25% Deduction limit in pro-rata allocation

[Becky Schwing]

Plan uses a pro-rata allocation and has three participants

The total eligible plan compensation for the three participants was $496,580

404 limit for the year is 25% of that or $124,145.

The employer deposited $124,140 to the plan which is just under the limit

Two of the employees are HCE's and

 

EE#         Comp                    PS Cont                PS Percent                                                         

EE1         $200,728              $53,000                  26.404%   - capped at 415 limit for 2016

EE2         $228,800              $53,000                  23.164%     - capped at 415 limit for 2016

EE3         $67,052                 $18,140                  27.054%    - got a higher % because other two capped.

Total      $496,580              $124,140

                25%

Limit      $124,145

First the auditor tells me no one could get more than 25%.  Then IRS auditor is arguing that because it is a pro-rata formula all three have to get the same percent - especially EE3 who got the extra amount to allocate the full deductible contribution.

It is my understanding that the contribution formula which in this plan is discretionary defines the contribution amount - which in this plan they wanted to take the full 25% deduction.  Then you have to follow the allocation formula which is pro-rata so you have to allocate pro-rata but only up to the 415 limit and they any extra contribution could go to the participant who has not hit their 415 limit.

So in essence they allocated a 27.054% contribution to employees but the plan had to limit the two HCE's to the $53,000 415 max.  Is this incorrect?  If yes please let me know.

 

[Mike Preston]

Unless your document is wacky you are correct.

[Kevin C]

The plan document should have something similar to this paragraph from our VS base document section addressing the 415 limit:

Quote

If an Employer Contribution that would otherwise be contributed or allocated to a Participant's Account will cause that Participant’s Annual Additions for the Limitation Year to exceed the Maximum Permissible Amount, the amount to be contributed or allocated to such Participant will be reduced so that the Annual Additions allocated to such Participant’s Account for the Limitation Year will equal the Maximum Permissible Amount. However, if a contribution or allocation is made to a Participant’s Account in an amount that exceeds the Maximum Permissible Amount, such excess Annual Additions may be corrected pursuant to the correction procedures outlined under the IRS’ Employee Plans Compliance Resolution System (EPCRS) as set forth in Rev. Proc. 2013-12.

 

[Tom Poje]

and EPCRS has

EPCRS 6.02b

(b) The correction method should keep plan assets in the plan, except to the extent the Code, regulations, or other guidance of general applicability provide for correction by distribution to participants or beneficiaries or return of assets to the employer. For example, if an excess allocation (not in excess of the § 415 limits) made under a Qualified Plan was made for a participant under a plan (other than a § 401(k) plan), the excess should be reallocated to other participants or, depending on the facts and circumstances, used to reduce future employer contributions.

...

so, ok to reallocate to others if NOT in excess of 415. so going on further in EPCRS

 

EPCRS 6.06

(2) Correction of Excess Allocations. In general, an Excess Allocation is corrected in accordance with the Reduction of Account Balance Correction Method set forth in this paragraph. Under this method, the account balance of an employee who received an Excess Allocation is reduced by the Excess Allocation (adjusted for Earnings). If the Excess Allocation would have been allocated to other employees in the year of the failure had the failure not occurred, then that amount (adjusted for Earnings) is reallocated to those employees in accordance with the plan's allocation formula. If the improperly allocated amount would not have been allocated to other employees absent the failure, that amount (adjusted for Earnings) is placed in a separate account that is not allocated on behalf of any participant or beneficiary (an unallocated account) established for the purpose of holding Excess Allocations, adjusted for Earnings, to be used to reduce employer contributions (other than elective deferrals) in the current year or succeeding year.

