1975, November, Pg. 2101. Person Reform: Benefit and Contribution Limits.

• Author: by R. Michael Sanchez

4 Colo.Law. 2101

Colorado Lawyer

1975.

1975, November, Pg. 2101.

Person Reform: Benefit and Contribution Limits

2101Vol. 4, No. 11, Pg. 2101Person Reform: Benefit and Contribution Limitsby R. Michael Sanchez, Cynthia C. Benson, and Doughlas M. CainThe Employee Retirement Income Security Act of 1974(fn1) (the Act) imposes maximum allowable benefit levels on all qualified defined benefit plans and maximum allowable contribution levels on all qualified defined contribution plans.(fn2) All qualified plans are subject to these limits.

Annual benefits payable under any defined benefit plan, or aggregated group of such plans, are limited to the lesser of $75,000 or 100 percent of annual compensation. An exception to the 100 percent of annual compensation limitation exists for total annual benefits of $10,000 or less. Annual additions to a defined contribution plan or aggregated group of such plans are limited to the lesser of $25,000 or 25 percent of annual compensation. To calculate this limitation, annual additions include employer contributions, forfeitures, and perhaps a portion of employee contributions. For most participants in most plans, the limits are more generous than plan sponsors. But exceeding the limits, even for one participant, will disqualify a plan. All plan draftsmen should be aware of the limits and ensure that neither their benefit nor contribution schedules put any participant over the allowable maximum.

Those interested in maximizing their tax-sheltered retirement savings should be advised to adopt two plans---one defined benefit plan and one defined contribution plan. The statutory formula for calculating the allowable limits in the case of participation in one plan of each type will result in higher maximums than would be allowable with only one plan or with multiple plans of one type.

LIMITATIONS

Maximum deductible contribution levels for different types of plans existed long before the Act.(fn3) Express contribution limitations (without regard to deductibility) previously applied only to owner-employees.(fn4) The Act has expanded the contribution limitations for H.R. 10 plans to include both owner-employees and self-employeds.(fn5) The Act also contains express contribution limitations for individual retirement accounts.(fn6) A major new addition to contribution limitations under the Act is I.R.C. § 415, which imposes a uniform limitation scheme on all "qualified" plans. The coverage subsection within I.R.C. § 415 reads like a shopping list of alternative retirement savings vehicles.(fn7) Prior to the Act, no contribution limitation existed for qualified corporate defined benefit and contribution plans.

The broad application of I.R.C. § 415 has created a direct statutory conflict with the new minimum deductibility feature of $750 for H.R. 10 plans.(fn8) I.R.C. § 404(e) clearly allows a minimum deduction of at least $750 for a contribution to an H.R. 10 plan without regard to the percentage of earned income limitation.(fn9) Yet I.R.C. § 415 expressly limits contributions to H.R.

210210 plans to 25 percent of compensation.(fn10) While Congress may have viewed the $750/100 percent limit in I.R.C. § 404(e) as one designed to aid the sole proprietor who earns under $10,000 a year, its most common utilization may in fact be by a member of a board of directors who wants to contribute $750 of his $1,500 director's fees to an H.R. 10 plan even though he fully participates in his own employer's qualified plan. This potential abuse prompted the Service to issue proposed regulations under which I.R.C. § 415 overrides I.R.C. § 404(e)(4)(B),(fn11) thereby effectively reading it out of the statute. Obviously, these proposed regulations are of questionable validity. Unfortunately, perhaps only an attorney with his own professional corporation could afford to contest the validity of the regulations as a matter of principle. The Service should seek a solution, perhaps by restricting the applicability of the $750/100 percent provision to earned income from the taxpayer's principal business or to individuals who are not participants in other qualified plans.

Enforcement of LimitsThe statutory penalty imposed by I.R.C. § 415 is disqualification. In effect, the limitation scheme described in I.R.C. § 415 should be written into every plan because any payment of benefits or contributions in excess of the prescribed limits disqualifies the plan. In most cases,(fn12) a plan that violates the limits in its operation will not qualify for any of the tax benefits the statute makes available to qualified plans.

