404 limit with DB and "frozen" PS

[Guest penman]

A potential client has an existing PS/k plan and would like to put in a DB plan for 2004. The last I heard was that even if there is no PS contribution for 2004 the 404 25% limt will apply because just by having an account balance in the PS plan they are a "beneficiary" under both plans. Has the IRS changed their thinking or is that still the case? What if the PS accounts were distributed before the DB was adopted, is that okay, or does the money have to be out for the entire year?

[Effen]

That is not how I understood the rule. I believe the employer must make a contribution to the profit sharing plan and the defined benefit plan for the same individuals in order for the deduction limit to kick in. In addition, 401(k) deferrals do not trigger the limit

404(a)(7)(A) IN GENERAL. --If amounts are deductible under the foregoing paragraphs of this subsection (other than paragraph (5)) in connection with 1 or more defined contribution plans and 1 or more defined benefit plans or in connection with trusts or plans described in 2 or more of such paragraphs, the total amount deductible in a taxable year under such plans shall not exceed the greater of --

404(a)(7)(A)(i) 25 percent of the compensation otherwise paid or accrued during the taxable year to the beneficiaries under such plans, or

404(a)(7)(A)(ii) the amount of contributions made to or under the defined benefit plans to the extent such contributions do not exceed the amount of employer contributions necessary to satisfy the minimum funding standard provided by section 412 with respect to any such defined benefit plans for the plan year which ends with or within such taxable year (or for any prior plan year).

A defined contribution plan which is a pension plan shall not be treated as failing to provide definitely determinable benefits merely by limited employer contributions to amounts deductible under this section. For purposes of clause (ii), if paragraph (1)(D) applies to a defined benefit plan for any plan year, the amount necessary to satisfy the minimum funding standard provided by section 412 with respect to such plan for such plan year shall not be less than the unfunded current liability of such plan under section 412(l).

[Guest penman]

Effen,

The fact that a just the PS account will triiger the 25% was discussed at a number of seminars, etc. I cannot give you cites offhand but a believe one or more old revenue rulings come into play. The speaker at session 203 from the 2003 EA meeting addressed this clearly. I have the outline and I will fax you the relevant pages if you like. I did not attend EA or the annual ASPA in 2004 so I wondered if anything has changed. I agree the deferrals don't count.

[Guest penman]

Okay, I just listened to the audio CD from the DB/DC combo session at the 2004 ASPPA annual conference. The speaker said that his interpretation last year of 1.404(a)-13 regarding the PS acct balances was incorrect and that the mere presence of those accounts does not kick in 404(a)(7) as long as there is no ER PS contribution being made for the year. He surmised that forfeitures should not be allocated though.

I believe his interpretation last year was populary accepted. Is the reinterpretation likewise populary accepted?

[Blinky the 3-eyed Fish]

Here is the proper cite. It clearly spells out that you have to make a DC contribution to trigger 404(a)(7). Reallocating forfeitures is not a contribution in my opinion, so I am not sure why he said that.

404(a)(7)©(ii)

"If, in connection with 1 or more defined contribution plans and 1 or more defined benefit plans, no amounts (other than elective deferrals (as defined in section 402(g)(3))) are contributed to any of the defined contribution plans for the taxable year, then subparagraph (A) shall not apply with respect to any of such defined contribution plans and defined benefit plans."

[Guest penman]

In 404(a)(7)©(i) it says the 25% limit will not apply "if no employee is a beneficiary under more than 1 trust", so apparently to some people that meant that if an employee was in the DB plan and simply had a PS acct with a nonzero balance then they are a beneficiary under more than one trust and the 404 25% limit kicks in (even if no ER PS contrib is made). Come to find out (today for me) that Rev. Rul. 65-295 defines "beneficiary under a trust" to be those who participate in the allocation of the employer's contribution in the year such contribution is made. Therefore the 25% limit would not apply in the above situation.

I would like to hear that the IRS agrees with this.

[Earl]

ask 'em!

[Guest merlin]

Q5 of the 2003 ASPA Conference asked the same question, and referred to PLR 8743096, which says "...Section 404(a)(7) would apply even though no contributions are being credited to the employee's profit sharing account. An employee does not cease to be a beneficiary under the profit-sharing planbecause contributions are not currently credited to his/her account." The answer was that the PLR is still valid and that 404(a)(7) would still apply, and that the only way to get out from under the combine d 25% limit would be to transfer the account balances of the overlapping participants out of the ps plan into the db plan.

Was the speaker in the DB/D Combo session saying that the answer has now changed?

