for DB and Combined Plans Plan year versus tax year for deductions and contributions Partnerships, Controlled Groups and other special circumstances Excise taxes and how to avoid them Advanced design strategies to maximize contributions within constraints 2
Overview (Continued) There is little hard guidance on 404(a)(7) the regulation is from 1961 and only helps understand some issues. Presented here is what we think is the best interpretation. 3
Deductible Limits for DB Plans Deductible limit equals the greater of: (1) The excess (if any) of the sum of - Funding target for the plan year, plus - Target normal cost for the plan year, plus - Cushion amount for the plan year Over the 430(g)(2) actuarial value of assets (2) Minimum required contributions under IRC section 430 4
Deductible Limits for DB Plans (continued) No reduction in Actuarial Asset Value for Carryover or Prefunding balances under 404 Actuarial Asset Value should be reduced for non-deducted contributions 5
Cushion Amount Cushion Amount equals the sum of (1) 50 percent of the funding target for the plan year (2) Increase in funding target if plan allows for future compensation increases If plan benefits are not compensation based Allow for expected future increases in benefits Based on average annual increase over prior 6 plan years 6
Cushion Amount Two Year Rule Small plan HCE liability exclusion Based on participant count for the plan year Include all non-multiemployer DB plans in controlled group Only count participants of employer For plans with 100 or less participants Reduce Target liability Excludes benefit increases for Highly Compensated Employees due to plan amendment made (or effective) within last 2 years 2 Year Lookback is for amendments adopted or effective in the two plan years immediately preceding the current plan year, regardless of valuation date 7
Compensation and Benefit Limits Compensation must be limited by 404(l) Compensation defined as section 415(c)(3) Benefits must be limited by 415(b) PBGC covered plans can project future increases in 404(l) compensation limit 8
Assumptions and Definitions Must use the same actuarial assumptions for deductible limit calculations as used under section 430 Higher segment rates under 430(h)(2)(C)(iv) are ignored Any term used in 404 has the same meaning as term in section 430 9
Special Rule for Not At-Risk Plans If a plan is NOT at risk under IRC Section 430(i) Deductible limit is the excess (if any) of the sum of (1)Funding target for the plan year, assuming at-risk rules apply, plus (2)Target normal cost for the plan year, assuming at risk rules apply Over the 430(g)(2) actuarial value of assets 10
At-Risk Assumptions Assume participants eligible to retire within 11 years from valuation date retire at earliest date they can receive an immediate distribution of fully vested benefit Assume all participants and beneficiaries elect form with highest present value 11
Special Rule for Terminating Plans Only applies to PBGC covered plans The amount required to make the plan sufficient for benefit liabilities under ERISA 4041(d) is always deductible This rule is applicable for the year of plan termination Can the amount can be deducted in subsequent years? Guidance is unclear Accountants say Yes? 12
Deductible Limits for DC Plans Tax deductions for stock bonus plans, money purchase pension plans, and profit sharing plans, including 401(k) plans, are taken under IRC Section 404(a)(3), but can be limited by IRC Section 404(a)(7). Money purchase pension plans, including target benefit pension plans, shall be treated like profit sharing plans except that the Secretary of the Treasury can provide exceptions. The basic maximum deduction is 25% of the compensation paid or accrued during the tax year of the employer to the beneficiaries under the plan. 13
Deductible Limits for DC Plans (continued) Excess contributions can be carried over, but such carryovers do not increase the tax deduction in a later year. The carryover will reduce the new deductible contributions for the year in which the carryover is deducted. (IRC 404(a)(3)(A)(ii).) This does allow some flexibility as to which Plan year a contribution is allocated and in which tax year it is deducted. 14
When does 404(a)(7) Apply? Must have amounts deductible for both a DB and DC plan (after excluding certain amounts disregarded). Must have a beneficiary in common. If there is a common beneficiary among two plans, all plans, even those with no overlapping beneficiaries, are included. 15
