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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
2
Defined Contribution Plans
• Reg. §1.404(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 80-145)
• 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.
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 65-295
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 #82 1996; #32 1995
• 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) ?
5
Defined Contribution Plans
• Use IRC §410(b) ‗benefiting‘ as guideline?
• Effectively done in Rev Rul 65-295
• Those eligible to defer considered to be benefiting for purposes of 401(k) portion of plan [Reg. §1.410(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 … • http://www.irs.gov/pub/irs-tege/epche903.pdf
• IRS Examination handbook; Page 9-18, next slide • (Who knows when this was updated!!??)
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. 1.410(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 201229012
• ―… 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.
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 9635045 and 199909060
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.
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 90-105; 2002-46
• See later discussion re IRC 404(a)(6) and RR 76-28
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 21
• §404(o)(2) amount [§404(o)(1)(A)]
9
Defined Benefit Plans
• Target Normal cost
• ―… present value of all benefits … earned … during the
plan year‖
• IRC §430(b) ; Reg. §1.430(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. §1.430(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)
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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. §1.404(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?
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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)
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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
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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. §1.401(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)
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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
15
Defined Benefit Plans – MAP 21
• For plan years beginning in -
• 2012 corridor 90-110%
• 2013 corridor 85-115%
• 2014 corridor 80-120%
• 2015 corridor 75-125%
• 2016 (and later) corridor 70-130%
• 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 / 6.19
• 25-year avg 6.15 / 7.61 / 8.35
• 90% 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 2012-55
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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 = $1,666.67
• Full/Immediate vesting
• Plan Actuarial Equivalence
• Pre retirement interest 5%, mortality - none
• Post retirement int. 5.5%, 2012 417(e) table
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Defined Benefit Plans – MAP 21
• 404 S1 = 1.75%; S2 = 4.62%; S3 = 5.72% • Sept 2012 rates – using 4th month prior
• 430 S1 = 5.54%; S2 = 6.85%; S3 = 7.52% • Per Notice 2012-55
• 415 $ limit 62 (NRA) $1,666.67
• 415 $ limit 58 (AA) $1,261.81
• APR 62 = 148.820; APR 58 = 161.004
• Max LS NRA = $248,033; AA = $203,157 • With immediate vesting latter = at risk TNC
Defined Benefit Plans – MAP 21
• 430 TNC = MRC • LS NRA 430 rates 417(e) table - $216,370
• Obtained by running 430 rates through 417(e) table
• LS NRA Plan rates - $248,033 • 1666.67 * 148.820
• LS NRA 415 max - $248,033 • 1666.67 * 148.820
• 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
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Defined Benefit Plans – MAP 21
• 404 TNC • LS NRA 404 rates 417(e) table- $257,477
• Obtained by running 404 rates through 417(e) table
• LS NRA Plan rates - $248,033 • 1666.67 * 148.820
• LS NRA 415 max - $248,033 • 1666.67 * 148.820
• 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
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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. §1.401(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% 2013 417(e) table
• B.O.Y. valuation • January 2013 unadjusted S1 - 1.62%
20
Defined Benefit Plans – Use of Cushion
• ―One Big Hit‖ trial lawyer (cont)
• FT = $215,996
• 1,500 * 156.045 * 1.0162 ^ (-5)
• TNC = $14,400
• 100 * 156.045 * 1.0162 ^ (-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
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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 * 156.045)
• 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% = $91,991
• 4.67% = 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)
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) / (1.0177 ^ 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
• ($104,430 + 3,680) + (0 + 700) – 0
• Full $100K contribution credit therefore deductible
Defined Benefit Plans – Post-year end amendments
• Often a plan fails coverage or non-discrimination 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
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
24
Defined Benefit Plans – Post-year end amendments
• Reg. 1.430(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. 1.430(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…‖
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Defined Benefit Plans – Post-year end amendments
• Reg. 1.430(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 §1.436-1(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. 1.436-1(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 …‖
26
Defined Benefit Plans – Post-year end amendments
• Preamble to Reg. 1.436-1(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).‖
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.‖
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. 2007-44]. 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)]
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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)
30
Combined Plan Deduction Limits
• IRS Notice 2007-28
• 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)
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
32
Simple DB/DC using PBGC coverage to our advantage
2012
Comp.
