Combined Plan Max & EGTRRA's New Excise Tax Rules

[LIBOR]

My question involves the inter-relationship between 404(a)(7) and the new excise tax exceptions found at 4972©(6) and 4972©(7) that came in with EGTRRA - An example :

Suppose my DB super max is 15% of pay and I have PS contributions of 5% of pay; the way I understand the rules is that an additional 5% into the DB will be non-deductible but the excise tax excepton rules in 4972©(6), ©(7) won't come into play until I exceed the combined limit of 25% of pay - at that point I look at the "stacking" rules in 4972©(6), ©(7) to see if an excise tax applies ??

In other words, the total non-deductible contribution will be the 5% additional plus any more over and above that amount - not just the amount exceeding 25% of pay.

Do I have it right ???

[SoCalActuary]

Where did you find the term "DB Super Max" in ERISA? I would like more detail.

[Blinky the 3-eyed Fish]

SoCal, the super max he mentions is synonomous with the unfunded current liability deduction.

Libor, to your questions (which I will preface by saying that this is so new I have never tried to apply it in a real world situation), first, 4972©(6) states that it applies if amounts aren't deductible solely due to 404(a)(7). This would not be the case here, where you are going over the DB deductible limit. Now 4972©(7), copied below, I read to say that you can disregard contributions not in excess of the ERISA FFL for excise tax purposes. You don't state what your FFL is, so I am not sure what additional amounts over the UCL can be contributed without triggering an excise tax.

I am curious as to why anyone would want to do this. Keep in mind that the nondeductible could continue on for years, and it may very well be possible that the plan's situation could change and an excise tax could be required.

(7) Defined Benefit Plan Exception.--

In determining the amount of nondeductible contributions for any taxable year, an employer may elect for such year not to take into account any contributions to a defined benefit plan except to the extent that such contributions exceed the full-funding limitation (as defined in section 412©(7), determined without regard to subparagraph (A)(i)(I) thereof). For purposes of this paragraph, the deductible limits under section 404(a)(7) shall first be applied to amounts contributed to defined contribution plans and then to amounts described in this paragraph. If an employer makes an election under this paragraph for a taxable year, paragraph (6) shall not apply to such employer for such taxable year.

[MGB]

"I am curious as to why anyone would want to do this." Many large plans had to use this provision in the past couple of years because they were contributing enough (over the deductible limit) to avoid the additional minimum liability on their financial statements. IBM alone would have lost over one-half of their equity (7 billion) had they not done it.

[Blinky the 3-eyed Fish]

MGB, thanks. That's twice you have provided the large plan perspective to my small plan world.

LIBOR, what size plan is this?

[Belgarath]

If you can get a copy of the 2003 "Grey Book" for the EA meeting, it has the following question and helpful example:

QUESTION 11

Excise Tax on Nondeductible Contributions: Ordering under Combined Limit

Effective in 2002 EGTRRA added an additional exception, §4972©(7), for nondeductible DB contributions that do not exceed the accrued liability (ERISA) full funding limit. Thus if the employer makes a nondeductible DB contribution, only the portion of the nondeductible contribution in excess of the ERISA full funding limit, is subject to excise tax. If the employer elects this provision, the exemption from excise tax for certain DC contributions, described in §4972©(6) does not apply. However, §4972©(7) provides that “the deductible limits under section §404(a)(7) shall first be applied to amounts contributed to defined contribution plans and then to amounts described in this paragraph.”

Consider the following example:

Company X sponsors both a defined benefit plan and a profit sharing plan. The unfunded current liability for the defined benefit plan is 30% of pay, while the full funding limitation is equal to 35% of pay. For 2003 Company X contributes an amount equal to 35% of pay to the defined benefit plan. In addition, the company contributes an amount equal to 7% of pay to the profit sharing plan. The sponsor elects to apply §4972©(7). What is the excise tax on nondeductible contributions?

