Tax planning with single-employer qualified plans.

• Author: Donovan, Kevin J.

EXECUTIVE SUMMARY

* Contributions to qualified plans that otherwise qualify as ordinary and necessary business expenses are deductible under Sec. 404, subject to the limits of that section.

* At a plan level, the deduction for contributions to a defined-contribution plan is limited to 25% of the compensation paid to beneficiaries during the employer's tax year.

* After 2007, the allowable deduction for contributions to defined-benefit plans is the greater of the minimum required contribution under the minimum funding standards or the sum of the funding target, the target normal cost, and the cushion amount for the plan year.

* Different limitations may apply where an employer maintains one or more defined-benefit plans and one or more defined-contribution plans.

* Employers are subject to a penalty tax under Sec. 4972 on nondeductible contributions.

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An employer may take a current deduction for contributions to a qualified retirement plan as allowed under Sec. 404. This article discusses the rules under Sec. 404 for determining the amount of deductible contributions to defined-contribution and defined-benefit qualified plans for a tax year and the penalties under Sec. 4972 for nondeductible contributions.

One of the primary attractions of qualified retirement plans is tax leverage. If the rules are properly followed, the employer obtains a tax deduction for the contribution to the plan, while the employee is not taxed until he or she receives the dollars from the plan (assuming the plan remains tax qualified under Sec. 401(a)). In addition, under Sec. 501(a), the plan's earnings are not taxed until distribution. This favorable tax treatment provides for powerful tax planning.

This article discusses the rules of Sec. 404 regarding the ability to deduct contributions to single-employer qualified retirement plans. It explains required contributions, and respective limitations, for tax deductible contributions to qualified retirement plans and outlines the requirements related to the timing of plan contributions.

General Rule

Sec. 404(a) begins, "If contributions are paid by an employer to a stock bonus, pension, profit-sharing, or annuity plan ... such contributions shall not be deductible under this chapter; but,/f they would otherwise be deductible, they shall be deductible under this section, subject, however, to ... limitations as to the amounts deductible" (emphasis added).

This opening paragraph conveys two things:

1. Contributions to qualified plans are not deductible under Sec. 162 as ordinary and necessary business expenses; and

2. If such contributions otherwise meet the requirements of Sec. 162 (for example, they are reasonable), then they are deductible under Sec. 404(a), subject to the limits thereunder.

   The limits of Sec. 404 vary depending on the type of plan or plans involved. The principal provisions of Sec. 404 discussed in this article include:

1. Sec. 404(a)(3) on deduction limits for contributions to defined-contribution plans;

2. Secs. 404(a)(12) and 404(1) on the definition of compensation;

3. Sec. 404(n) on the treatment of elective deferrals;

4. Sec. 404(a)(6) on the timing of payments;

5. Sec. 404(o) on deduction limits for contributions to defined-benefit plans for tax years beginning after 2007;

6. Sec. 404(a)(7) on deduction limits when the employer maintains one or more defined-benefit plans and one or more defined-contribution plans; and

7. Sec. 404(a)(8) on special limits in the case of self-employed persons.

   Defined-Contribution Plans

   A defined-contribution plan (that is, a profit-sharing, stock bonus, or money-purchase plan) is allowed a deduction of up to 25% of the compensation paid to beneficiaries of the plan during the employer's tax year) If the contributions are made to two or more such plans, such plans shall be considered a single plan for purposes of applying the 25% limit. (2)

   It is important to note that the 25% limit is a plan-level limit. That is, the allocation to any one participant under the plan is not limited to 25% of such participant's compensation. Rather, Sec. 415(c)(1) provides for an individual limit of the lesser of the dollar limit ($46,000 for plan years ending in 2008) (3) or 100% of the participant's compensation for the year. (The dollar limit is increased by the amount of catch-up contributions, for individuals 50 years of age or older, available under Sec. 414(v), up to $5,000 for 2008.) (4)

   Example 1: In 2008, Company A employs a workforce of 20 union employees and two nonunion employees (the owner and her spouse). Plan 1 covers all union employees and provides for a contribution of 10% of compensation. Union payroll totals $1 million. Plan 2 covers the owner and her spouse, each of whom receive an annual salary of $50,000. Total covered payroll is therefore $1.1 million, 25% of which is $275,000. The contribution to plan 1 is $100,000--that is, 10% of $1 million, leaving $175,000 available for plan 2. A contribution of $92,000 could be made to plan 2, $46,000 each for the husband and wife.

   Compensation

   The limitation on compensations is based on compensation paid during the employer's tax year to the employees who, during that year, are beneficiaries of the funds accumulated under the plan. In Rev. Rul. 80-1456 the Service confirmed that the definition of compensation in the plan is not relevant for purposes of the previously mentioned limits.

   Example 2: A calendar-year employer maintains a calendar-year profit-sharing plan that uses a traditional dual entry system. Employees who enter the plan midyear receive an allocation based only on their compensation earned while participants in the plan. Nevertheless, for purposes of the 25% deduction limit, the individual's compensation for the full year is included.

   Example 3: An employer maintains a plan that defines compensation for allocation purposes as "base" compensation, therefore excluding overtime and bonuses. For deduction purposes, all compensation, including bonuses and overtime, is counted.

   Compensation in excess of the Sec. 401(a)(17) limit--S230,000 for years beginning in 20087--may not be considered for purposes of the deductible limits. (8) Finally, compensation includes the following amounts not included in the employee's income: (9)

   * Amounts not included in the employee's income under Sec. 402(g) (3) pertaining to amounts contributed to 401(k) plans, 403(b) arrangements, salary reduction simplified employee pension plans, and savings incentive match plans for employees;

   * Amounts not included in the employee's income under Sec. 125 pertaining to amounts contributed to cafeteria plans; and

   * Amounts not included in the employee's income under Sec. 132(f) (4) pertaining to amounts contributed to qualified transportation fringe benefit plans.

   Benefiting Participants

   As indicated above, both the Code and the regulations limit the compensation that may be included to compensation paid to "beneficiaries under the plan." In Rev. Rul. 65-295, (10) the Service held that where a profit-sharing plan provided that a terminating employee did not participate in the allocation of the contributions in the year of employment termination, the compensation paid to the employee in that year was not included in the total compensation for purposes of determining the deduction limit.

   The above rule seems relatively clear; if employees are not receiving an allocation, their compensation may not be considered. The ruling, however, was issued long before the advent of 401(k) plans.

   Many 401(k) plans provide for numerous types of contributions--profit-sharing contributions, matching contributions, employee deferrals, etc. Where a profit-sharing...