[Guest penman]

Merlin,

I have read Q&A 5 and that was what I had been going by until I heard the ASPPA meeting speaker. He said that he has changed his mind on the issue since last year. My take from listening to the audio CD was that he changed his mind after reading Rev. Rul. 65-295. I read it and I can see where he's coming from.

[Belgarath]

The IRS has flip flopped on this one like a Blinky out of water so many times, that I wouldn't trust any answer from the podium. Being of an essentially conservative bent on such issues, I'd wait for something official before trusting that it is ok to "damn the torpedoes, full speed ahead."

[Guest penman]

That's good advice.

[Belgarath]

I'm not sure that it is necessarily good advice. It's conservative advice - you certainly can't get in trouble with the IRS by choosing this more conservative route. Conversely, the employer could lose out on a substantial, legitimate deduction if the IRS believes that it is ok. I should have mentioned that I wouldn't ever advise the client - I'd give him both sides of the argument, and tell him to consult tax/legal counsel to make the determination.

We had a client with a similar set of circumstances, (although somewhat more convoluted) and the payroll was such that the PS contribution was around 200,000. When the client reviewed with tax counsel, they determined NOT to go ahead with a PS contribution.

[Blinky the 3-eyed Fish]

I don't have access to it so those referencing Q&A 5 of the 2003 ASPA Conference, are you sure it's the same situation? It sounds like the question is addressing a situation where participants are in the DC and DB plan and no participants in the DB plan get an employer contribution in the DC plan, but there is an employer contribution being made. That is not the same as if no employer contribution is being made to the DC plan for anyone. In those situations, which is the situation of the original question, I don't see how you argue with 404(a)(7)©(ii). This provision is an addition to the code within the last few years, but I couldn't track when exactly.

I tracked it down and the code was amended by the JCWAA, so it's a recent change.

[Guest merlin]

I don't see a conflict between the RR and the PLR. I think between them it works out like this:

1. PLR: As long as a common participant has a balance in the dc plan he creates a db/dc combination that's subject to 404a7.

2. RR: The dc side of the 404a7 limit is calc'd either using the pay of a terminated participant or not using it, depending on whether he gets an allocation or not.

Any thoughts?

[Blinky the 3-eyed Fish]

1. No, that is not correct. You NEED to have a DC ER contribution in that year. Think of all the DB/401(k) arangements that are becoming popular because of the JCWAA law change.

I went and found what Sal has on it in the 2004 ERISA Outline Book pg. 7.338.

Exception if only contributions to DC plan are elective deferrals. If there is an overlapping plan situation between a defined benefit plan and a defined contribution plan, but for the taxable year the only contributions made under the defined contribution plan are elective deferrals under a 401(k) arrangement, the IRC §404(a)(7) limit does not apply. See IRC §404(a)(7)©(ii), as amended by the Job Creation and Worker Assistance Act of 2002.

[Belgarath]

I agree with Blinky that there appears to be some confusion on the precise question being asked.

Here's how I see it. If you have a DC and a DB plan, and no contributions other than employee deferrals are made to the DC plan, then your deductible limt under 404(a)(7)(A) will be the GREATER of 25% or the required funding for the DB plan.

Where you run into potential problems is when your required funding for DB plan exceeds 25%, and you STILL want (or need) to make an employer contribution to the DC plan. To amplify a bit as to how this applied to the bizarre situation we ran into - Employer had both DB and PS plan. Plans were set up so that certain employees were excluded in both plans, so that there was NO overlapping participation. Then, due to a change in job status, a participant who had previously received contributions in the PS plan now became ineligible for further contributions in PS plan, but became eligible and covered in DB plan, which had a required contribution in excess of 25%. So the question arose as to whether there was "overlapping participation" which would preclude a deductible contribution to the PS plan. The client's tax counsel took a look at it and determined not to contribute to the PS plan based upon the uncertainty as to whether it would be deductible or not.

Sal has a good writeup as Blinky mentioned - worth reading, and continues for a few pages beyond the deferral only question.

[Blinky the 3-eyed Fish]

Here's how I see it. If you have a DC and a DB plan, and no contributions other than employee deferrals are made to the DC plan, then your deductible limt under 404(a)(7)(A) will be the GREATER of 25% or the required funding for the DB plan.

This is not stated properly. If no contributions other than employee deferrals are made to the DC plan, then 404(a)(7) DOES NOT APPLY. I am not sure if you meant that or not because certainly the maximum deductible contribution to the DB plan could exceed 25% of compensation and be perfectly fine in such a situation.

