Discontinuance Charges deemed a contribution?

[rblum50]

I have a client with a 401(k) plan that is switching it's investment custodian. They just received the following message from the custodian they are switching from:

We received the signed discontinuance letter and I noticed that there was a request to issue an invoice for any outstanding charges. Unfortunately, it is not possible to create an invoice for upfront payment of outstanding fees because under current tax law, the payment of the discontinuance charge may be considered a plan contribution, rather than a payment of plan expenses. If this happens, there are several issues that may need to be addressed, such as:

- whether the terms of the company's plan document allows such contributions

- whether the payment has to be allocated into participant accounts in accordance with the plan's allocation formula

- whether the allocation violates the Code Section 415 limitation on contributions

- whether any non-discrimination requirements may be violated

- whether the company will be able to deduct this as a plan contribution

- even if this is considered to be a reimbursement of plan expenses, John Hancock is not able to reflect this payment in the Schedule A report.

To avoid any of these potential issues, it would be advisable to adhere to the terms of the contract and deduct the outstanding charges at time of discontinuance.

Has anyone had to deal with this situation before? I would have thought that the discontinuance charges would be considered simply plan expenses that could be paid for and deducted by the Plan Sponsor.

Thanks for the help.

[K2retire]

If the charges are deducted from participant accounts and later reimbursed by the employer it is considered a contribution that must be allocated in accordance with the formula in the document. To avoid that problem we have always asked for an invoice so that the employer could pay the charges directly. Not sure where this interpretation originated.

[Bird]

If the charges are deducted from participant accounts and later reimbursed by the employer it is considered a contribution that must be allocated in accordance with the formula in the document.

That's definitely true.

To avoid that problem we have always asked for an invoice so that the employer could pay the charges directly. Not sure where this interpretation originated.

And I didn't think that you could accomplish the same thing just by pre-paying the surrender charges as an "expense" (and wasn't aware that any carriers would even let you do it). But what do I know?

[masteff]

a request to issue an invoice for any outstanding charges. Unfortunately, it is not possible to create an invoice for upfront payment of outstanding fees

To avoid any of these potential issues, it would be advisable to adhere to the terms of the contract and deduct the outstanding charges at time of discontinuance.

I read this as a concern about timing... they should have been a little more clear and simply said "we'd rather issue the invoice after the charges, not before them".

My answer to that is "hey, if you want to wait to get your money, I'm happy to hold on to it a bit longer"

Of course, they seem to be mixing costs... they first say "outstanding charges" and the switch to "discontinuance charges". Unless they misquoted the client's request then they're abusing the English language... "outstanding" means "unpaid"... it does not include charges that are not yet incurred.

[K2retire]

If the charges are deducted from participant accounts and later reimbursed by the employer it is considered a contribution that must be allocated in accordance with the formula in the document.

That's definitely true.

To avoid that problem we have always asked for an invoice so that the employer could pay the charges directly. Not sure where this interpretation originated.

And I didn't think that you could accomplish the same thing just by pre-paying the surrender charges as an "expense" (and wasn't aware that any carriers would even let you do it). But what do I know?

It's pretty rare that an employer wants to take on charges. But I ran into a few who felt it was unfair for the participants to be charged a surrender fee because the employer decided to move the plan to a new provider. Most of these were moving away from an insurance company platform, but a few were mutual funds with back end sales loads. In these instances, the only way the provider would agree (and many of them won't agree) to not charge the accounts at liquidation was for the employer to prepay charges. Since the payment went directly from the employer to the provider without ever going into the plan, it would be difficult to call it a plan contribution.

[KJohnson]

I think in some ASPAA or JCEB Q&As a few years back the IRS may have said (informally) that payment by the employer to the provider was ok and not a contribution. But in 86-142 (in reference to brokerage commissions) they seem to have gone the other way stating: "Similarly, if instead of making additional contributions to the trust, the employer paid the brokers' commissions directly to the broker, such amounts are treated as though they had been contributed to the trust and used to provide benefits under the plan. "

Rul. 86-142, 1986-2 CB 60.

ISSUES

(1) Are additional contributions made by the employer to reimburse the trust of a

qualified plan for brokers' commissions on transactions involving plan assets deductible

under section 162 or 212 of the Internal Revenue Code?

(2) Are additional contributions to an individual retirement account (IRA) within the

meaning of section 408(a) to reimburse the IRA for brokers' commissions on transactions

involving IRA assets deductible under section 162 or 212?

FACTS

Situation 1.

A corporation established a plan for its employees. The plan is qualified under section

401(a) of the Code and the related trust is exempt from tax under section 501(a). The plan

year and the taxable year of the employer are the calendar year.

The plan provides that the employer will reimburse the trust for brokers' commissions

charged in connection with the purchase and sale of securities for the employees' trust.

The employer, over the plan year, makes the maximum deductible contribution to the

plan under section 404 of the Code. During the plan year, the employer makes additional

contributions to reimburse the trust for the brokers' commissions paid by the trust.

Situation 2.

An individual established an IRA within the meaning of section 408(a) of the Code on

July 1, 1985, and upon establishment contributed the maximum amount allowable as a

deduction under section 219 for that year. Later, during 1985, the individual made

additional contributions to the IRA to reimburse the account for brokers' commissions

incurred in connection with the purchase of securities on behalf of the IRA.

