(From the June 20, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
Updated 415 Regulations-- An In-Depth Review
On May 25, 2005, the Treasury Department and Internal Revenue Service issued proposed regulations under Section 415, which governs maximum benefits and contributions under qualified plans and similar arrangements (such as Section 403(b) plans, SEPs and SIMPLEs). The proposed regulations incorporate the numerous changes that Congress has made to Section 415 since the current regulations were issued in 1981. They also would make a number of notable changes to current rules.
This article will examine the rules under Section 415(c), which sets forth maximum limits for defined contribution plans. A separate article, to be published in a future edition of Washington Bulletin, will examine the rules under Section 415(b), applicable to defined benefit plans.
I - Background
A Section 401(a) qualified plan (as well as other plans not qualified under Section 401(a) but to which Section 415 applies),1 must comply with the Section 415 limits on benefit accruals and allocations to participants' accounts. For a defined contribution plan, annual additions to each account in any "limitation year" (usually the same as the plan year, though it is possible for the two not to coincide)2 may not exceed the lesser of the dollar limit ($42,000 for 2005, adjusted for inflation in $1,000 increments) or 100 percent of the participant's compensation. Annual additions under all plans maintained by members of a controlled group or an affiliated service group are aggregated to determine whether the limitation has been exceeded (with modifications to the Section 414(b) and (c) test of "control" by substituting a "more than 50 percent" test for the standard "at least 80 percent").
To a large extent, the proposed regulations reflect IRS guidance issued in various forms over the past 24 years. The description below includes those changes but does not generally call attention to the fact that the current regulations are being updated. We have, however, noted points where the proposal differs from the existing guidance and thus, if adopted in final form, will represent a change in the law.
Unlike many proposed regulations, this set may not be relied on by taxpayers prior to adoption in final form. In many instances, however, the proposal merely restates earlier guidance and presumably can be considered authoritative except where the IRS has indicated an intention to alter its prior rules. However, a special rule that discusses the treatment of post-termination of employment "compensation" for purposes of Section 415(c), discussed in more detail below, may be relied upon immediately.
II-- Plans and Contributions Subject to § 415(c)
1. Defined Contribution Plans
A "defined contribution plan" ("DC plan") is a plan providing individual participant accounts and benefits based solely on contributions to those account balances, allocated forfeitures and earnings thereon. IRC § 414(i); Treas. Reg. § 1.415-2(c)(2). Separate accounts maintained for defined benefit plan ("DB plan") participants (e.g., to hold voluntary employee contributions) are treated as separate DC plans for Section 415 purposes. For example, each plan included in a DB/DC floor-offset arrangement is independently subject to the limitations applicable to its type of plan. Hence, projected annual benefits under the "floor" (DB) plan cannot exceed the Section 415(b) DB plan limit, and annual additions to "offset" (DC) plan accounts cannot be greater than permitted by Section 415(c).
Thanks to the repeal of Section 415(e), effective in 1999, there is no longer a combined DB/DC limitation to consider. An individual may receive the maximum permitted benefit under one type of plan without any effect on his accrual or allocation under the other type.
2. Employee Contributions to Defined Benefit Plans
Some defined benefit plans are designed to include mandatory employee contributions that fund a portion of the benefit. Those contributions are subject to Section 415(c) limits, and the portion of the participant's benefit that they fund is disregarded in applying the Section 415(b) DB limit. Note: This rule does not apply to employee contributions "picked up" by a governmental employer under Section 414(h)(2). Picked-up contributions are not treated as employee contributions and therefore are not Section 415(c) annual additions. As a result, the benefit attributable to such contributions is subject to Section 415(b).
Voluntary employee contributions to DB plans are treated as if they were made to a separate DC plan and therefore are annual additions.
3. Other Plans and Contributions Subject to Section 415(c) Limits
Also limited by Section 415(c) are contributions to tax-sheltered annuities or custodial accounts (Section 403(b)), Simplified Employee Pensions (Section 408(k)) and SIMPLE plans (Section 408(p)). Contributions to any of these arrangements are annual additions and must be aggregated with annual additions under qualified plans to determine compliance with Section 415(c). In addition, contributions to an account in a pension plan (see Section 401(h)) or welfare benefit trust (see Section 419A(d)(2)) to provide post-retirement medical benefits for a "key employee" (as defined in Section 416(i)) are considered contributions to a defined contribution plan.
Exception: Contributions to a section 403(b) plan are treated, for Section 415 purposes, as if the employee were the employer maintaining the plan. As a result, they are not aggregated with contributions to any other plan unless the employee and the employer that maintains the other plan form a controlled group or affiliated service group. This is an issue that particularly affects doctors affiliated with tax exempt hospitals who also have private medical practices.
