401(a)(17) proration

[Guest JDL]

Hello -

I know there have been a number of discussions regarding when the 401(a)(17) compensation limitation needs to be prorated. However, I would still like to pose the following question and see if anyone has any advice.

We have a plan that provides a benefit based on "average compensation," which is the average compensation of a participant's 5 consecutive completed years of service. A Year of Service is the 12 month period of Service, beginning on the date of hire. Therefore, if a participant terminated employment on July 1, 2003, the plan would look back 5 years to June 30, 1998 to determine average compensation. We have a number of highly compensated individuals who participate in the plan and we are faced with a situation where we are not sure whether we need to prorate the comp. limit.

For example, suppose a participant makes $400,000 a year and therefore easily surpasses the current $200,000 comp limit. Suppose this participant earned the same salary the past 5 years, and suppose she decides to quit on July 1, 2003, having already earned $200,000. We look back to June 30, 1998 (the beginning of the 5 year period) and during that 6 month calendar period she met the 401(a)(17) comp. limit as well. Therefore, here are the 401(a)(17) limits in question, which this participant exceeded each period.

1998 (June 30 - December 31 - 6 months) - 160,000

1999 (full year) - 170,000

2000 (full year) - 170,000

2001 (full year) - 170,000

2002 (full year) - 200,000

2003 (January 1 - July 1 - 6 months) -200,000

Now, can we take these six amounts (as they total five completed years) and divide the total by 5 to get average compensation? We would get average compensation of $214,000. Can this be done? Or would this be violating the 401(a)(17) comp limit? If so, would we instead need to prorate the comp limit for the 6 month period in 1998 and the 6 month period in 2003 (therefore 80,000 in 1998 and 100,000 in 2003)?

I know this is LONG, but I would appreciate any advice. I have been unable to find clarification in the regs. Thank you!

[AndyH]

The 401(a)(17) limit is prorated only for a short PLAN year, not based upon a period of employment. Since you don't have any short plan years, you don't have any prorated limits.

But the definition that you state is peculiar. Usually average comp is based upon a stated period of time, e.g. the plan year or the calendar year. Otherwise you would have a different measurement period for every employee. I'd suggest reading that definition more closely.

[Guest JDL]

Thanks for the reply.

The plan is indeed odd. Average Compensation is defined as "the average of a participant's compensation over the 5 consecutive compleated Years of Service which produces the highest average."

A "year of service" is "a period of 12 consecutive months of service."

Service is "the aggregate of all time periods commencing with the participant's first day of employment and ending on the date of a period of severance begins" or "termination."

Therefore, do you think the plan can actually take into account six amounts of compensation for a five year period of time w/o prorating?

Of course, this strange result comes about due to the high degree of compensation this participant is receiving. I've also been trying to get ahold of an IRS rep about this issue, but have had no luck up to this point. Thanks.