Basic 404(a)(7) Limit IRC 404(a)(7)(A) provides the general rule: the deduction is the greater of 25% of compensation or Greater of 430 DB plan minimum and Lesser of (1) 430 Funding Target minus Actuarial Asset Value (2) DB Plan Contribution 16
Elective Deferrals 402(g)(3) deferrals are included in total compensation Are not considered employer contributions 401(k) deferrals are disregarded for all purposes under 404 pursuant to 404(n) 17
Elective Deferrals (continued) A combination DB plan and 401(k) only is not subject to 404(a)(7) Even if a beneficiary under the defined benefit pension plan made 401(k) salary deferrals, the 404(a)(7) deduction limit will not apply solely because of the 401(k) deferrals 401(m) matching contributions and safe harbor elective contributions, however, are still fully subject to 404(a)(7) 18
Exclusion of DC Up to Six Percent of Compensation Any deductible amounts for a DC plan are excluded from consideration up to six percent of compensation. Compensation only includes compensation for DC beneficiaries DB beneficiaries are not included. Compensation for those who only have 401(k) deferrals should not count for 404(a)(7) 19
Other Exemptions DB plans covered by Title IV of ERISA (PBGC) shall not be subject to 404(a)(7) - Could be advantageous to have coverage No employee is covered under both DB and DC plans (assuming other testing passes) Any multi-employer plan is disregarded. 20
Alternative Limit for DB MRC or FT Minus Assets Alternatively, the limit can be increased to the amount actually contributed to satisfy the DB MRC or, if greater, FT minus assets. But this rule only applies to the extent that an actual contribution is made. Therefore, cannot contribute less than DB MRC, accept a funding deficiency, and use the difference to deduct DC contributions over six percent. 21
Cannot Avoid by Not Deducting The limit applies to amounts deductible under prior 404 sections, not amounts actually deducted. Therefore, cannot avoid triggering 404(a)(7) by choosing not to deduct DC contributions over six percent. 22
31 Percent Simplified Rule The simplified rule is that the limit is 31 percent of compensation, which works in many situations. Some exceptions are: There are some who are beneficiaries only in the DB plan so the compensation for the six percent DC exclusion is less than the compensation for the 25 percent limit. DC only beneficiaries are not an issue. The DB contribution is under six percent of compensation. The DB MRC / FT assets rule applies. 23
Who Is a Beneficiary for the DC? There is some general IRS guidance on DC beneficiary for 404(a)(3) linking it to 410(b) benefitting. Exceptions may occur if the 410(b) year is not the same as the tax year. Ask who is truly receiving an allocation from the deductible contribution? One implication of the IRS general 410(b) benefitting rule should be that those who only receive an allocation of a forfeiture and no employer contribution should still be considered a beneficiary of the contribution. 24
Who Is a Beneficiary for the DB? General principle of who is actually benefitting from the contribution should apply. In application, seems most reasonable to consider every participant in the DB plan to be a beneficiary, even if plan frozen, terminated, or any other circumstance. As DB assets can change, always possible that a contribution will benefit any participant. 25
Spreadsheet Example 26
Plan Year vs. Tax Year Can contribution be on account of one year for minimum funding purposes and another year for deduction purposes? Let s assume: payment made within 8 ½ months after year-end treated as prior year deposit for 412 not deducted on prior year tax return, and nothing in writing designates contribution is on account of prior tax year 27
Plan Year vs. Tax Year (continued) Accountants think they have until due date of tax return to make contributions With partnerships this now lines up with minimum funding date (assuming plan year = tax year and extension filed) but sole props can still have until 10/15 to file How about deposit made 10/15 (within 404(a)(6) period for Sole Prop) for calendar year plan? 28