III-- Annual Additions
1. In General
The limits of Section 415(c) apply to the "annual additions" allocated to a participant for the limitation year. Annual additions include employer contributions (including pre-tax employee contributions), after-tax employee contributions and forfeitures.
Not included in annual additions are earnings on participants' accounts, amounts transferred or rolled over from another plan, and elective deferrals in excess of the maximum permitted by Section 402(g) (provided that they are timely distributed to correct the excess deferral). Elective or matching contributions that exceed the maximum permitted by the Section 401(k)(3) or 401(m)(2) "nondiscrimination" standards (the "ADP/ACP test") are annual additions, even if they are distributed or forfeited to correct the violation.
Reflecting a change made by EGTRRA, ESOP dividends that are reinvested pursuant to Section 404(k)(2)(A)(iii) are not annual additions.
The IRS has the authority to recharacterize as "annual additions" gains accruing to a participant's account from sources other than contributions and forfeitures. For example, the sale of employer stock to a plan for less than fair market value could be considered to give rise to annual additions to the extent of bargain element.
2. Employer Contributions
Employer contributions credited for a limitation year are one component of a participant's "annual additions". Prop. Reg. § 1.415(c)-1(b)(2)(i). In general, amounts contributed by the employer for the benefit of the employee are employer contributions for purposes of Section 415. There are, however, several exclusions:
3. Employee Contributions
Pre-tax and after-tax employee contributions (including, as noted above, contributions to DB plans) are Section 415(c) annual additions. Not included in annual additions are:
4. Determining the Amount or Value of Annual Additions
(a) In General
In general, the amount of an annual addition simply equals the amount contributed or, where the contribution is made in kind, the fair market value of the contributed property. The proposed regulations do not address situations in which a contribution is made before the date of allocation. Most practitioners assume that earnings between the contribution and allocation dates are annual additions.
(b) Special Rules for Leveraged ESOPs
In a leveraged ESOP, employer contributions are used to make principal and interest payments on the ESOP's indebtedness. As repayments are made, stock acquired with the loan proceeds is allocated to participants' accounts. Under the current regulations, the resulting annual addition is based on the amount contributed by the employer, not on the value of the allocated stock. Treas. Reg. § 1.415-6(g)(5). The proposed regulations retain this rule, but, following the lead of several IRS private letter rulings (PLR)s, allow a plan to provide that if the value of the allocated shares is less than the related principal and interest payment, the annual addition is limited to the value of the shares at the time of payment. Prop. Reg. § 1.415(c)-1(f)(2)(ii).
5. Other Rules for ESOPs
Under Section 415(c)(6), if no more than one-third of the contributions to an ESOP are allocated to the accounts of highly compensated employees (as defined in Section 414(q)), allocations arising from forfeitures of employer securities and from payment of interest on the ESOP loan are excluded from "annual additions." Prop. Reg. § 1.415(c)-1(f)(3).
6. Timing of Annual Additions
a. In general
A contribution or forfeiture is considered an annual addition for a limitation year if it is allocated to the participant's account under the terms of the plan as of any date in the limitation year. If, however, the allocation is dependent on plan participation as of a later date, the amount is not considered an annual addition until that later date. Prop. Reg. § 1.415(c)-1(b)(6).
b. Employer contributions
Under the current regulations, employer contributions cannot be treated as annual additions in a particular limitation year unless they are made no later 30 days after the due date, including extensions, of the employer's federal income tax return for its taxable year containing the last day of the limitation year. Prop. Reg. § 1.415(c)-1(b)(6)(B). For a tax-exempt employer, the tax return (Form 990) deadline is the 15th day of the sixth month following the end of its tax year. The proposed regulations would allow an exempt employer's contributions to be included in annual additions for a limitation year so long as they are made no later than the 15th day of the tenth month following the end of the tax year.
Contributions made after the deadline are annual additions for the limitation year in which they are actually made, with one important exception: A contribution to restore an erroneous forfeiture or on behalf of a participant who was erroneously omitted from a prior year's allocation is credited to the year in which it should have been made. Prop. Reg. § 1.415(c)-1(b)(6)(ii).
c. Employee contributions
Employee contributions (voluntary or mandatory) are not included in the annual additions for a limitation year unless they are actually made to the plan within 30 days after the close of the limitation year. This rule does not apply to elective deferrals described in section 402(g), which are treated as employer contributions for tax purposes (including for purposes of Section 415), although other ERISA rules generally require those contributions to be made shortly after they are withheld from participants' pay.
Forfeitures are included in "annual additions" for the limitation year that contains the date as of which they are allocated to participants' accounts.
