General
On May 25, 2005, the Internal Revenue Service (the “IRS”) published comprehensive proposed regulations under Section 415 of the Internal Revenue Code (the “Code”) dealing with limitations on benefits and contributions for qualified plans. Code section 415 establishes specific limits on benefits under qualified defined benefit plans and on contributions and other additions under qualified defined contribution plans. These limitations also apply to annuity contracts under Code section 403(b) and to simplified employee pensions under Code section 408(k), as well as to Code section 401(h) individual medical accounts and to key employee medical benefits accounts under Code section 419A(d)(1). The Code section 415 limits also affect the amount of deduction a plan sponsor may take under Code section 404 for contributions to a qualified plan. In addition, the definition of compensation under Code section 415 used for determining plan limits is used for a number of other purposes under the Code.

The IRS last issued final comprehensive regulations under Code section 415 in 1981. Since that time numerous public laws have made various changes to Code section 415; however, with a few minor exceptions the statutory changes have not been reflected in the regulations but in various IRS notices, revenue rulings and other guidance. A comprehensive listing of the relevant public laws and IRS guidance appears in the first section of the preamble to the proposed regulations.

The proposed regulations, with some modifications, reflect the previously published guidance. In addition, the proposed regulations include various and potentially quite significant changes, modifications and clarifications of the existing final regulations. The IRS has also included proposed conforming changes to regulations under Sections 401(a)(9), 401(k), 403(b) and 457 of the Code.

Analysis
The proposed regulations (including the preamble) extend to over 160 pages and cover a number of different issues. The following analysis focuses on certain key parts of the proposed regulations.

Proposed Regulations Section 1.415(a)–1
Section 1.415(a)–1 of the proposed regulations provides the general rules for the limitations under Code section 415 and provides cross-references to special rules for Code section 403(b) annuity contracts, governmental plans and multiemployer plans. A useful feature of this section is the guidance concerning a plan’s incorporation by reference of the Code section 415 rules, including detailed guidance on incorporating cost-of-living adjustments.

Proposed Regulations Section 1.415(b)–1
Section 1.415(b)–1 of the proposed regulations establishes the rules for applying limitations on benefits under a qualified defined benefit plan. Specifically, the proposed regulations reflect the current statutory limitation under Code section 415(b)(1): the lesser of $160,000 (as adjusted) or 100% of the participant’s average compensation during the three consecutive years of his or her highest compensation. In addition, proposed regulations under Section 1.415(b)–1 provide:

• changes made by the Economic Growth Tax and Relief Reconciliation Act of 2001 (“EGTRRA”) to the rules for age adjustments to the relevant limits when a participant begins receiving benefits before age 62 or after age 65;
• the rules for benefit adjustments and the actuarial assumptions to be used in adjusting a benefit payable in a form other than a straight life annuity in order to determine the actuarially equivalent benefit subject to Code section 415(b); and
• the phase-in of the dollar limitation over 10 years of participation.

Other provisions deal with the exclusion from the annual benefit limitation of that portion of the annual benefit attributable to mandatory employee contributions or rollover contributions and clarify the treatment of benefits transferred among plans.

The provisions described in the preceding paragraph, for the most part, reflect previously enacted statutory changes and relevant guidance. The most significant feature, however, of proposed regulations under Section 1.415(b)–1 is a provision restricting compensation used in determining the average compensation of the participant during the three consecutive years of his or her highest compensation to compensation earned during the period the participant was an active participant in the plan. This provision does not relate to a specific statutory change, or any previous regulatory guidance, since the publication of the current final regulations in 1981. Instead, the provision represents an interpretation or clarification of Code section 415(b)(3) by the IRS. A related restriction arises under the proposed regulations for Section 1.415(c)–2. The IRS states that its intent in the proposed Section 1.415(c)–2 regulations is to clarify the relationship between Code section 401(a)(17) and the proposed definition of compensation that a plan must use for determining a participant’s three consecutive years of highest compensation. Under the IRS interpretation, a plan’s definition of compensation for the purposes of applying the limitations of Code section 415 may not reflect compensation in excess of the limitations under Code section 401(a)(17).

The two interpretations of compensation outlined in the preceding paragraph are likely to have a significant impact on benefits. The restriction of compensation to compensation earned while an active participant in the plan could especially affect plans established by owners of small businesses. Such individuals often significantly reduce their compensation after the establishment of a defined benefit plan in order to fund a benefit which would then be based on compensation earned prior to the establishment of the plan. The IRS itself provides an example of the effect of the imposition of the Code section 401(a)(17) limit on compensation to benefit limits, in the preamble to the proposed regulations. If a participant begins receiving benefits in 2005 at age 75, the adjusted dollar limitation under Code section 415(b)(1)(A) could be as high as $379,783; however, if the participant had compensation in excess of the Code section 401(a)(17) limit for 2002, 2003 and 2004, the participant’s benefit would be limited to the average compensation for the participants highest three years as limited by Code section 401(a)(17): that is, $201,667 (the average of $200,000, $200,000 and $205,000).