RESPONSE

The maximum deductible contribution under §404(a)(7) is independent of §4972. In this example the §404(a)(7) maximum is 30% of payroll. Solely for purpose of §4972©(7), this maximum is applied first to DC contributions, leaving the remaining 23% of payroll (30% - 7%) for the DB plan. Since the total DB contribution is 35% of pay, 12% of pay is treated as nondeductible for purposes of §4972©(7). However, since the DB contribution doesn’t exceed the full funding limit, there is no excise tax.

[AndyH]

MGB, thank you for that fascinating comment (as usual).

I find the word "lost" within that context quite ironic given recent financial reporting irregularities. I wonder if the FASB properly defines "lost". (Just a little sarcasm towards the FASB there.)

Where can I find similar "lost" stock values? Hmmm. Read the (footnotes to the) financial statements I suppose. So AA bond rates go up and stock values double???? They didn't teach me that in Economics or Math.

So, (stretching a bit I admit) if the Fed raises rates a couple of times pension professionals should all buy large Caps?

[MGB]

AndyH:

There is a very good economic paper done by some researchers at the Federal Reserve about two years ago. They build off of the generally accepted academic theory that the stock value should be equal to the present value of future income plus the current book value (equity), but perhaps discounted for equity that will get "used up" in the production of future income.

Their study shows that the only thing that investors pay attention to in pension accounting is the expense, and do not factor in any under or over-funding that is in the footnotes (which should be added to equity first under the general theory). However, other comprehensive income from an underfunded plan will affect investors' pricing of a stock in a direct manner (because of the immediate decrease in equity), without relating it to being a pension accounting item. In other words, investors are only looking at net equity and not adjusting it.

So, your comment is correct on companies that did record an additional minimum liability in recent years. When interest rates go up and they reverse this out, it will have an effect on stock price because of the immediate effect on equity.

On the flip side, the change caused by interest rates in over or under-funding for plans that have not generated an additional minimum liability will have very little effect on stock price, except to the extent that the expense figure changes (and then it needs to be a large compenent of overall net income to have a real effect).

So, yes, buy large caps, but only those with previous AML.

The Fed paper (Did Pension Accounting Contribute to the Stock Market Bubble? by Coronado and Sharpe - it doesn't say so, but they are with the Federal Reserve) is the last one at the bottom of the linked page (when I first read it, a group of us were in the middle of organizing the financial economics & pensions seminar in Vancouver last summer; I immediately wanted the paper to be the keynote address):

http://library.soa.org/library-html/m-rs04...ofcontents.html

[Hokielady]

I have a client who has a DB plan and put in a SEP for 2011- I am trying to figure out if the excise tax applies under 4972 (c ) (7).

Other facts- it is a one man plan and his pay has always exceed the dollar limit

The Deduction limit for SEP and DB is the greater of

1-25% of pay- capped at the dollar limit for the year or

2-the minimum funding requirement for the DB Plan

3-When computing this calculation there is a 6% of pay “freebie” given to the SEP that is permitted before the maximum deductible calculation is performed under steps 1 and 2

So if $49,000 SEP deposit was made in 2012:

1-The deduction for the 2011 contributions would be:

a-DB $250,000-contribution determined by actuary

b-SEP- $14,700- this is the 6% freebie (245,000 times 6%)

the deductible is met since the DB contribution is greater than 25% of $245,000 and there is no SEP beyond the “freebie”

2-The deduction for the 2012 contribution would be:

a-DB- minimum $50,317 calculated by actuary

b-SEP-$27,183; total which is made up of $15,000 freebie (6% of $250,000 dollar limit) plus SEP Balance $12,183 (25% of $250,000 minus the DB contribution of $50,317)

The total SEP deposit in 2012 is $49,000

1. of which $14,700 is attributable to 2011 and
2. $27,183 is attributable to 2012;
3. therefore $7,117 is a nondeductible contribution

The $7,117 can be carried forward and used and deducted in 2013 to help fund the 6% freebie. If participant's total compensation is at least $255,000 the freebie would be $15,300

Question:

1-Can we apply 4972 ©(7) and say there is no nondeductible contribution and therefore there would be no excise tax?