IRS small pension plan audit (and amnesty) program; March 31 deadline nears for program that resolves cases quickly and reduces taxpayer liability.

• Author: Bayer, Frieda A.

In connection with the Employee Retirement Income Security Act of 1974 (ERISA), Congress established the concept of "reasonable over a significant range" as a guideline for selecting values for the actuarial assumptions that are essential inputs to determining annual funding for defined benefit pension plans. Congress considered authorizing the establishment of specific assumptions, e.g., specific turnover rates for certain types of firms, but decided that "proper actuarial assumptions may differ substantially between industries, among firms, geographically, and over time." (1) Since then, the IRS has sought to establish objective, enforceable benchmarks for this concept in its Actuarial Guidelines Handbook and technical advance memoranda, and in the courts. (2) Recently, through the Actuarial Examination Program, the Service moved to enforce a floor for two assumptions--investment return and average retirement age--for small plan sponsors. This action has already reduced prior year tax deductions and resulted in tax penalties for thousands of plans. (3) Several completed audits are headed for the Tax Court in winter 1992. (4) Now, in an abrupt an uncommon move, the IRS has offered taxpayers potential protection from penalties through the Actuarial Resolutions Program in exchange for acceptance of the new IRS assumption restrictions.

Practitioners with small business clients should know the implications of the examinations and resolutions programs. Since IRS inquiries are typically directed to the plan administrator or the taxpayer, the tax practitioner may be unaware that an audit of the assumptions is in progress even though there may be a significant tax effect for the client. The taxpayer may underestimate the potential tax consequences of the audit and may miss an opportunity to avert, or at least to narrow, the scope of the audit. (5) If an audit has already been initiated, the tax practitioner may be called on to evaluate options under the new resolutions program.

This article will describe the origin and development of the actuarial audit program; discuss the new resolutions program; and examine the choices available to taxpayers.

Pension Plans and

IRS Regulatory Guidelines

A pension plan is an arrangement in which an employer provides benefits to employees after they retire. One common plan is a defined benefit plan in which the benefits are a function of the level of compensation near retirement and of the number of years of service. The benefits defined in this formula must be funded by the employer over the work lives of the employees covered by the plan. The funds set aside are tax-deductible for the employer, but are not taxed as income to the employee until the benefits are received during retirement. (6)

* Assumptions required for funding

The final cost of a funded pension plan consists of total benefits paid plus operating expense outlay minus investment income. This cost is only observable when the last participant (or his beneficiary) is deceased. An estimate of the various factors that determine net pension plan cost is necessary to calculate the contributions needed to maintain a financially sound plan. Actuaries consult with the plan sponsor to estimate long-term costs and current contributions.

Mortality rates of the participants, work force turnover, investment return, compensation scales, retirement rates and ages, and disability experience are the principal variables considered by actuaries in estimating pension costs. Each will affect the total cost of the plan. Yet each factor is unknown except in retrospect, and must be estimated as a part of the funding formula. The investment return on assets and the retirement age are the two assumptions currently under investigation by the Service. Small plans typically fund over a short period of time and have less plan experience to use as a guide to setting assumptions. They are also perceived as a vehicle to tax shelter income for the primary plan participant. As a result, small plans tend to use more conservative assumptions, which increase annual funding.

* IRS attack on plan assumptions

The IRS's concern over "excessive" current tax deductions is not new. What is new, however, is the focus on small plans and the apparent adoption of a much...