7. Correction of Excess Annual Additions
The current Treas. Reg. § 1.415-6(b)(6) sets forth mechanisms that may be used if certain conditions are met for correcting excess annual additions, the most popular of which is refunds of elective deferrals. The proposed regulations would eliminate these rules. Instead, the preamble to the proposed regulations indicates that excess annual additions that may arise will now be corrected pursuant to the Employee Plans Compliance Resolution System (EPCRS). This revision may cause some inconvenience for the plan sponsor, if the correction must be made by filing an application under the Voluntary Correction Program (VCP), but it may also be possible for the plan sponsor to use the self correction mechanisms of EPCRS. However, the correction mechanisms in the current regulations were available only under certain conditions, which added complications to the plan sponsor's corrections. EPCRS, whether self correction or voluntary correction, does not impose conditions comparable to the conditions imposed by Treas. Reg. § 1.415-6(b)(6). Note: The current regulations do not prevent a plan from including fail-safe provisions to prevent Section 415 violations by automatically reducing allocations to the accounts of participants who would otherwise have excess annual additions. The proposed regulations retain this rule, in slightly revised form. Any such provision must operate without employer discretion in order to avoid contravening the requirement that a DC plan must have a predefined allocation formula. Prop. Reg. § 1.415(a)-1(d)(2).
1. "415 Compensation" in General
As noted, the 100% limit on annual additions is based on a participant's "compensation." The proposed regulations include rules that define "compensation" for this purpose.
2. Basic Definition
The proposed regulations largely retain the structure established in the current regulations at Treas. Reg. § 1.415-2(d)(2-3), which enumerates the items specifically included and excluded from compensation.
The following items are specifically included in Section 415 compensation:
The exclusions of Sections 911, 931 and 933 do not apply to Section 415 compensation. The proposed regulations, like the current ones, do not address to what extent compensation paid to nonresident aliens without U.S. source income constitutes Section 415 compensation.
Specifically excluded from Section 415 compensation are the following:
c. Elective deferrals and other pre-tax deferrals
Various elective deferrals and salary reduction contributions to welfare plans are not subtracted from Section 415 compensation even though they are excluded from taxable income.6 Added back to compensation are elective deferrals under 401(k) cash-or-deferred arrangements, Section 408(k) SEPs, Section 408(p) SIMPLEs, Section 403(b) plans, and Section 457(b) plans, as well as cafeteria plan elections under Section 125 and qualified transportation elections under Section 132(f)(4).
d. Self-employed individuals
The Section 415 compensation of a self-employed individual is the individual's earned income. Treas. Reg. §1.415-2(d)(2)(ii); Prop. Reg. § 1.415(c)-2(b)(2). Self-employed individuals are required to use this definition of compensation exclusively, and may not avail themselves of the alternative definitions described below. Although contributions on behalf of a self-employed individual are generally excluded from "earned income", the proposed regulations provide that the items added back to compensation (described above) are also added back for a self-employed individual. Note that for qualified plan contributions, this add-back is limited to contributions that qualify as elective deferrals.
3. Safe Harbor Definitions
In lieu of the definition set forth in the regulations, a plan may use either W-2 wages or wages subject to income tax withholding as its definition of "compensation" for Section 415 purposes. Also permitted is a "simplified" definition that includes only wages, salaries, fee and other amounts received for personal services and excludes all other items listed in the regulatory definition. The current regulations contain a safe harbor compensation definition, but characterize W-2 wages or wages subject to withholding as "alternative" definitions.
4. Interaction with IRC § 401(a)(17)
Addressing a topic not considered in previous IRS guidance and reversing what was generally believed to be the applicable rule, the proposed regulations state that a plan's definition of compensation used for applying the Section 415 limits cannot consider compensation in excess of the Section 401(a)(17) limit ($210,000 in 2005).
Rules governing the interaction of Section 401(a)(17) and 415 are included in both the defined benefit and defined contribution provisions of the 415 regulations. For defined benefit plans, this will have some consequences, as it addresses situations in which the DB plan dollar limit exceeds the 401(a)(17) dollar cap (as can occur in cases of later retirement). On its face, it has no impact on DC plans, where, for a participant making as much as $210,000, the applicable Section 415(c) limitation is the $42,000 dollar limit, not the limit based on compensation.
There is concern among practitioners, however, that this change may affect the administration of Section 401(k) plans. The proposed regulations include an amendment to the Section 401(k) regulations providing that 401(k) deferrals can only be made with respect to "Section 415 compensation." The incorporation of a Section 401(a)(17) limit in the definition of Section 415 compensation could mean that a participant who reaches the Section 401(a)(17) limit for compensation during a year would have to cease making deferrals, even though he has not yet deferred the maximum amount permitted under Section 402(g). As an extreme example, a highly paid participant who earned more than $210,000 during the first half of a year but made no elective deferrals might be precluded from deferring out of pay received later in the year. On the other hand, it is doubtful that a plan can be said to "consider" compensation in excess of the 401(a)(17) limit where the amount deferred does not exceed the maximum permitted deferral rate multiplied by the compensation cap. The revision to the Section 401(k) regulations may be intended only to prevent deferral from post-termination compensation, as discussed below. This point needs to be clarified in the final regulations.
