"Participants" in a 401(k) plan

[Lori Friedman]

For a 401(k) plan, I know that the term "participant" generally includes anyone who's eligible to make elective deferrals under the plan. An individual who chooses not to defer income and, therefore, may not have an account balance, is a nonetheless a participant.

Does this expansive definition also apply to the Sec. 404 limit? For example, Jack and Jill each have $100,000 compensation and are eligible for coverage under their employer's 401(k) plan. Jack makes elective deferrals, but Jill chooses not to do so and has no account balance. Is $50,000 (25% x $200,000) the Sec. 404 limit? Does an employer get some "wiggle room" on the Sec. 404 calculation when eligible employees decide not to participate in the 401(k) plan?

[david rigby]

Do you mean the 415© limit? That limit is individual.

[wmyer]

Yes, Lori, the 404(a) deductibility limit is $50,000. Also, recall that the deferrals don't count towards the deductibility limit. So, the employer can provide a $50,000 contribution in addition to any deferrals made by the employees.

[Kirk Maldonado]

wmyer:

Do you feel that your answer is consistent with Revenue Ruling 65-295, 1965-2 C.B. 148?

[Lori Friedman]

pax,

No, I'm not referring to the Sec. 415 limit in any way. I'm also not concerned about the Sec. 402(g) limit. I'm asking strictly about the Sec. 404 limit, which is calculated on the total eligible compensation for the employer's tax year.

[wmyer]

Consistent? Who knows? But this is the answer from the 401(k) Answer Book, Question 8:59 -- wait, am I allowed to reproduce this here?

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In determining the maximum deductible amount, may the employer take into account the compensation of all employees, or just those who are plan participants?

Only the compensation of those participants who benefit under the 401(k) plan may be taken into account. [Rev. Rul. 65-295, 1965-2 C.B. 148] The cited revenue ruling does not deal specifically with a 401(k) plan. Presumably, the compensation of a participant who elects not to make contributions would still be taken into account.

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[Blinky the 3-eyed Fish]

I think most practioners would agree with wmyer's position, including Sal Tripodi. However, Jim Holland stunned the crowd earlier this year in LA, when he said to not count the compensation of the participant that is only considered benefiting because they had the right to defer.

Now of course in your example, to utilize your full deduction limit you are going to have to allocate some of the money to Jill, and of course she will then be do doubt considered benefiting and her compensation will indisputably be counted.

[Belgarath]

I don't know that there is a definitive answer. There are definite opinions, but which opinion you choose is another story. As Kirk points out, referencing RR 65-295, one opinion is that such a participant is not considered a beneficiary under the plan, and hence the compensation may not be usable in calculating the

deduction limit. Alternatively, one could interpret 1.410(b)-3, which states that an employee is considered as benefitting if they are eligible to defer, as an argument that it is allowable to consider the compensation of such employees when calculating the limit.

Has anyone had any discussion with some of the IRS movers and shakers on this question? Maybe they figure that 415 will limit the allowable allocations to such an extent that this deduction question doesn't turn out to be a big issue?

[GBurns]

Lori,

Why the concern with the employer having "wiggle room" on the Sec. 404 calculation ? Are you trying to exceed the $50,000 or the calculated limit?

A number of posts are discussing the "deduction limit", however, I read your post to be concerned with an employer match or contribution and not the employee's deferral.

[Lori Friedman]

GBurns, Yes, you're correct. I'm asking only about the Sec. 404 limit, which provides for the employer's deductible contribution (match or other).

Why the concern about "wiggle room"?...The potential for larger deductible employer contributions. A greater number of plan "participants" adds up to a bigger eligible compensation base, with the resulting 25% limit being greater.

[R. Butler]

I'm getting lost in some of the discussion. I interpret the initial facts to mean that both Jack & Jill are elgibile for both employee deferral and employer money. Jill does not make deferrals, but Jack does. What is the maximum deductible employer contribution? -- Its $50,000. The $50,000 does not include Jack's deferrals, but it also its not increased by amounts Jill could have deferred.

Now my answer would not change even if Jill was only eligible for deferrals, although I was not aware of Mr. Holland's recent comments. As Belgrath points out 1.410(b)-3 states that an employee is benefitting if he is eligible to defer. Although not clear, many professionals interpret 1.410(b)-3 as modifying the rule in RR 65-295.