As for your scenario, that is the exact one that the PLR cited applies to and is a situation where 404(a)(7) appears to still apply. Their tax counsel made a wise decision.

[Guest penman]

C(ii) is clear, but some practitioners, apparently including some IRS people, looked at C(i) "no employee is a beneficiary under more than 1 trust" and determined that in this DB/PS situation that if any of the DB people had just an account balance in the PS plan (no contribs), then the 404(a)(7) 25% limit kicks in.

My original post wasn't the greatest so I'll restate my issue: The situation I have seen is when an employer already has a PS or PSK plan and wants to add a DB plan. The new combined plan design has half of the ee's in the DB and the other half in the DC. There is no crossover. If both plans were brand new, you would have no concern with the 25% limit. But, in the case where the PS or PSK plan has been around and the DB people will now have "dormant" PS account balances, I have read more than one discussion (including Q&A 5, and various seminars) that said the dormant account balances cause the 25% limit to kick in because the DB people are considered beneficiaries under more than one trust.

Then, I heard/read the speaker at the 2004 ASPPA Conf. mention RR 65-295 and he had a different opinion. See pages 2 and 3 from the outline for Workshop 2.

Personally, I don't think the intention of 404(a)(7)C) was to make the 25% limit kick in just because someone has an old account balance sitting around.

[Blinky the 3-eyed Fish]

Penman, this scenario is entirely different than your original post. You ARE making a nonelective contribution to the DC plan and are correct that there is some confusion concerning C(i). Tread carefully, if you intend to disregard the opinion from the old PLR.

[Guest merlin]

Blinky,

Enlighten me further wrt the following:

Employer sponsors two plans. Plan 1 is a db covering certain employees, including the business owner. Plan 2 is a ps/401k covering all other employees for deferrals and ps, and the owner for deferrals only. Do I have a 404a7 limit or not?

[Blinky the 3-eyed Fish]

You have a strong concern of a 404(a)(7) issue. Personally, I would not set up plans that way because of the concern. I think a third plan where only 401(k) deferrals are allowed for the owner and anyone else in the DB plan is warranted until a more concrete opinion from the IRS is generated. This would be a good Gray Book question to give to pax, unless it was answered recently.

[Guest merlin]

I was asked about this design by a finacial planner a few months ago. I told him I didn't think it worked. Thanks for the support.

[Belgarath]

Hi Blinky - you're absolutely right - I stated this very poorly. What I was trying to get across was that even with a conservative approach, none if this matters unless you are trying to make a deductible employer contribution to the DC plan - since even if you consider them to have "overlapping" participation, (7)(A) allows you to contribute the full DB cost even if greater than 25%.

Your comment states it much more succinctly and accurately. Instead of fishing, I'll cut bait.

[Guest merlin]

Just to muddy the waters again, I think Kurt Piper disagrees. His DB/DC Combo outline fom ASPA says:

"If no individual employee benefits under one or more defined benefit plans and one or more defined contribution plans for the year

[Guest merlin]

Sorry, had a finger spasm. To continue:

"..., then the plans are not subject to the ...404a7 limit. The fact that an employee who benefits under the defined benefit plan made 401k salary deferals does not result in the application of the 404a7 deduction limit solely because of the salary deferrals."

[Guest penman]

merlin, that's exactly the session I'm talking about. It is contrary to what PLR 8743096 states. RR 65-295, wrt 404(a)(3), interprets the words "beneficiary under more than one trust" to mean only those benefitting in the current year. These are the same words used in 404(a)(7).

He speculated that it would be doubtful a federal judge would let the IRS say "blue means blue" one place and "blue means red" in another place.

(For me though, I don't want to get involved with federal judges.)

[Guest merlin]

penman,

After seeing your earlier post I downloaded the outline from the ASPA website. Pretty interesting reading, as are the rest of the comments here. Anybody who is willing to predict what a fedeal judge would do is a better man than I am.

Anyway, in the Q&A session this year, somebody (Craig Hoffman? Larry Starr?)solicited questions for ASPA's database. I don't know if this means ASPA will try to get answers throughout the year, or if they'll just store them up for next year's conference. I'll try to get this one in. In the meantime, maybe someone could try to get it into the 05 Gray Book, as mentioned above?

[Guest penman]

Thanks merlin.

[Guest PensionNW]

Here is what I have regarding the whole 404(a)(7) issue.

PLR8743096 says: "As mentioned above, section 404(a)(7) is not applicable if no employee (including former employees) is a beneficiary under both the pension plan and the profit-sharing plan. If, however, an employee is a beneficiary under the pension plan and also under a profit-sharing plan, section 404(a)(7) would apply even though no contributions are currently being credited to the employee's profit-sharing account. An employee does not cease to be a beneficiary under the profit-sharing plan because contributions are not currently credited to his/her account."

