5.6 Qualified Pension and Profit Sharing Plans

• Library: Corporations and Partnerships in Virginia (Virginia CLE) (2016 Ed.)

5.6 QUALIFIED PENSION AND PROFIT SHARING PLANS

5.601 In General. The "qualified" pension or profit sharing plan is an important element in any compensation arrangement for both executive and rank-and-file employees. It is a means of compensation that has been granted favorable federal income tax treatment. However, in order for a plan to be or remain qualified, it must comply with an increasingly complex body of law. Because of the complexity of the rules described below, an employer should always consult a knowledgeable professional in the benefits area for advice in establishing and maintaining a qualified retirement plan. This chapter describes the types of plans and features available and highlights the requirements. It does not fully describe the legal requirements contained in the I.R.C. and regulations.

All requirements of ERISA apply to "qualified" pension or profit sharing plans. An ERISA-covered pension plan must comply with the following provisions of ERISA just like an employee welfare benefit plan: (i) the reporting and disclosure requirements; (ii) the fiduciary responsibility requirements; and (iii) the claims procedure. ³¹⁸ In addition, ERISA requires that a pension benefit plan comply with certain minimum coverage and minimum vesting requirements that parallel in most instances the requirements contained in the I.R.C. Thus, if a plan meets the requirements of the I.R.C., it will also meet the requirements of ERISA with respect to minimum coverage and vesting.

5.602 Tax Consequences. The principal income tax advantages of qualified plans may be summarized in three categories.

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A. Employer Contributions Are Deductible. Employer contributions to a qualified plan are tax deductible. ³¹⁹ Generally, contributions to a stock bonus or profit sharing plan are deductible up to a maximum contribution of 25 percent of the amount of employee compensation otherwise paid or accrued during a plan year. ³²⁰ Amounts deferred from compensation by participants do not count against the 25-percent limit. ³²¹ For pension plans, the amount deductible is an amount that results from an actuarial computation of the minimum funding amount as designated under I.R.C. § 412(a). ³²² All employer contributions are subject to certain limitations on the maximum annual amount that may be deducted. ³²³

B. Effect on Employee. Employer contributions are not taxable to employees until the benefits are actually distributed to the employees or their beneficiaries. ³²⁴ When the time for distribution to employees arrives, the amount generally taxable to the employee is taxable under the rules relating to the taxation of annuities. ³²⁵ In effect, the employee will be taxed each year only on the amount he or she receives or becomes entitled to receive.

However, distributions made before an employee retires or reaches age 59½ will be subject to an additional 10-percent excise tax unless such distributions meet one of several qualifying requirements set forth in I.R.C. § 72(q)(2) and (t).

If the benefit is paid to an employee in the form of a lump sum and certain other conditions are met, the employee may roll over the distribution into an individual retirement account (IRA) and realize further deferral of taxation. Ten-year averaging is available for individuals who were born before January 2, 1936. ³²⁶

Generally, a pro rata part of the accrued benefit of a participant under a qualified plan must be distributed each year over the employee's life expectancy or joint life and last survivor expectancy. Distribution must begin

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no later than April 1 after the calendar year in which the later occurs: (i) the participant terminates employment (unless he or she is a five-percent owner) or (ii) the participant reaches age 70½. ³²⁷ If minimum distributions for a year are not made, a 50-percent excise tax is imposed on the excess of the required distribution over the actual distribution for the year. The tax may be waived if the shortfall was due to reasonable error and reasonable steps are being taken to remedy the shortfall. ³²⁸

Under the minimum distribution rules, employees other than five-percent owners who continue to work beyond age 70½ are not required to begin receiving distributions until they separate from service. Employees who may have already begun to receive distributions because of their age, but who are still working after 1996, may consent to stop receiving the distributions while they remain employed. ³²⁹

Plan distributions that are made in the form of a lump sum or in periodic installments not exceeding 10 years are subject to a mandatory 20-percent federal income tax withholding and a 4-percent Virginia income tax withholding (for Virginia residents), unless the amount is contributed by "direct rollover" to an IRA or other qualified retirement plan, including a section 403(b) or governmental section 457 plan. The withholding is an advanced payment of tax similar to wage withholding. ³³⁰

Not only are contributions exempt from income for the employee and not subject to employment taxes under the Federal Insurance Contributions Act (FICA), but they may also result in a saver's credit against taxes. ³³¹ It should be noted that, while contributions increase the amount of the credit, distributions reduce the amount.