[WDIK]

In my view, the most important aspect of the Jack and Jill example was already pointed out by Blinky in the second paragraph of his most recent post. The example is looking at deducting $50,000, but since that exceeds the individual annual additions limit for Jack, Jill must receive an allocation and will be benefiting.

I suspect, however, that Lori meant the discussion to be more general.

[R. Butler]

I got so upset about Mr. Holland I couldn't finish Blinky's post.

I really couldn't understand what she meant by "wiggle room". I sort of thought she was asking whether the $50,000 could be increased because Jill wasn't deferring.

Who knows? What I do know is that I am ready for a good long weekend of college football.

[stephen]

Unless of course you are anxious to see Florida State vs. Miami on Monday night as the hurricane has postponed that game ... to next Friday.

[R. Butler]

It doesn't matter. Any college football game is great. Miami(OH)-Michigan is good enough. Besides the BIG game is Sunday when my beloved Kentucky Wildcats challenge the hated Louisville Cardinals.

My wife & I had our first child in May. The boy & I watched our first College Gameday together last week. It was one of those moments a dad never forgets. The boys only 3 months, but somehow he knew it was a special moment.

[Brian Gallagher]

The way I always remember it is this way:

The limit is 25% of covered compesation. To me, that's the people "covered" under the plan. In this case, Jack and Jill.

[Blinky the 3-eyed Fish]

I am not sure how that distinction helps you. What if it was a PS only plan, no 401(k), that covered Jack, Jill and her "friend" Butch? But because Butch is jealous of Jack, he decided to leave employment in pursuit of Sally and her seashells and does not receive a PS contribution for the year. Butch was covered under the plan but you can't count his compensation for determining the deduction limit.

[R. Butler]

There is a store on Sannibel Island, She Sales Seashells. Is Sally the owner? Could Butch be covered under her plan?

[stephen]

R. Butler-

two comments:

1) Kentucky vs. Louisville (Reminder this is not BASKETBALL SEASON!)

2) Are you sure the store is still standing on Sannibel Island (after Charley)?

By the way GO WOLFPACK!

[Lori Friedman]

Kentucky v. Louisville?!?! This is September. How about the glorious Boston Red Sox v. the hateful New York Yankees?

[alanm]

EGTRRA stated that the annual deduction limit is 25% of total compensation paid to all eligible employees for the plan year. I don't think it makes any difference whether the eligible employee chooses to defer or not.

[mbozek]

Reg. 1.404(a)-9(b)(1) includes the compensation of employees who are beneficaries of of trust funds accumulated under the plan in the year the contribution is made. There is no requirement that the employee be credited with an allocation in the tax year in order for comp to be included -only that the employee benefit under the trust which could include any participant who made a contribution or received an allocation under the plan in a prior year.

For those that do not wish to take an audit risk on the tax deduction before the s/l expires why not make a nominal contribution of $10 from forfeitures for each eligible employee who does not participate in the plan.

[Blinky the 3-eyed Fish]

Of course to allocate the $10 you would first need an amendment to the plan that would allow for such an allocation. This amendment would be unique and would require the separation of the forfeitures from the nonelective contribution. This would run the client a few hundred dollars. Second, there would be the potential for many participants who previously didn't have an account balance to now have one worth a few cents. There is no deminimus amount that would justify not distributing these amounts. These small distributions would continue each plan year. The price for this distribution instructions and 1099's again could run a few hundred to a few thousand dollars depending on the number involved.

[Brian Gallagher]

Red Sox v. Yankees.

I'm going to the game on 9/17!

Yay!

Let's go Bosox!

[mbozek]

Its still less than the cost of an opinion from a competent tax advisor. Or you can always play the audit lottery with a 3 year lookback for denying deductions plus interest. You do the math.

[Blinky the 3-eyed Fish]

It is infinitesimal the chance of any deduction being disallowed because participant's compensations were being counted for the deduction limit because they had the right to defer but didn't. In fact I would say it would NEVER happen with the current state of guidance and pervasive opinion on this matter.

So according to my math. 1 cent of cost / no chance of any audit sanctions = 1 cent was too much.

[Lori Friedman]

Brian,

It's nice to meet a kindred spirit! Let's hope that Derek Lowe can keep the magic going tonight. (Unfortunately, those west coast games go on way past my bedtime, so I missed last night's dramatic ending.)

September 17th...so, you'll be venturing into hostile territory.