At the 2003 ASPA Annual Conference IRS Q&A the question was asked if this is still correct and they said it is. Evidentially they said just the opposite at a previous ASPA meeting.

I encourage each of you to read Rev. Rul. 65-295 to determine how you think this would apply to 404(a)(7).

I think that the issue now is, does the language in 404(a)(7)©(ii) trump the language in 404(a)(7)©(i)? I talked to another actuary last week about this and his firm contends that unless a the plan sponsor makes a deductable contribution to the DB and DC plan (other than elective deferrals) that are allocated to at least one person who is a participant in both the DB and the DC plan, then 404(a)(7) does not apply. I like this because it is consistent with 404(a)(7)©(ii) and it just makes sense. I'm just not sure if I agree with it.

[Blinky the 3-eyed Fish]

I think that the issue now is, does the language in 404(a)(7)©(ii) trump the language in 404(a)(7)©(i)?

No, that is not the issue at all. Let me say it again. 404(a)(7)©(ii) is clear that if an employer contribution is not made to the DC plan, then the limits of 404(a)(7) do not apply. It can't be clearer than that.

The PLR issue is when you have participants in both plans and an employer contribution is made, but not to anyone who is a participant in the DB plan.

  I talked to another actuary last week about this and his firm contends that unless a the plan sponsor makes a deductable contribution to the DB and DC plan (other than elective deferrals) that are allocated to at least one person who is a participant in both the DB and the DC plan, then 404(a)(7) does not apply.  I like this because it is consistent with 404(a)(7)©(ii) and it just makes sense. I'm just not sure if I agree with it.

That is not what 404(a)(7)©(ii) says or means at all. This is the same question being debated here though. This actuary is being aggressive being that there isn't formal guidance on this situation, but I can't say he's definitely wrong.

[Guest penman]

Blinky,

The PLR issue is when you have participants in both plans and an employer contribution is made, but not to anyone who is a participant in the DB plan.

This situation is what I am trying find out about here. I have a potential new DB client with an existing PS/K Plan.

The informal opinion from the IRS seems to say "roll the money out" so that would be the safest approach. On a practical level it seems silly. Also, it is giving the employees access to funds that are intended for retirement. It seems counter-intuitive to the governments efforts to promote individuals saving for retirement.

As for rolling the PS accounts out, I am wondering when the accounts have to be rolled out? Let's say you roll the money out 12/15 and adopt the new DB plan 12/16, is that okay? Can the PS accounts not exist at any time during the year, effectively making it impossible to start the DB in 2004?

[Guest merlin]

I've put the question in to ASPPA. They only answer at conferences, and the next one looks like the LA conference in January. Too late to help anyone trying to deal with it for 12/31. Any volunteers to follow up at the LABC?

[Blinky the 3-eyed Fish]

Penman, here is how I see it.

Ultra-conservative: no DB plan can happen for 2004

Less Conservative: start a new PS plan and transfer balances for those that will be in the DB before the adoption of the DB plan

Aggressive: don't worry about moving balances, just don't give a DC employer contribution to those in the DB

First, a transfer is much easier than providing rollovers and it preserves the retirement benefits. Plus you would be restricted from 401(k) distributions anyway. But I agree the whole excercise is silly. I could say that about other issues as well, but that won't help you if the IRS disagrees.

[Guest PensionNW]

OK, I've read all of this again and I've come around.

First, keep in mind that 404(a)(7)©(i) talks about an employee who is a "beneficiary" under the DB and DC plans. Is a DC participant who has an account balance and is entitled to a future benefit from the DC plan not a beneficiary of the DC plan? However, 404(a)(7)©(i) address the limitations of 404(a)(1), (2), and (3).

Now 404(a)(7)©(ii) makes it clear that if no amounts other than elective deferrals are contributed to the DC plan then 404(a)(7)(A) does not apply and this is the section that could limit the contribution to a DB and DC plan.

The issue that I have run into is where an employer who currently sponsors a DC plan that covers all employees wants to establish a new DB plan that will only cover some of the employees and the DB participants will no longer get a DC contribution.

Under a strict reading of 404(a)(7)©(ii), it appears that an employer contribution to the DC plan, even if the DB plan participants do not share in the allocation, would cause the provisions of 404(a)(7) to kick in.

[Guest penman]

Blinky,

I have never been involved in an asset transfer. Are you talking about a nonelective transfer where benefit options are protected? What paperwork is required (amnedments, forms, notices, etc.)?