AAC
BOY
AAC
EOY
YOS
EOY
Age
Owner $ 250,000 $211,667 $223,167 6 60
Son 32,000 31,929 31,965 2 26
NHCE 1 100,000 5 49
NHCE 2 30,000 5 45
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
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% 2012 417(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 = $1,763.89
• Limited by IRC 415 to $1,666.67
• $200,000/12 = $16,666.67
• One year of participation so limit to 1/10th
• Son –
• $31,929 * .5% * 1 ÷ 12 = $13.30
34
Simple DB/DC using PBGC coverage to our advantage
• DB (monthly) benefits end of year 1:
• Owner-
• Limited by IRC 415 to $1,666.67
• SO NO INCREASE –> BOY benefit = EOY benefit
• THEREFORE no Target Normal Cost for owner
• Son –
• $31,965 * .5% * 2 ÷ 12 = $26.64
• Increase = 26.64 – 13.30 = $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 2012 – 4 month lookback)
• Funding Target:
• Owner (NRA 62, AA 60) -
• AB * APR / (1+S1)^(NRA-AA)
• $1,666.67 * 148.820 / 1.0177^2 = $239,481
• Son (NRA 62, AA 26) -
• 13.30 * 148.820 / 1.0578^36 = $262
• Target Normal Cost (Son only): • 13.34 * 148.820 / 1.0578^36 = $263
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= $2,417.64
• $2,417.64 * 148.820 = $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 32,000 0 525 525
NHCE 1 100,000 7,500 7,500
NHCE 2 30,000 7,500 7,500
Cushion 119,872 119,872
Total $ 412,000 $65,000 $359,878 $424,878
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 / 8.477 / 250,000 = 2.78%
• 8.5% = standard interest rate
• 2 = Years from attained age (AA) to testing age (TA)
• 8.477 = Testing APR based on ‗71GAM 8.5% age 62
• NHC 2 Normal Accrual Rate = 11.8%
• DC only: 7,500 * 1.085^17 / 8.477 / 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 65-295 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
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
38
Cash Balance/401(k) Combo
Compensation Age
HCE 1 – owner $ 255,000 60
HCE 2 – non owner 255,000 44
NHCE 1 30,000 30
NHCE 2 30,000 46
NHCE 3 30,000 60
NHCE 4 30,000 60
NHCE 5 30,000 44
NHCE 6 30,000 31
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
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%, 2012 417(e) table (same for all)
• QJSA = 50% J&S (same for all)
40
Cash Balance/401(k) Combo – Ex.1 DC over 6%
• Components of Design – DB plan (same for all)
• NRA later age 65 / 5th 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 §§2530.204-1; 2530.204-2
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 -0- 7,650 17,500 25,150
NHCE 1 2,100 750 2,850 2,850
NHCE 2 2,100 750 2,850 2,850
NHCE 3 2,100 750 2,850 2,850
NHCE 4 2,100 750 2,850 2,850
NHCE 5 2,100 750 2,850 2,850
NHCE 6 2,100 750 2,850 2,850
Total
$ 53,750
$160,050
$213,800
$ 40,500
$ 254,300
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
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 -0- 7,650 17,500 25,150
NHCE 1 2,100 750 2,850 2,850
NHCE 2 2,100 750 2,850 2,850
NHCE 3 2,100 750 2,850 2,850
NHCE 4 2,100 750 2,850 2,850
NHCE 5 2,100 750 2,850 2,850
NHCE 6 2,100 750 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
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 -0- 7,650 17,500 25,150
NHCE 1 2,100 750 2,850 2,850
NHCE 2 2,100 750 2,850 2,850
NHCE 3 2,100 750 2,850 2,850
NHCE 4 2,100 750 2,850 2,850
NHCE 5 2,100 750 2,850 2,850
NHCE 6 2,100 750 2,850 2,850
Total
$ 53,750
$198,300
$252,050
$ 40,500
$ 292,550
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. 81-114
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 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 plan documents are properly executed.
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 non-
deductible contributions for amounts required
by §412 but not deductible due to above
Self-employed‘s Earned Income
• ―Earned income‖ = net earnings from self-employment (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)
47
Self-employed‘s Earned Income
• When determining net earnings from SE
(and therefore SE tax)
• Contribution for owner not deductible
• GCM 39807
• Laflamme v. Comr, TCM 2012-36 2/6/2012
• 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
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 .9235 110,820
• Lesser this amount or TWB 110,100
• Outside wages 60,000
• Amount to tax at 10.4% 50,100
• 50,100 X 10.4% 5,210
• 110,820 X 2.9% 3,214
• 1/2 SE tax deduction
• 5,210 X .596 = 3,105
• 3,214 X .50 = 1,607 $ 4,712
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. §1.404(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
50
Partnerships
• Reg. §1.404(e)- 1A(f)(2) • ―In the case of a defined benefit plan, a partner's
distributive share of contributions on behalf of self-employed 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 2000 - 6.
• Q. Field Service Advice 1999-743 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.
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 76-28
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 year-
end corrective amendment under Reg.
§1.401(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
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 77-82
• 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.
§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):
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. §11.412(c)-12(c)(2)]
(emphasis added)
Year Deductible
• PLR 9107033: • 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. §11.412(c)-12(c)(2) and RR 77-82, Service allowed taxpayer to treat contributions in above manner
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. §1.404(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 2010 §404 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?
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 76-28 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
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
66-144, affirmed by Revenue Ruling 84-18 (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 8336006