...

so I think the IRS is correct. you have pro-rata, everyone get 25%. but since you can't get more than 53,000, that excess amounts gets tossed into suspense, and not reallocated since it is a 415 issue, and that seems to be forbidden by EPCRS 6.02

 

the only possible out but it sounds like pushing the envelope, same document Kevin C listed has

 

Prior to determining the Participant's actual Statutory Compensation for the Limitation Year, the Employer may determine the maximum permissible amount for a Participant on the basis of a reasonable estimation of the Participant's Statutory Compensation for the Limitation Year, uniformly determined for all Participants similarly situated. As soon as is administratively feasible after the end of the Limitation Year, the maximum permissible amount for the Limitation Year will be determined on the basis of the Participant's actual Statutory Compensation for the Limitation Year.

my only possible problem with that, is it is like saying we are going to contribute 27.054% to everyone (which we know is over the 25% plan limit) , but limit people at 53,000. and by chance this comes out to be 25% of total comp. on the other hand, if it is known a plan would fail the ACP test you can limit the HCE match, so maybe it can be argued the same, that the formula was indeed 27.054% and the contribution was limited. Instead of we allocated 25% to all, and since folks are limited to 53,000 we allocated the excess to others.

same result, different reasoning.

[Becky Schwing]

Kevin C - your language looks like it is from the ASC VS document which is what we use.  I found this before posting question and was going to provide this back to the auditor but I was not sure about the following verbiage

However, if a contribution or allocation is made to a Participant’s Account in an amount that exceeds the Maximum Permissible Amount, such excess Annual Additions may be corrected pursuant to the correction procedures outlined under the IRS’ Employee Plans Compliance Resolution System (EPCRS) as set forth in Rev. Proc. 2013-12.

 

I admit I would never have thought this was a 415 issue.  I thought I had to allocate the contribution they made and since it met the deduction limit and I kept everyone at or under the 415 limit I thought I would have to allocate the amount contributed and taken as a deduction.  This was the only year they did 25% - they always did 10% except this one year.  They have since terminated the plan and everyone has been paid out. 

I'm waiting for an ASC response before I reply to IRS but I better understand the logic now (wish I would have before).   Will be interested in what the IRS has to say about any type of correction now that plan is terminated. 

 

[Larry Starr]

1 hour ago, Becky Schwing said:

Plan uses a pro-rata allocation and has three participants

The total eligible plan compensation for the three participants was $496,580

404 limit for the year is 25% of that or $124,145.

The employer deposited $124,140 to the plan which is just under the limit

Two of the employees are HCE's and

 

EE#         Comp                    PS Cont                PS Percent                                                         

EE1         $200,728              $53,000                  26.404%   - capped at 415 limit for 2016

EE2         $228,800              $53,000                  23.164%     - capped at 415 limit for 2016

EE3         $67,052                 $18,140                  27.054%    - got a higher % because other two capped.

Total      $496,580              $124,140

                25%

Limit      $124,145

First the auditor tells me no one could get more than 25%.  Then IRS auditor is arguing that because it is a pro-rata formula all three have to get the same percent - especially EE3 who got the extra amount to allocate the full deductible contribution.

It is my understanding that the contribution formula which in this plan is discretionary defines the contribution amount - which in this plan they wanted to take the full 25% deduction.  Then you have to follow the allocation formula which is pro-rata so you have to allocate pro-rata but only up to the 415 limit and they any extra contribution could go to the participant who has not hit their 415 limit.

So in essence they allocated a 27.054% contribution to employees but the plan had to limit the two HCE's to the $53,000 415 max.  Is this incorrect?  If yes please let me know.

 

As Mike noted, unless your document is wacky, it should have language like this in the Maximum Annual Addition section:

Annual Additions can ceases when maximum permissible amount reached. If the Employer contribution that ouwe otherwise be contributed or allocated to the Participant's Accounts would cause the Annual Additions for the Limitation Year to exceed the maximum permissible amount, then the amount that would otherwise be contributed or allocated will be reduced so that the Annual Additions for the Limitation Year will equal the maximum permissible amount, and any such amount which would e been allocated to such Participant may be allocated to other Participants. (emphasis added).

If you plan has that normal language, then your "auditor" is an idiot, but many are!  Making up his own rules.

The easy solution: tell him you disagree and ask him to request "tech advice".  He HAS to do that, but probably will just talk to his boss and come back and agree with you.  Tech advice means he has to write it all up with his analysis as to why he's right (when he tries to do that, he'll figure out that he's wrong), his boss has to agree, and then they have to submit to the National Office (which they hate to do).