Plan Year vs. Tax Year (continued) Revenue Ruling 77-82 Taxpayer allowed to take deduction in 1975 for contribution made within 404(a)(6) period, but count for 412 in 1976 ( 412 did not apply until years beginning after 1975) Service cited following language in Temp. Reg. 11.412(c)-12(c)(2) (allowing 8½ month post year-end period to satisfy minimum funding in case of pension plans other than single employer DB plans) 29
Plan Year vs. Tax Year (continued) Temp. Reg. 11.412(c)-12(c)(2)] 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. 30
2011 Gray Book 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 2010 404 contribution grace period (January 1, 2011 to September 15, 2011)? a) Deduct contribution in 2010, reflect on 2010 Schedule SB. b) Deduct contribution in 2010, reflect on 2011 Schedule SB. c) Deduct contribution in 2011, reflect on 2010 Schedule SB. d) Deduct contribution in 2011, reflect on 2011 Schedule SB. 31
2011 Gray Book Q&A 7 (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 What is the basis for this? 32
Plan must be in existence Plan must be in existence prior to end of tax year 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. 81-114 33
Plan must be in existence (continued) The Service also ruled in 81-114 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 the documents are properly executed. 34
Plan must be in existence (continued) 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 For example: Plan year 9/1/15-8/31/16 Tax year 1/1/15-12/31/15 Plan signed 8/31/16 cannot take deduction in 2015 irrespective of fact that it s signed before end of plan year that begins in tax year 35
Overlapping Plan/Tax Year - DC Recall 25% limit based on tax-year compensation Example Calendar plan-year June 30 tax-year Participant comp. June 30, 2016 = $400,000 Employer contribution for 2015 plan-year = $75,000 If timely, $25,000 of contribution for 2016 plan year could be deducted in tax-year-ended June 30, 2016 But not matching cont. on post 6/30/16 deferrals Revenue Rulings 90-105; 2002-46 36
Overlapping Plan/Tax Year - DC Plan Year Tax Year Limit determined for plan year beginning within tax year Limit determined for plan year ending within tax year Weighted average of above based on number of months of each plan year falling within taxable year Same alternative used for each taxable year unless consent to change accounting method obtained under IRC 446(e) Reg. 1.404(a)-14(c) Still valid? 37
Special Rules for Self-Employed IRC section 404(a)(8)(C) Limits deduction on behalf of self employed to earned income (after subtraction of ½ FICA) This can preclude the deduction for minimum funding for a DB plan This can make 404 limit calculations iterative Can non-deductible contributions be carried forward? If yes, on a first in first deducted basis? Or amortized? IRS opinion No, never deductible in a future year 38
Partnerships Reg section 1.404(e)-1A(f)(1) allows a partner to deduct DC contributions the partnership contributes on his behalf. Reg section 1.404(e)-1A(f)(2) says a partner s deductible share of a DB contribution is determined in the same manner as his distributive share of partnership taxable income. Special allocation agreement may (should???) be made in the partnership agreement 39
Partnerships (continued) Code and ERISA clear that for retirement plan purposes the partnership is the employer and the partners are each employees It follows from there that the deduction limits are determined at the partnership level This can cause a percentage of compensation deduction issue 40
Partnerships Example Two 50% partners each with $150K comp (after required adjustments) Total employee comp $200K Total plan comp $500K and DC deduction limit $125K $25K allocated to employees $50K to each partner 41
Partnerships Example (continued) CPAs will often contact TPA and say their software is limiting partner to $37,500 (i.e. 25% of their comp) They need to be told to override software possibly by lying to system and telling it it s a DB plan Software has no way of knowing there s comp over and above the partners that is supporting deduction 42
Partnership of P.C. s Plans of affiliated service groups treated as multiple employer plans [Prop. Reg. 1.414(m)-3(c)] Multiple employer plans provide for separate deduction limit for each employer [IRC 413(c)(6)] Special election for plans in effective prior to 1989 Somewhat common in professional settings where partners are individual PCs and LLC employs non-owners 43