5. Compensation of Disabled Participants
Section 415(c)(3)(C) permits a DC plan to impute Section 415 compensation to "permanently and totally disabled" participants, so that contributions can continue to be made in their behalf. Under this rule, a disabled participant's compensation may be treated as continuing at the rate of pay in effect immediately before he became disabled. Participants who were highly compensated employees before disability are not entitled to imputed compensation, unless the plan provides for contributions for all disabled participants for a "fixed and determinable period". How long the period must be is not specified. All contributions based on imputed compensation must be fully vested.
6. Timing of Compensation
For purposes of applying Section 415, compensation is treated as paid in the limitation year in which it is actually paid to the employee. The proposed regulations specify that 401(k) and other pre-tax deferrals are included in compensation in the year the participant would have received them but for the deferral election. Under a de minimis rule, amounts earned in one limitation year but not actually paid until the following year may nevertheless be treated as Section 415 compensation for the earlier year if they are paid within "the first few weeks" after year end and are included on a uniform basis for all similarly situated employees. Prop. Reg. § 1.415(c)-2(e)(2).
7. Payments After Termination of Employment
Addressing an issue that has lain dormant since the inception of Section 415, the proposed regulations state that Section 415 compensation generally does not include payments made after termination of employment, except for regular compensation, commissions, bonuses, overtime, shift differential and cashouts of accrued leave that could have been used if employment had continued. So long as these payments are made within 2-1/2 months of severance from employment, they may be considered compensation for purposes of Section 415. However, pure "severance pay" is not considered compensation for Section 415 purposes. (There are special rules under which payments during periods of military service may be counted as Section 415 compensation.)
Related amendments to the regulations under Sections 401(k), 403(b) and 457(b) provide that post-termination payments may be electively deferred if and only if they meet the conditions for treatment as Section 415 compensation. If they are 415 compensation, deferral is allowed even if payment is made after the year of termination. For instance, if a participant left in December and received a cashout of accrued PTO in January, he would be able to make an elective deferral from the cashout (assuming that it was permitted under the terms of the plan). Plans may rely on this portion of the proposed regulations immediately.
V - Miscellaneous
1. Plan Provisions
The proposed regulations add rules concerning the incorporation of Section 415 by reference in plan documents. In general, incorporation by reference is permitted, but plans must specify what rules will be followed in those cases where Section 415 offers a choice of alternatives and no default rule. For example, if a controlled group maintains more than one DC plan, all of the plans must specify (consistently!) which plan will cut back allocations if necessary to avoid exceeding the Section 415 limits.
2. Cost of Living Adjustments
The Section 415(c) dollar limit is adjusted each calendar year to reflect cost-of-living increases, with changes rounded to the nearest $1,000. The adjusted limitation applies to all limitation years ending within the calendar year. For example, the $42,000 limit for the year 2005 applies to the year running from June 1, 2004, through May 31, 2005, of a plan that uses a May 31 plan and limitation year.
3. Aggregation of Plans
Under Section 415(f), all defined contribution plans maintained by a single employer are treated as a single plan for purposes of Section 415(c). All members of a controlled group or affiliated service group are treated as one employer, applying the rules of Sections 414(b), (c), (m) and (o). Controlled group principles are modified for this purpose by substituting "more than 50 percent" for "at least 80 percent" in the control tests. For example, a corporation and its 51-percent-owned subsidiary do not form a controlled group under the standard rules of Section 414(b) but would do so for Section 415 purposes.
4. Limitation Year
For a defined contribution plan, the limitation year is the basis for measuring annual additions for determining whether the limits of Section 415(c) have been satisfied. The limitation year does not have to coincide with the plan year, though it almost always does. The default, if no limitation year is specified in the plan, is the calendar year. A change in limitation year creates a short limitation year, for which the Section 415(c) dollar limit must be prorated. No proration is required in a plan's initial or final year. The proposed regulations contain rules for applying Section 415(c) in the rare case where a controlled group maintains DC plans with different limitation years, updating those contained in Revenue Ruling 79-5, 1979-1 C.B. 165.
1 See II.3.
2 See IV.4
3 The proposed regulations also exclude repayments made pursuant to IRC §415(k) in order to restore prior years of service under governmental plans. See Prop. Reg. § 1.415(c)-1(b)(3)(iii).
4 The Employee Retirement Income Security Act of 1974, 29 U.S.C. § 1001 et. seq. (2005).
5 The proposed regulations also exclude repayments made pursuant to IRC §415(k) in order to restore prior years of service under governmental plans. See Prop. Reg. § 1.415(c)-1(b)(3)(iii).
6 See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755, §1434(a) (1996) (note, the changes were effective for plan years beginning after 1997).
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