Hope that helps. What does your document language say?

[Larry Starr]

12 minutes ago, Becky Schwing said:

Kevin C - your language looks like it is from the ASC VS document which is what we use.  I found this before posting question and was going to provide this back to the auditor but I was not sure about the following verbiage

However, if a contribution or allocation is made to a Participant’s Account in an amount that exceeds the Maximum Permissible Amount, such excess Annual Additions may be corrected pursuant to the correction procedures outlined under the IRS’ Employee Plans Compliance Resolution System (EPCRS) as set forth in Rev. Proc. 2013-12.

 

I admit I would never have thought this was a 415 issue.  I thought I had to allocate the contribution they made and since it met the deduction limit and I kept everyone at or under the 415 limit I thought I would have to allocate the amount contributed and taken as a deduction.  This was the only year they did 25% - they always did 10% except this one year.  They have since terminated the plan and everyone has been paid out. 

I'm waiting for an ASC response before I reply to IRS but I better understand the logic now (wish I would have before).   Will be interested in what the IRS has to say about any type of correction now that plan is terminated. 

 

You need to be careful; see my language example.  No allocation in excess of the MPA has been made, so no correction needs to be taken. If you stopped allocation at the max, nothing to fix.  My language works just as you would want it to .

[Tom Poje]

I see no such language Larry described in the FT William document, and it sounds like ASC might not have that language either.

And I would hardly consider them 'wacky'.

[Mike Preston]

For some reason the OP is admitting to an excess allocation where none took place. If you don't have an error you can't invoke EPCRS, so that whole line of reasoning is ..... wacky.

[Belgarath]

FWIW, FIS docs do have such language.

[Kevin C]

This thread seems have to evolved a bit off topic.  The paragraph I posted was from the base document for our ASC VS document.  The applicable sentence is:

Quote

If an Employer Contribution that would otherwise be contributed or allocated to a Participant's Account will cause that Participant’s Annual Additions for the Limitation Year to exceed the Maximum Permissible Amount, the amount to be contributed or allocated to such Participant will be reduced so that the Annual Additions allocated to such Participant’s Account for the Limitation Year will equal the Maximum Permissible Amount.

This is what the OP said they did and since they use the same document, showing it to the auditor should make the issue go away.

The EPCRS reference later in the paragraph refers to what you can do if an allocation has been made that exceeds the 415 limit, which is not what I read the OP as saying happened.  She asked a follow-up question about that sentence, so I'll address it.  It would normally apply to a situation where someone has salary deferrals such that the allocation of employer contributions would cause a 415 violation and the sponsor wants to refund deferrals so that employer contributions are not reduced.  From Rev. Proc. 2016-51, 6.06 (2):

Quote

...  If an Excess Allocation resulting from a violation of §  415 consists of annual additions attributable to both employer contributions and elective deferrals or after-tax employee contributions, then the correction of the Excess Allocation is completed by first distributing the unmatched employee's after-tax contributions (adjusted for Earnings) and then the unmatched employee's elective deferrals (adjusted for Earnings). If any excess remains, and is attributable to either elective deferrals or after-tax employee contributions that are matched, the excess is apportioned first to after-tax employee contributions with the associated matching employer contributions and then to elective deferrals with the associated matching employer contributions. Any matching contribution or nonelective employer contribution (adjusted for Earnings) which constitutes an Excess Allocation is then forfeited and placed in an unallocated account established for the purpose of holding Excess Allocations to be used to reduce employer contributions in the current year and succeeding year. Such unallocated account is adjusted for Earnings. While such amounts remain in the unallocated account, the employer is not permitted to make contributions (other than elective deferrals) to the plan.

The OP situation has the entire allocation being PS contribution and no one exceeded 415, so there is no need to use EPCRS.

[Mr Bagwell]

3 hours ago, Becky Schwing said:

First the auditor tells me no one could get more than 25%.

