Initial short plan year

[Guest lerieleech]

I have a situation where the client established his unincorporated business on 9/1/2004. He will have Schedule C income of about $200,000 this year. To simplify, assume his net compensation after the social security tax deduction and defined benefit plan contribution is $150,000.

We know that for 401(a)(17) purposes, we must pro-rate the $205,000 limit for the short plan year. But what about comp for 415 purposes? Does the whole $150,000 count as part of his three-year average for 415 purposes?

[SoCalActuary]

Your concerns about short plan year make more sense in a DC plan.

In the DB plan, the contribution is prorated.

However, you can still use the entire year for limitation year. You can define a year of participating service to less than 1000 years, so the participant gains a full one year accrual. This can also apply to the compensation, which is not prorated for 415 purposes.

Projected benefits must be based on some reasonable assumption of the expected benefit at retirement, so your full year normal cost should not be hurt. Neither should your one-year benefit accrual.

You might also ask if the sole proprietor spent any time before 9/1/04 planning to become a sole proprietor. Why? From the time they started planning, you can establish a hire date.

[Guest lerieleech]

You can define a year of participating service to less than 1000 years

Well, I hope so, because I don't think the client or I will live that long. :-)

My question right now comes down only to the comp used for the 415 limit. You are saying that the entire $150,000 can be used toward that 415 limit. Putting aside for a moment the issue of whether any planning was done before 9/1/04 (not that it isn't a valid issue-- just putting it aside for the moment), by saying that the entire year can be used for limitation year, do you mean the entire 2004 calendar year? Or are you suggesting the limitation year begin on 9/1/04?

[mwyatt]

SoCal was trying to hint here with the DC comment. For funding purposes, remember our elaborate models are going forward, so we would be annualizing the comp in your short year, which clearly will be well over the salary limit. Is your concern the initial accrual or the projected benefit for funding purposes?

[Guest lerieleech]

I understood the DC comment, but I need clarification. I am sure SoCal is a fine actuary, but I don't take anything at face value.

I am not concerned about the initial accrual, nor the projected benefit for funding purposes.

I am only concerned about the ultimate 415 limit, and whether the entire $150,000 will count in the three-year average.

[Blinky the 3-eyed Fish]

The Hi-3 compensation 415 limit does not reference 401(a)(17), so there would be no reason to pro rate it.

Do you want to pro rate the NC in the first year for some reason or are you trying to get a full contribution in year 1? If the latter, why not just make the effective date of the plan 1/1/2004? See prior discussions on this board about plan effective dates that pre-exist the employer. The IRS has said it's fine.

[Guest lerieleech]

My primary concern was the ultimate 415 limit, as the employer projects to have lower income in future years, so I won't be able to rely on very high income amounts every year.

I wasn't looking to get more than 1/3 of a year's contribution out of the first year, but if IRS says it's fine, then of course I would present that to the client.

[Guest lerieleech]

In such an instance, would the owner's date of participation be 1/1/04?

[SoCalActuary]

Thanks for the good laugh over the millenium accrual rules.

Seriously, sole proprietors can claim the entire year starting back to 1/1/04 if they want to. You indicated your intent to use the short plan year because it gives you the deduction you need. The deduction rules for short plan years only limit the deduction, generally not the 415 limits.

However, you could use the entire year since most sole prop's do their planning for sometime before they open the doors of the business. If so, they get to have a complete 12 month year.

On the compensation issue, 415 looks to the highest 3 year consecutive compensation without using any proration for short years. If the $150 k happens to be part of your hi 3, then no adjustment is needed.

On a related issue, I personally don't use annualized compensation from a short year in my plan documents or administration, so I would not assume that future compensation will be at $450 k (150 x 12 / 4 months) unless the client gives me assurance that this is a reasonable assumption.

[Guest lerieleech]

Thanks to SoCal, Blinky and mwyatt.

On an interesting side note (keeping in mind he is a sole prop), if we use the whole year, we get a 2004 contribution of about $100,000 and about $72,000 going forward... this opposed to about $37,000 now and $92,000 going forward if we pro-rate.

I haven't done everything in detail yet, but I think the latter actually gives him a higher projected benefit and higher contributions. This appears to make no sense until one realizes that when using the highest 3 years, there are a lot of years in which comp ends up having no use toward the plan.

So, if the goal is to maximize future contributions as a whole, it is probably better to pro-rate, or even skip 2004. But I think he will want to maximize his deductions up front; that's what I would do.