Deduction Rules/New Rules on Selecting Annuity Providers
Deduction Rules
The deduction rules are defined in IRC Section 404 - Deduction for contributions of an employer to an employees’ trust or annuity plan and compensation under a deferred-payment plan.
25% Limit for Stock Bonus and Profit-Sharing Contributions
IRC Section 404(a)(3) - Stock bonus and profit-sharing trusts provides that contributions will be deductible up to 25% of compensation.
- The 404(a)(3) limit considers all stock bonus and profit-sharing plans of the employer.
- 401(k) deferrals are not included in the 25% calculation.
- C Corporation contributions used for principal and interest payments are generally not counted towards this limit (see below).
- S Corporation contributions used for principal and interest payments are included in this limit
Additional 25% Limit for C Corporation Contributions used for Principal and Interest Payments
Can Both 25% Limits Be Used for C Corporations?
It depends. We discussed this topic in Deducting 50% under IRC Section 404/Who Gets Stock Options as part of our discussion on PLR 200732028:
- IRC Section 6110(k)(3) - Precedential status provides that a Private Letter Ruling (PLR) cannot be “used or cited as precedent.”
- The PLR concluded that additional contributions, which will not be used to pay principal or interest on the ESOP loan, would be deductible up to 25% of compensation under IRC Section 404(a)(3) - Stock bonus and profit-sharing trusts. The requesting party stated that they would amend the plan to “specifically prohibit the application of any contributions made pursuant to Code section 404(a)(3) to the repayment of either principal or interest on the ESOP Loan or any other loan described in Code Section 404(a)(9).”
- This position is consistent with PLR 200436015.
- Combining the 404(a)(3) and 404(a)(9) limits can be further traced back to PLR 9548036, which is discussed in this article. Please note that many of the rules and regulations have changed since it was written.
Contributions Must Not Exceed the IRC Section 415 Limits
The above deductions are provided that the aggregate of the contributions does not exceed the 415 limits, as provided under IRC Section 404(j)(1)(B) - No deduction in excess of section 415 limitation.
What amount should you use as compensation for deduction purposes?
IRC Section 404(a)(12) – Definition of compensation refers to IRC Section 415(c)(3) – Participant’s compensation for the definition. Back-to Basics: Defining Compensation discusses Section 415(c)(3) compensation:
"Code §415(c)(3) provides a “soup-to-nuts” definition of compensation. It
is total compensation, plus certain items of income that are not included on
Form W-2. Examples of 415(c) compensation include wages and fees included in
gross income, earned income of the self-employed, taxable health reimbursements
and the cost of group-term life insurance coverage in excess of $50,000,
reimbursed moving and auto expenses, and taxable nonqualified stock options and
restricted property. It is the required definition for owners of unincorporated
businesses such as partnerships and sole proprietors. Employees of these
entities may have an alternative definition applied. It is the required
definition for determining annual additions; however, the following two
definitions are available for this purpose because they are safe-harbor
definitions under Code §414(s). Note: Since 1998 this definition includes
pre-tax deferrals to 401(k), 403(b) and Section 125 plans. Those amounts can be
disregarded and the definition would still satisfy the Code §414(s)
requirements."
The article also discusses which compensation to use for deductions:
"Determining what compensation must be included in calculating the deductible
contribution limit under Code §404 for defined contribution plans can be
complicated. The limit for a profit-sharing or money purchase pension plan is
25% of eligible compensation, as noted above. Often, questions arise over the
treatment of compensation of terminated participants or employees who receive
allocations in order for the plan to pass coverage requirements or nondiscrimination testing. Is the employer entitled to include the compensation
of such individuals when determining its maximum deductible amount? The answer is yes. Where an individual receives a plan allocation for any purpose including satisfying coverage or correcting a failed ADP or ACP test, the entire
compensation of these individuals is included in determining compensation paid
by the employer. Similar treatment is also extended to 401(k) plans providing
employer matching and discretionary contributions. So long as a participant is
eligible to make elective deferrals to the plan, his or her compensation is
included in determining the maximum deductible contribution. Whether the
employee is eligible to receive a match or profit-sharing contribution is
irrelevant for this purpose."
Additional InformationThese ESOP blog post answer the following questions:
So how much can an employer contribute to an ESOP?
Whoops - what if we contributed too much to our ESOP?:
"The problem is that the contribution in excess of the limit is not only
non-deductible but is generally subject to a 10% excise tax. And the
excise tax may not just be a one-time occurrence. The excess contribution is
carried over and is applied toward the contribution limit in the succeeding
taxable year. Thus, if the employer intends to contribute up to the maximum in
that succeeding year and does not reduce that contribution by the prior year
excess, there will likely be another excess and another excise tax."
New Rules on Selecting Annuity Providers
The Department of Labor announced rules on selecting annuity providers for benefit distributions from pension plans:
"Washington – The U.S. Department of Labor today announced an interim final rule that amends Interpretative Bulletin 95-1 to limit the application of the bulletin to the selection of annuity providers for benefit distributions from defined benefit plans.
The department also announced a proposed rule to provide guidance, in the form of a safe harbor, for the selection of annuity providers by fiduciaries for benefit distributions from individual account plans, such as 401(k) plans.
These rules are being issued pursuant to the Pension Protection Act of 2006, which requires the Labor Department to issue regulations clarifying that the selection of an annuity contract as an optional form of distribution from an individual account plan is not subject to the “safest available” standard under Interpretive Bulletin 95-1, but is subject to all otherwise applicable fiduciary standards.
“The new safe harbor rules will help fiduciaries in prudently choosing annuity providers for distributions from their 401(k)-type plans,” said Bradford P. Campbell, assistant secretary of labor for the department’s Employee Benefits Security Administration.
Under the proposed safe harbor, fiduciaries must: Conduct an objective, thorough and analytical search to identify and select providers. Consider the need to engage
an expert to assist in its evaluation of providers.
Appropriately conclude that the annuity provider would be financially able to make all future payments under the contract, and the cost of the contract is reasonable in relation to the benefits and services to be provided under the contract."
Links to the new release and the regulations can be found in the Rules and Regulations section, which can be accessed from the main menu or by using the buttons located on the top of the right sidebar.