This is the part that has me asking questions...   Where is this coming from?  Why can't an Employer contribute 30% profit sharing?  I understand they couldn't deduct more than 25% for tax purposes and you may have 415 issues, but I don't remember a 25% cap.  Maybe the employer is just generous and can figure that no one is going above the 415.....

[BG5150]

I seem to remember something about non-deductible contributions not allowed in QPs.

 

But then again, my memory can be "wacky" sometimes.

[Mike Preston]

Wacky memory it is. Unless it rises to a an exclusive benefit violation and this isn't even close.

[EBECatty]

Haven't read through posts, but Section 4972 imposes an excise tax on non-deductible contributions.

[duckthing]

2 hours ago, Tom Poje said:

I see no such language Larry described in the FT William document, and it sounds like ASC might not have that language either.

And I would hardly consider them 'wacky'.

Hope I'm not contributing to this thread wandering even further afield... but I think the applicable language from the FTW doc is in 5.05(a) of the BPD. Under 5.05(a)(1), for participants covered by a single plan:

"...If the Employer contribution that would otherwise be contributed or allocated to the Participant's Account would cause the Annual Additions for the Limitation Year to exceed such maximum permissible amount, the amount contributed or allocated will be reduced so that the Annual Additions for the Limitation Year will equal the maximum permissible amount."

 

[Larry Starr]

1 hour ago, Mr Bagwell said:

This is the part that has me asking questions...   Where is this coming from?  Why can't an Employer contribute 30% profit sharing?  I understand they couldn't deduct more than 25% for tax purposes and you may have 415 issues, but I don't remember a 25% cap.  Maybe the employer is just generous and can figure that no one is going above the 415.....

The auditor has an immediate credibility problem when he says no one can get  more than 25%.  That is NOT the 415 limit (100%  of pay is the limit).  Just take a simple integrate plan with two participants at comps of $100k and $10k.  Contribute 25% of that total comp, and the one who is at $100k will get MORE than 25% allocate and the other will get less.  The auditor has significant "shortcomings".

Now, if the employer contributes 30% for the two participants in a non-integrated plan (comp to comp allocation), they will each get 30% and the employer will have a non-deductible amount for which an excise tax will be due.  But it is still allocated so long as 415 is not violated.

[Larry Starr]

47 minutes ago, BG5150 said:

I seem to remember something about non-deductible contributions not allowed in QPs.

 

But then again, my memory can be "wacky" sometimes.

They are "not allowed" to be deducted, but they ARE allowed to be allocated.  The non-deductible excise tax will apply as well.

[Larry Starr]

8 minutes ago, duckthing said:

Hope I'm not contributing to this thread wandering even further afield... but I think the applicable language from the FTW doc is in 5.05(a) of the BPD. Under 5.05(a)(1), for participants covered by a single plan:

"...If the Employer contribution that would otherwise be contributed or allocated to the Participant's Account would cause the Annual Additions for the Limitation Year to exceed such maximum permissible amount, the amount contributed or allocated will be reduced so that the Annual Additions for the Limitation Year will equal the maximum permissible amount."

 

What is missing in that language is the additional piece that I quoted that says it's ok to allocate the left over amount to other participants. But I think without that language it can still be done so long as there is not language that says any amount not allocated due to 415 limits goes to a suspense account to be allocated in a future year.  But clearly, the language I quoted is ideal.  It's the Relius document language.  

[Mr Bagwell]

Thanks for the explanation Larry. 

[Bri]

Too bad this is 2016 and not 2017 - Maybe coulda just -11g the excess above 23.164%.

Otherwise you've got one HCE getting a little extra but an NHCE getting even more extra, so I think that might have flown.

[duckthing]

18 minutes ago, Larry Starr said:

What is missing in that language is the additional piece that I quoted that says it's ok to allocate the left over amount to other participants. But I think without that language it can still be done so long as there is not language that says any amount not allocated due to 415 limits goes to a suspense account to be allocated in a future year.  But clearly, the language I quoted is ideal.  It's the Relius document language.  