LAW AND ANALYSIS

Section 162 of the Code allows a deduction for the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on any trade or business.

Section 1.162-10(a) of the Income Tax Regulations provides that no deduction shall be

allowed under section 162 of the Code if, under any circumstances, the amounts may be

used to provide benefits under a stock bonus, pension, annuity, profit-sharing, or other

deferred compensation plan of the type described in section 404(a).

Section 404(a) of the Code allows, subject to certain limitations, a deduction for

employer contributions under a stock bonus, pension, profit-sharing, or annuity plan, or

for compensation paid or accrued under a plan of deferred compensation, provided that

such contributions or compensation satisfies the provisions of section 162 or 212.

Section 1.404(a)-3(d) of the regulations provides that expenses incurred by the employer

in connection with a qualified employees' plan, such as trustee's fees and actuary's fees,

that are not provided for by contributions under the plan are deductible by the employer

under section 162 of the Code (relating to trade or business expenses), or section 212

(relating to expenses for production of income), to the extent that such expenses are

ordinary and necessary. Amounts that are not ordinary and necessary expenses are not

deductible under section 162.

Rev. Rul. 68-533, 1968-2 C.B. 190, holds that a sole proprietor's payment of trustee's fees

that were expenses not provided for by contributions under a qualified plan are deductible

by the sole proprietor under section 162 or 212 of the Code to the extent that they are

ordinary and necessary. Such expenses are deductible in addition to the maximum

deduction for employer contributions under the plan allowable by section 404.

The principles enunciated in the regulations under section 162 of the Code are equally

applicable to section 212, except that the production of income requirement is substituted

for the business requirement. Section 1.212-1(e) of the regulations provides in part that

section 212 of the Code does not allow the deduction of any expenses which are

disallowed by any of the provisions of Subtitle A of the Code (relating to Income Taxes)

even though such expenses may be paid or incurred for one of the purposes specified in

section 212.

Brokers' commissions are not recurring administrative or overhead expenses, such as

trustee or actuary fees, incurred in connection with the maintenance of the trust or plan.

Rather, brokers' commissions are intrinsic to the value of a trust's assets; buying

commissions are part of the cost of the securities purchased and selling commissions are

an offset against the sales price. Accordingly, employer contributions to reimburse the

trust for brokers' commissions are used to provide benefits under the plan of which the

trust is a part and thus are not deductible under section 162 or 212. Similarly, if instead of

making additional contributions to the trust, the employer paid the brokers' commissions

directly to the broker, such amounts are treated as though they had been contributed to

the trust and used to provide benefits under the plan. Such direct payments thus are not

deductible under section 162 or 212.

Amounts contributed (or treated as contributed) to a plan are deductible subject to the

rules and limits in section 404. This is the case without regard to whether the amounts are

used to pay brokers' commissions, administrative or overhead expenses (such as trustee

or actuary fees), or cash benefits.

In situation (1), the employer's contributions to reimburse the trust for brokers'

commissions are not deductible as a separate expense under section 162 or 212. Also,

because such contributions result in the employer's total contributions exceeding the

amount deductible under section 404 for the taxable year, such additional contributions

are not deductible under section 404. Such contributions, however, may be deductible in

future years under the carryover rules of section 404(a).

Section 219(a) of the Code provides that there shall be allowed as a deduction an amount

equal to the qualified retirement contributions of the individual for the taxable year.

Section 219©(1) provides that such contributions include amounts paid by or on behalf

of an individual to an IRA.

Rev. Rul. 84-146, 1984-2, C.B. 61, discusses the deductibility of trustee's fees with

respect to IRAs. It holds that, consistent with the rules governing deductions in

connection with qualified plans, amounts paid by the IRA owner for such fees in

connection with an IRA are deductible under section 212 of the Code to the extent they

satisfy the requirements of that section, but that amounts paid that are not ordinary and

necessary expenses, such as capital expenditures and disguised IRA contributions, are not

deductible under section 212.

The analysis that applies to employer contributions to a trust to pay brokers' commissions

on transactions involving qualified plan assets also applies to IRA contributions. Thus,

IRA contributions to pay brokers' commissions on transactions involving IRA assets and

direct payments by the IRA owner to a broker for commissions on transactions involving

IRA assets are not deductible under section 162 or 212. Such contributions (and

payments treated as IRA contributions) are deductible subject to the limits of section 219.

In Situation (2), the additional contributions to the IRA to reimburse the IRA for brokers'

commissions result in the total IRA contributions for 1985 exceeding the amount that can

be deducted under section 219 for 1985. The contributions that exceed the limits of that

section are subject to the tax on excess contributions described in section 4973.

HOLDINGS

The employer contributions to the trust of the qualified plan in Situation (1) to reimburse

the trust for brokers' commissions on transactions involving trust assets cannot be

separately deducted as an ordinary and necessary business expense under sections 162 or

212 of the Code.

Similarly, the IRA contribution by the IRA owner in Situation (2) to pay brokers'

commissions on transactions involving the assets of the IRA cannot be separately

deducted under section 162 or 212 of the Code.