Partnership of P.C. s (continued) For non-pbgc plans this means one person partner/corps with $270K of owner only payroll can deduct either $16,200 DC plus max DB, or $83,700 between DC and DB This assumes the CPA knows that the comp needs to be taken Deduction for employees at LLC level usually not an issue 44
Controlled Group Deductions In a controlled group, the deduction limits are determined on a combined basis Safest course of action is for each corporation to deduct the contributions based on compensation paid by that corporation Very little guidance available on how to do this with DB Plans Only known exemption is for termination liability under IRC 404(g) 45
Avoiding Non-Deductible Contributions In general, avoid 404(a)(7) by not making DC contributions over six percent of compensation. Finalize six percent limit before committing to DC contributions. If contributions are made after the end of the year, do not designate them to the prior year by action or note until verified. This allows for any amount deposited in excess of six percent due to initial calculation error to be designated as a contribution for the year of deposit. 46
4972 Excise Taxes for Non-Deductible Contributions 10% Excise tax on non-deductible contributions If non-deductible contribution is carried forward, employer must pay 10% excise tax each year 47
4972 Excise Taxes for Non-Deductible Contributions (continued) Exemption for employer deductions limited by 404(a)(7) for combined DB/DC Plans Excise tax applies to non-deductible contributions in excess of the sum of Employer matching contributions 401(m)(4) Contributions under 402(g)(3)A CODA 404(a)(7) limit first applies to DB plan contributions, then DC Only consider DB plan contributions in excess of 6% 48
4972 Excise Taxes for Non-Deductible Contributions (continued) There are special rules regarding the election under 4972(c)(7) to exempt DB contributions from the excise tax. If the 4972(c)(7) election is NOT made, DC contributions up to amount of match are exempt from excise tax to the extent they are only non-deductible due to 404(a)(7). If the 4972(c)(7) election is made, DB contributions are exempt. Now the 404(a)7 limit applies to DC plan contributions first, then DB 49
4972 Excise Tax Election Must be elected by employer for taxable year in lieu of 4072(c)(6) How does the employer make the election? Somewhat ambiguous guidance Safest alternative to file 5330 Some filed election should be acceptable (5500 attachment) Written election 50
Funding and Plan Design Strategies Maximize initial DB contribution by recognizing past years of service - Will have non-zero funding target and cushion - Increases overall DB deductible maximum Allocate a small DC employer contribution to highly paid employees so that their compensation is used towards the overall 6% limit 51
Funding and Plan Design Strategies (continued) Maximizing a DB contribution and deduction for a few years will not increase the lifetime deductions. Final plan assets will always be what is needed to provide 415 max. The DC contributions, in contrast, are use it or lose it with respect to 415, so any increased amount of DC contribution provides a lifetime of potential investment growth. 52
Funding and Plan Design Strategies (continued) A simple 404(a)(7) strategy limits the DC contribution each year to six percent of compensation, leaving all of the DC 415 limit over six percent unused and lost forever. Big/little Strategy alternates years of maximum contributions Advanced DC Max Strategy includes shifting DC contributions so that they are in different tax and limitation years 53
Big/Little Strategy 54
Advanced DC Max Strategy 55
Applications with R&F Employees One 404(a)(7) problem with NHCEs is providing the 7.5 percent DB/DC gateway when you are trying to limit the DC to six percent. Common approach is to reduce the HCE DC below six percent to leave total exactly at six percent. But another strategy is to use the same advanced shift of contributions for a current tax year to a prior 401(a)(4) allocation year by contributing within 30 days of tax filing date. This shifts for both 415 and 401(a)(4). 56
Applications with R&F Employees (Continued) This strategy should be used to shift from big tax year (when DB is max and DC limited to six percent) to a little tax year (where DC is not limited to six percent). A 401(a)(4)-11(g) amendment is not necessary. Just contributing after tax filing due date accomplishes the same result. 57
Questions? 58