Application of 404(a)(1)(d)(ii) current liability calc

[Guest saeissler]

At the ASPPA conference there were several references to the fact that current liability calculations for maximum deduction purposes should not include increases in current liability for HCEs in plans that are newly established within the last 2 years as well as to plans amended in the last 2 years. Jim Holland said that the reason is that a plan could terminate and start a new plan to avoid this rule. If that is the only reason for his stance, why wouldn't the rule just include as an amended plan any plan that is established within 2 years of the termination of another plan of the employer? I am hesitant to change my current procedure of using the full current liability for new plans, unless I have to, and I am concerned about my prior valuations. Any thoughts?

[david rigby]

As far as I know, they seem to be sticking to that position. This is from the Gray Book:

GRAY BOOK QUESTION 2006-14

Deductible Limit: Adjustment to Unfunded Current Liability for Deduction for Small Plan

IRC §404(a)(1)(D)(ii) provides that in the case of a plan having 100 or fewer participants for a plan year, unfunded current liability does not include the liability attributable to benefit increases for highly compensated employees (HCEs) resulting from a plan amendment which is made or becomes effective within the last 2 years.

a) A new calendar year DB plan is started effective 1/1/2006 and grants past service for benefit accrual purposes. For purposes of § 404(a)(1)(D)(ii), is the new plan considered an amendment subject to the two-year restriction or may the full UCL be deducted?

b) Section 404(a)(7)(A) limits deductions when there is a combination of DB and DC plans, generally to 25% of payroll. However, if §404(a)(1)(D) applies, the maximum deduction “shall not be less than the unfunded current liability.” Does the §404(a)(1)(D)(ii) requirement to exclude HCE liability apply for this purpose?

RESPONSE

a) Adoption of a new plan is considered to be an amendment for this purpose.

b) Yes.

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[Guest Jeff Hartmann]

Any thoughts?

We recognize that IRS treats a new plan adoption as an amendment for this purpose, so we generally do not quote the higher deduction limit during the first 2 plan years. That said, I am convinced that if this goes to court that IRS would lose taking that interpretation. A plan adoption is a plan adoption, and an amendment is an amendment. IRS cannot change the meaning of words to suit their purpose. If Congress had intended this rule to apply to new plan adoptions, they would not have included the limiting words "resulting from a plan amendment", or they would have said "resulting from adoption of a plan or a plan amendment".

I still have questions about how to apply the "2 year" rule, given that there can be more than 12 months difference between the effective date and adoption date of an amendment. i.e. does the 2 year rule effectively become a 3-year rule in certain situations. It seems the intent of the rule was that if benefits were increased for the 2004 plan year, the increases should be recognizable in the deduction for the 2006 plan year, but what if the 2004 increase amendment was adopted 3/15/2005, retro to 1/1/2004? Here, the literal text of the Code provision does not allow the increase to be recognized in the 2006 deduction, so there would be 3 tax years it has to be ignored.

[Guest saeissler]

Agreed on the 2 year period. It appears quite specific that the first year of the 2 year period is the year in which the later of adoption or effective date occur.

Thanks, both of you, for your responses.

[David MacLennan]

Susan, I echo the above comments - you will never see a deduction challenge over this go to Tax Court because the outcome is certain to go against the IRS. Although the Grey Book answers are apparently given considerable thought before release (input from Treasury, etc), they have no legal reliance. Interesting how the "literal interpretation" of the Code can be so selective (think of the recent pre-participation 415 comp issue where public statements were "we must follow the Code"). The IRS could issue regulations or other guidance but they have not. My position is that if the client is the type that defers the decision to me, I would of course be conservative and assume new plan = amendment. If the client wants to make decisions and be involved, I will inform them and let them decide. I would not lose any sleep over your earlier valuations.

[rcline46]

Let us look to the 'insanity' of the IRS position. Frequent reference for counting the 2 years is the nice 412©(8) (?) amendment made within 75 days of the year end. The IRS says the LATER of adoption or effective date.