Good point -- in my mind the FTW language treats it exactly as the OP suggested: "we're allocating X% to everyone, and it might happen that not everyone gets all of it due to the 415 limit." There's not really an "excess" to be allocated to anybody, since the document just says their allocation is lowered. (And since the document limits the allocation amount before it's actually allocated, there's no 415 or other failure to correct.)

The language you provided definitely leaves less room for other interpretations.

[Becky Schwing]

Thanks to all of you.  I was thinking about this last night and the auditor being stuck on the "pro-rata allocation'" issue. 

 What if you had a plan with 11 ee's - 1 HCE eanred 265,000 and the 10 nhce's all earned 100K.  The employer wanted to give a 22% contribution to everyone - but the HCE can only get 20% to cap them at the max of $53,000 for 2016.  So if they give 22% to every NHCE is it no longer "pro-rata?" 

I don't see anything that says the individual contribution must be limited to 25% so in my plan why can't the contribution formula call for a pro-rata allocation of 27% to allocate the full amount they contributed which is under the 25 % deduction limit.  It just so happens that two HCE's get cut off at the 415 limit so they don't get the full 27% contribution.  No one is over the 415 limit and the overall contribution is at 25%. 

I can see her point saying you can't pro-rata a 27% contribution - but when you look at if that the contribution formula calls for a 124K contribution you then you can argue that you have to allocate the full amount limiting the 2 HCE's to 53K and the other NCHE gets the excess. 

The ASC doc states the contribution formula is:

(1) Discretionary Employer Contribution. If a discretionary contribution is selected under AA §6-2(a), the Employer may decide on an annual basis how much (if any) it wishes to contribute to the Plan as an Employer Contribution. If the Employer elects to make a discretionary contribution, such amount may be allocated under the pro rata, permitted disparity, Employee group, age-based or uniform points allocation method (as selected in AA §6-3).

This language does not state "percent" it states "amount".  They chose an amount that was equal to 25% deduction limit.

The allocation formula then states:

(i) Pro rata allocation formula. Under the pro rata allocation formula, a pro rata share of the Employer Contribution is allocated to each Participant’s Employer Contribution Account. A Participant's pro rata share may be determined based on the ratio such Participant's Plan Compensation bears to the total Plan Compensation of all Participants or as a uniform dollar amount, as designated in AA §6-3(a). This allocation formula will satisfy a design-based safe harbor under Treas. Reg. §1.401(a)(4)-2(b) provided if the allocation is based on Plan Compensation, the Plan uses a definition of Plan Compensation that satisfies the nondiscrimination requirements under Treas. Reg. §1.414(s)-1.

The formula tells you how to allocate which we did - it just so happens the two HCE's are capped at $53,000 and both of them get a different percentage of pay because they had different comp.

I'm waiting to see if ASC has a response to this - as it's possible I've missed something in their document which has further guidance. 

But thank to everyone for their input.  It has been quite eye opening and helpful.

 

[Bird]

You're overthinking it.  The auditor is wrong (it's not that uncommon).  Just gently ask her to review that with her manager and it should go away.  If not, then drag out all the document crap but don't complicate it now.

[Becky Schwing]

If anyone is interested - IRS lady called me today and said plan allocation although a violation is fixed under EPCRS self-correction the way we did it allocating a higher percent to the NHCE.  Employer signs off on form and issue is deemed corrected so all is good.  

We had 9 IRS audits all Profit Sharing only plans in the last 3 weeks.  Heard another firm had 11.

 I believe Philly office is training IRS staff in Cincinnati,  

 

 

[duckthing]

11 minutes ago, Becky Schwing said:

If anyone is interested - IRS lady called me today and said plan allocation although a violation is fixed under EPCRS self-correction the way we did it allocating a higher percent to the NHCE.  Employer signs off on form and issue is deemed corrected so all is good.  

Thanks for the follow-up. Did they happen to say what violation occurred that they believe needed correcting under EPCRS?

[Belgarath]

What district are you in? We, thankfully, have not yet seen any uptick in audits. Hope it stays that way!