C. Income Taxation of a Qualified Trust. A qualified tax exempt pension or profit sharing trust is, with certain exceptions, exempt from income taxation. ³³² As a result, the trust is able to reinvest all earnings rather than a lesser amount of earnings after reduction for taxes. A trust may

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not, however, carry on a business, and it may not borrow money in order to invest. ³³³

5.603 Classification of Plans.

A. Defined Contribution Plans. A defined contribution plan establishes an individual account for each participant and provides benefits based solely on the amount credited to the participant's account, including contributions and any income, expenses, gains, losses, and forfeitures by other participants that may be allocated to the participant's account. ³³⁴

This type of plan is also referred to as an individual account plan and includes stock bonus and profit sharing plans. The amount to be contributed may be left entirely to the discretion of the employer, which may determine not to make a contribution for a particular year. ³³⁵ Furthermore, the amount to be contributed need not be determined until after the end of a plan year, whether the employer is on the cash or accrual basis, provided the designation of the amount of contribution is made and the amount of contribution is paid on or before the time for filing the tax return for the corporation for the year in which or with which the plan year ends. ³³⁶ A stock bonus plan is similar to a profit sharing plan except that the plan invests primarily in employer stock and, as a result, must meet certain rules permitting such investment.

Defined contribution plans also include money purchase pension plans in which the annual contribution is fixed but the benefit of each participant is derived from his or her individual account. A money purchase pension plan is a defined contribution plan since the computation of an employee's benefits is based on the amount in the employee's account. However, it is not a profit sharing plan, because the level of contribution is based on a definite formula, such as percentage of compensation, while the contribution to a profit sharing plan may vary from year to year.

B. Defined Benefit Plans. A defined benefit plan provides definitely determinable benefits to employees, usually payable for life,

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beginning at retirement, death, disability, or termination of employment. ³³⁷ The benefit is based on a formula described in the defined benefit plan, and the employer contributes annually the amounts actuarially determined necessary to fund the benefit.

Generally, if the participant is married, the benefit must be provided in an annuity over the participant's life with 50 percent of the annuity provided to the participant's spouse upon the participant's death. This is called a Qualified Joint and Survivor Annuity (QJSA). ³³⁸ If a married participant wants to receive his or her pension benefit in another form besides the QJSA, the participant's spouse must waive his or her right to the QJSA. ³³⁹ ERISA has requirements on the timing, contents, and waiver of the QJSA explanation. ³⁴⁰ Generally, the QJSA explanation must be provided no less than 30 days before the participant's annuity starting date and no more than 180 days before the participant's annuity starting date. ³⁴¹ Nevertheless, in limited circumstances, the plan is permitted to provide the QJSA explanation after the participant's annuity starting date where the spouse has 30 days to elect to waive the QJSA. ³⁴² This is called a retroactive annuity starting date. If a retroactive starting date is offered, the plan must meet requirements relating to the make-up payment and the information provided to participants and spouses.

IRS regulations require disclosure about the relative value of each optional form of benefit payment to participants. ³⁴³ The information must include a comparison of the relative value of each optional form of benefit and the value of the QJSA. This comparison must be expressed to the participant in a manner that provides a meaningful comparison of the relative economic value of each optional form of benefit and the QJSA. In other words, both optional forms are expressed in the same form, taking into account the time value of money and the life expectancies, without reference to interest or mortality assumptions.

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The Pension Protection Act of 2006 (PPA) ³⁴⁴ clarified the rules governing hybrid defined benefit plans. The two most common hybrid plans are cash balance plans and pension equity plans. A cash balance plan defines an employee's "account" based on an annual contribution rate for each year of...