One uncertainty is whether the I.R.S. will disqualify a plan or refuse to issue a determination letter if the plan fails to include the limitation language in the plan itself. In other words, is operation of the plan within the limits for contributions or benefits sufficient? I.R.C. § 415 does not expressly require that the limitation be set forth in the plan. I.R.C. § 401(a)(16) states, however, that "a trust shall not constitute a qualified trust. . . if the plan of which such trust is a part provides for benefits or contributions which exceed the limitations of section 415" (emphasis added). Does "provides for" mean that a plan will be disqualified if it fails to limit in writing the potential benefits or contributions to the topside restrictions of I.R.C. § 415? Prudent drafting suggests the inclusion in the plan of the I.R.C. § 415 limitation provisions.

Disqualification of the plan means loss of deductions during the open years to the extent the contributions are unvested and realization of income to the participants for all years to the extent vested.(fn13) Hence, disqualification is a draconian penalty for innocent and guilty parties alike. Use of an excise tax remedy for excessive contributions or benefits akin to the treatment for both IRA's and H.R. 10 plans(fn14) would have been a preferable remedy.

One arguable safety valve for excessive contributions to defined contribution plans may be § 403(c)(2)(A) or (B) of the Labor Title. This section creates a method of repayment in the case of a contribution made by an employer by a mistake of fact, or a contribution conditioned upon qualification of the plan under I.R.C. § 401, if such contributions are returned to the employer within one year after payment or denial of qualification. Section 403(c)(2)(B) is not limited literally to initial qualifications, although this may have been the intention of the draftsmen. Possibly buttressing, or limiting, this return argument is § 403(c)(3) which expressly permits the return of excess contributions as defined in I.R.C. § 4972, and which applies to H.R. 10 plans only. Faced with a plan disqualification for an excessive contribution, the plan sponsor should argue that the return provisions of § 403(c) in the Labor Title apply.

Purpose of Limitation Scheme

The benefits limitations under the Act are based on the premise that retirement benefits constitute a "substitute for earning power."(fn15) The House Committee that drafted one version of the statute made it clear that they wanted to limit income deferral and its consequential tax benefits to an amount reasonably related to earned income

2103during working years: "The Committee. . . believes that it is desirable to impose some dollar limitations on the size of a pension which may be paid out of tax-sheltered dollars. . . ."(fn16) Clearly, the intent of the draftsmen is that not all retirement savings be sheltered. Nothing in the limitations precludes the possibility that pension benefits may exceed the statutory limits. Excess benefit plans(fn17) must be maintained on a nontax-sheltered basis, must be within the general rule that compensation to employees be reasonable,(fn18) and must be in a separate account for each employee receiving excess benefits.(fn19)

Section 415 is aimed at the bottom line of tax-sheltered retirement savings, the benefit payout.(fn20) In defined benefit plans, the limit applies directly to benefits. In defined contribution plans, the section indirectly limits tax-sheltered benefits by placing limits on contributions. In both cases, the limitation formulas are related to earned income and subject to adjustments for changes in the cost of living.

Limitations on Defined Benefit Plans

A qualified defined benefit plan is limited to payment of an annual benefit which does not exceed the lesser of $75,000 or 100 percent of the participant's average compensation for his high three consecutive years.(fn21) For example, if 100 percent of the participant's high three consecutive years of compensation is $30,000, and the retirement benefit is $50,000, the defined benefit plan limitation is violated and the plan is disqualified. For purposes of determining whether a benefit exceeds the limit, the benefit actually payable is expressed as a straight life annuity.(fn22) Because compliance is a condition of plan qualification, consideration of this problem should be a part of the drafting process and cannot wait until benefits actually are payable to participants. Some of the computation questions raised by the limit formula are answered by the statute; others will have to be answered by the regulations.(fn23)

The annual benefit limit is based on a benefit payable in the form of a straight life annuity.(fn24) If the plan provides for ancillary benefits, if employee or rollover contributions are made, or if the benefit is payable in...