[Brian Gallagher]

Lori,

...With Bosox cap prouldy on display. You'd be surprised at how many Red Sox fans go to those games.

PS: Don't those west coast games suk!

[Lori Friedman]

Brian,

Yep, the time zone difference makes things rough for us east coast people. Tonight, we'll be forced to miss most of the latest installment of The Pedro Martinez Show.

Have you heard about the reason for the now-famous Tek/A-Rod brawl? From what I've read, A-Rod began complaining about having been hit by a pitch, and Tek came back with, "We don't throw at .260 hitters."

I have tickets to this Saturday's Yankees game at Camden Yards. But, it won't be an ordinary game; the September 11th date should make things very somber and subdued.

Yours,

Lori

[AndyH]

I thought I was the last person on pension planet to be convinced that the comp of someone eligible but not deferring can be counted for 404 purposes.

I'm 100% sure that I can find this documented from either the 2002 or 2001 ASPA National Conferences materials. A couple of Q&As if I recall correctly.

[R. Butler]

I thought I was the last person on pension planet to be convinced that the comp of someone eligible but not deferring can be counted for 404 purposes.

I'm 100% sure that I can find this documented from either the 2002 or 2001 ASPA National Conferences materials. A couple of Q&As if I recall correctly.

I do remember reading in the ERISA Outline book that some practioneers feel that this changed after EGTRRA. The reasoning was that elective deferrals are now deducted separately from employer contributions.

[No Name]

I'm with you, Andy. I remember getting that answer from Dave Baker years back.

[Kirk Maldonado]

MBozek:

You quite correctly stated that Treasury Regulation Section 1.404(a)-9(b)(1) does not require that the person must actually receive an allocation for their compensation to be taken into account.

However, that regulation was last updated in 1961. Thus, the IRS would argue that Revenue Ruling 65-295 "clarified" the regulation.

Also, in effect, the position in Revenue Ruling 65-295 was upheld in Dallas Dental Lab, Inc., 72 TC 117 (1979). Thus, taxpayers taking a contrary position should expect not only a fight with the IRS, but to lose if they got to Tax Court.

I don't want to be seen as discouraging people from taking a position contrary to Revenue Ruling 65-295. On the contrary, I'd like to see this issue resolved, which would require that either the IRS rewrite the regulation or a court decision rejecting the IRS position. I just think that clients need to be aware that it is an aggressive position to flout that ancient ruling.

[mbozek]

Under the Supreme Ct decision in the Mead case, 533 US 218, administrative agency rulings are no longer entitled to automatic deference by the courts unless the enabling legislation specifically grants the agency the right to speak with the force of law on the matter and the agency's position on the matter is reasonable. Otherwise the agency's position is merely an informal agency policy not entitled to deference by the courts. See Matz v. Household international, 265 F3d 572- IRS position on which employees must be counted for determining if partial termination occurred as expressed in revenue rulings and termination manual was not entitled to deference by courts but is merely an informal agency policy pronouncement. Under the Mead case there doesnt appear any basis for granting deference to IRS Ruling 65-295 as a "clarification" of the regulation on who must receive an allocation in order for compensation to be counted for deductions under IRC 404(a).

[Kirk Maldonado]

mbozek:

Please don't misunderstand me; I'm not saying you should advise your clients to "rollover" on this issue. All that I'm saying is that the client needs to know that to vindicate that position, it is very likely (but not guaranteed) that they will have to fight first with the IRS, go to Tax Court (where they will lose again), and so that their only hope of winning is upon the Circuit Court level.

Thus, the client needs to be aware that the costs could easily run $50,000 at the low end and up to $100,000 to $200,000 on the high end.

If you have clients that are willing to spend that amount of money over an issue like this, they are certainly more litigious than mine. But if they ever need counsel to represent them before the IRS or the Tax Court, I'd love to do it. That's the type of attitude that you dream about finding for a tax controversy practice.

My clients tend to avoid fights with the IRS, particularly my clients that are publicly traded. I represent a couple of companies that are listed on the New York Stock Exchange and believe me, they do not take a lot of aggressive tax positions with respect to their employee benefits matters.

In all sincerity, I wish I had clients that would do that and were willing to pay the litigation costs. It would make for a more interesting practice. Also, if a lot of those issues were litigated and resolved, there would be a lot less uncertainty in our area.