So does that mean if you make such an amendment radically increasing benefits for 2006 adopted by March 15th 2007, your first year is 2007? I think I heard the answer is yes. So you cannot use the 150% of the increase in AB for any HCE for 2007 and 2008. Side note - you CAN use 150% of the unamended AB during this period plus 100% of amended AB so it is not really that bad.

However, if the counting year starts 2007, then you get to use the FULL AMENDED AB at 150% for 2006!

I would suggest the correct interpretation of the 2 year rule would be the year for which the amendment is effective, regardless of adoption date.

And why are they still picking on small plans? Why does the IRS have such deep-seated bias?

[AndyH]

Insane or not, Marty Pippins reiterated in a webcast today that the IRS considers a new plan to be an amendment for this purpose.

[Guest saeissler]

Rcline46 - you lost me. I start a plan effective 1/1/2005 and adopted 1/1/2005. I am doing a valuation at 1/1/2005. The current liability of the only participant, an HCE, is $0 at 1/1/2005 and $50,000 at 12/31/2005. The minimum funding requirement is $40000 at year end. 100% X $50,000 - $50,000 (increase in CL) - $40,000 assets at year end) = $0 so my maximum deductible contribution is $40,000.

I am now doing a valuation at 1/1/2006. The current liability attributable to the 2006 increase, using 2006 CL rates, as of 1/1/2006 is $55,000. The total current liability is $130,000 at 12/31/2006. My minimum funding requirement at year end is $44,000. My maximum deductible contribution is ($130,000-$55,000) X 150% -$85000(projected assets at year end) = $27,500 which is less than $44,000 so $44,000 is the maximum.

I didn't get where your 150% /100% combination calculation was coming from?

[Mike Preston]

How confident are you that excluding the current liability attributable to the current year is the appropriate metric?

[Guest saeissler]

404(a)(1)(D) says that amount subtracted from current liability is the "liability attributable to benefit increases for highly compensated employees resulting from a plan amendment which is made or becomes effective, whichever is later,within the last 2 years." I interpret this to mean that the benefit increase attributable to the amendment is the increase that took place at the time of the amendment. The only change to that amount would be the present value increase of the benefit accrual from the time of amendment, due to the passage of time and due to any change in the current liability interest rate from year to year to value the accrual.

I am also wondering now, on rereading the other comments, whether the Grey Book answer would be different if there was no past service credited for benefit accrual?

[Mike Preston]

Interesting interpretation. If you are going to go along with the concept that the initial adoption of the plan on 1/1/05 is an amendment for this purpose then most calculations I've seen for 2006 would not be, as you posted, "($130,000-$55,000) X 150% -$85000" but instead, just like you did for 2005, "($130,000-$130,000) X 150% -$85000".

Or am I misinterpreting?

[FAPInJax]

I, for one, agree with your interpretation.

Additionally, in RCline 46, an amendment adopted 2/14/2006 for the 2005 calendar year would not be eligible to be included until the 2009 calendar year (regardless of whether the valuation date is 1/1 or 12/31). This is because the 2 year period is measured from the beginning of the plan year for which the calculation of current liability is being made. It is in effect a 3 year rule in my interpretation.

[Mike Preston]

Frank,whose interpretation are you agreeing with?

[FAPInJax]

The interpretation that the liability for the HCE only excludes benefits created by the amendment (prior benefits could be used). For example, an HCE has a current accrued benefit of 1,500 (and we are doing an end of the year valuation to make life easier) and his benefit would have been 1,250 if an amendment had not been executed during the prohibited time frame. For purposes of the 150% calculation only the 1,250 benefit can be used. Once the 24 month period expires then the full accrued benefit can be used in the calculations.

[Mike Preston]

That sounds right to me. However, the example being discussed is with respect to a plan initially adopted 1/1/05, isn't it? I didn't see any calculations that drew the distinction you are making and with which I agree.