Deduction for contributions (Sec. 404)

[Guest Melissa Winslow]

I have a 401k DC plan which allows for deferrals and a profit sharing contribution. The sponsor is a not-for-profit entity. They would like to make a profit sharing contribution which would exceed the 15% threshold under 404. They are arguing that the 15% does not apply to them as they do not pay taxes as a NFP organization.

I am not aware of exemptions from the 404 limit due to an entity's IRS filing status. Does anyone know of such an exemption? If so, can I have a citation?

[John A]

Here's a good answer from the Journal of Pension Benefits, Volume 6 Issue 1, Autumn, 1998:

Tax-Exempt Entities—

Sharing Profits in a Not-for-Profit

By KEVIN J. DONOVAN

Considerations for tax-exempt entities contemplating maintaining a profit sharing plan.

A question that often appears on the Pension Information Exchange (PIX) is whether or not a tax-exempt entity is subject to a 15 percent limit for contributions to a profit sharing plan. Generally, the answer to this question is no, a tax-exempt entity is not subject to this limitation; therefore, a tax-exempt entity could maintain a profit sharing plan that provides for a fixed contribution of up to 25 percent of each participant’s compensation. Alternatively, in a discretionary profit sharing plan, a contribution in excess of 15 percent of participant compensation could be made, as long as the amount allocated to any participant’s account does not exceed 25 percent of his or her compensation.

DEDUCTION LIMIT

The genesis of the question is of course the 15 percent deduction limit found in Internal Revenue Code (Code) Section 404(a)(3). Under this section, an employer’s deduction for contributions to a profit sharing plan is limited to 15 percent of the compensation paid to the beneficiaries under the plan during the taxable year. To the extent that contributions exceeding this amount are made, a 10 percent penalty tax is imposed. [iRC § 4972] Generally, however, this penalty is not applicable in the case of a tax-exempt entity. An exception applies in the case of a tax-exempt entity that has been subject to the unrelated business income tax (UBIT) or such an entity that is part of a controlled group with a taxable entity. [see 5 J Pension Benefits 3 for a discussion of penalty taxes and tax-exempt entities.]

Whether the entity is taxable or not, the deduction limit under Code Section 404 is just that—a deduction limit. Unlike the individual limit on annual additions contained in Code Section 415, the limitation under Section 404(a)(3) is not a qualification issue. [iRC § 401(a)(16)] That is, an employer who contributes more than 15 percent of participant compensation to its profit sharing plan is not subjecting its plan to disqualification (unless, of course, the terms of the document specifically forbid such a contribution, in which case there would be a disqualifying defect for failure to follow the terms of the document). It is merely subjecting itself to a penalty tax. A tax-exempt entity’s profit sharing plan may therefore clearly allow for contributions in excess of 15 percent of participants’ compensation to its plan without risking disqualification.

[AndyH]

The Pension Answer Book Q&7 clearly states that the limit is 25% for a non-profit, although there is no cite given.