[AndyH]

Sorry for not letting this die, but apparently I am too dense to understand what people's conclusions are and I have to respond to a similar question.

Blinky, it is probably me, but my read is that you changed your conclusion at least once. Are you saying that a DB/DC combo deduction limit is 25%? Or not? What do you mean that 404(a)(7) does not apply? Then what does?

Belgarath, you keep making a point that interests me and seems to me to make other discussions moot, that the deduction limit is NOT 25% but the GREATER OF 25% of the 412 minimum. Does anybody disagree with that? As long as you do not contribute to a DC (other than deferrals) then this is a non-issue unless you want to deduct more than the 412 minimum.

Here is a simple question, followed by the real question which is a bit trickier:

1 person corporation has a calendar PS plan. Contributed $100 in 2004 for 2004. Wants to set up a DB plan with a 412 minimum of 100% of pay. Assume pay is $150K and the DB minumum is $100K. What is his deduction limit, $150K or $37,500 (25%)?

(ed. $150K s/b $100K and 37,500 s/b $25K)

Now the real situation is more complicated. The business is actually a proprietership that once was a corporation which has a 3/31 year end. Apparently the calendar proprietership had a PS plan and kept it and it's a 3/31/04 PYE. There was a contribution actually made in 2004 for 3/31/2004. We are not yet certain whether it was deducted 12/31/2003 or would be deducted 12/31/2004. If it was deducted 12/31/2003, can't we still deduct the full DB minimum for 12/31/2004? If it was not deducted 12/31/2003, isn't the deduction for 2004 still the DB minimum which means all they lose is the PS deduction? But then I guess excise penalties would apply, right?

Sorry for the rambling and thanks for any clarification.

[Blinky the 3-eyed Fish]

Blinky, it is probably me, but my read is that you changed your conclusion at least once. Are you saying that a DB/DC combo deduction limit is 25%? Or not? What do you mean that 404(a)(7) does not apply? Then what does?

I didn't reread my posts, but I am curious where I went John Kerry? Ouch, your from Massachusetts, forget I said that. Anyway 404(a)(7) applies when there is an employer contribution to the DC plan, not otherwise.

Belgarath, you keep making a point that interests me and seems to me to make other discussions moot, that the deduction limit is NOT 25% but the GREATER OF 25% of the 412 minimum. Does anybody disagree with that? As long as you do not contribute to a DC (other than deferrals) then this is a non-issue unless you want to deduct more than the 412 minimum.

This is correct. Although if you don't contribute other than deferrals then you can contribute to the maximum DB deductible amount.

1 person corporation has a calendar PS plan. Contributed $100 in 2004 for 2004. Wants to set up a DB plan with a 412 minimum of 100% of pay. Assume pay is $150K and the DB minumum is $100K. What is his deduction limit, $150K or $37,500 (25%)?

I assume the $100 is an employer contribution? If so then his deductible limit is $100,000. The $100 would be nondeductible, although no excise tax is imposed due to the 4975 changes by EGTRRA.

Sorry, I can't get to your last scenario right now.

[AndyH]

Thank you. That much is very helpful. Now I'm back to where I though I was before I read the thread! And I'm not in MA (but I was born there), so you can't blame Kerry and Dukakis on me, but I will not say where I am until, as they said in Planet of the Apes "you reveal your innermost self unto" (in that case, to the doomsday bomb, in this case to the other Board Members).

[Blinky the 3-eyed Fish]

Oh yeah, I forgot where you are. I won't reveal your secret though unless forced to by a hefty cash payment by those that want to know.

[AndyH]

Red Sox Nation is quite large you know.

Gotta go, got an offer of some type from Hoard2!

[Guest merlin]

Was the question addressed at the LABC?

[SoCalActuary]

The question was brought to Jim Holland during one of the sessions.

Jim expressed concern that the continued funding of the frozen db plan might have the result of the owner "benefiting under the db plan" since the assets available provide more protection for his benefits. However, he did not make a formal position.

Not really unusual to see such ambivalent guidance.

[Guest penman]

SoCal, can you elaborate on the scenario Jim Holland was commenting on?

[SoCalActuary]

Ongoing PS plan, covering some participants with account balances in an underfunded DB plan with continuing contributions to end underfunding.

No participant "benefits" in DB plan for non-discrimination purposes. Total contribution of PS plan normally limited to 25% of pay. Question was asked if the DB plan required contribution would lower the PS limit.

Holland answer: "not sure", since the owner's db benefit is still being funded.