Although a literal reading of current Code section 415(b)(3) supports the proposed restriction to compensation earned while an active participant in the plan, the current regulations (Treas. Reg. Section 1.415–3(a)(3)) provide, certainly at least on an initial reading, a definition based on total service with the employer. In contrast, the limitation on benefits to Code section 401(a)(17) compensation does not appear to have a statutory justification.

Proposed Regulations Section 1.415(b)–2
The IRS has added a new section to the regulations. Section 1.415(b)–2 provides rules that apply for determining an annual benefit under one or more qualified defined benefit plans when there are multiple annuity starting dates. These rules are most likely to apply when distributions to a participant have commenced under one plan and that plan is then aggregated with a plan from which the participant receives current accruals. Another typical situation in which these rules would apply is when a new distribution election by a participant is effective during the current limitation year for a distribution that began in a preceding limitation year.

Proposed Regulations Section 1.415(c)–1
Section 1.415(c)–1 of the proposed regulations establishes the rules for applying limitations on contributions and other additions under a qualified defined contribution plan. In this regard, the proposed regulations reflect the current statutory limitation under Code section 415(c)(1): the lesser of $40,000 (as adjusted) or 100% of the participant’s compensation. The proposed Section 1.415(c)–1 regulations also reflect a number of other statutory changes and previously issued guidance, including, among other items:

• the revised rules applicable to employee stock ownership plans;
• the application of the limitations imposed under Code section 415(c) to certain medical benefit plans;
• the rules applicable to Section 403(b) annuity contracts; and
• confirmation that payments made to restore losses to a plan resulting from actions by a fiduciary for which there is a reasonable risk of liability for breach of a fiduciary duty do not give rise to annual additions for any limitation year provided that similarly situated participants are treated in a similar manner.

In addition, the proposed regulations under Section 1.415(c)–1 clarify the rules relating to the deadline for making a contribution to the plan to be credited to a participant’s account for a specific limitation year. For taxable employers, the proposed regulations retain the current rule: no later than 30 days after the end of the period described in Section 404(a)(6) of the Code. For taxexempt employers, however, the proposed regulations extend the deadline to the 15th day of the tenth calendar month following the close of the taxable year within which the limitation year ends. (In those instances where the employer’s taxable year coincides with the plan year, this date is the due date for the Form 5500 with extensions.)

Proposed Regulations Section 1.415(c)–2
Section 1.415(c)–2 provides detailed rules concerning the definition of compensation which is used for purposes of applying the limitations of Code section 415 as well as for various other purposes of the Code. As with other sections of the proposed regulations, the rules under Section 1.415(c)–2 reflect a number of statutory changes, the most significant of which is the inclusion in compensation of certain nontaxable elective deferrals under Code sections 125, 132(f)(4), 401(k), 403(b) and 457.

In addition to reflecting statutory changes, the proposed regulations dealing with the definition of compensation also provide significant new guidance in several different areas. As discussed in the section on the proposed Section 415(c)–1 regulations, the proposed regulations under Section 1.415(c)–2 set forth a relation between the limitations on compensation imposed under the Code section 401(a)(17) and compensation as it is defined for various purposes under Code section 415. While this particular clarification may cause certain problems and unexpected restrictions on benefits, new guidance on when payments made after severance from employment are considered compensation for purposes of Code section 415 is likely to prove useful in resolving a previously ambiguous issue. Specifically, payments after severance from employment are included in compensation if they are paid within 2½ months following severance from employment and if:

• absent the severance from employment, they would have been paid to the employee while the employee continued in employment and are regular compensation for the employee’s services, commissions, bonuses or other similar compensation; or
• they are payments for accrued bona fide sick leave, vacation leave or other leave, but only if the employee would have been able to use the leave if he or she had continued employment.

Aside from this exception, severance pay is not includible in compensation for purposes of Code section 415. The proposed regulations also clarify that compensation received by an individual who does not currently perform services for the employer because of qualified military service is included in the definition of compensation for purposes of Code section 415 to the extent the payment does not exceed the amounts the individual would have received if he or she had continued to perform services for the employer.

Miscellaneous Provisions
Remaining sections of the proposed regulations deal with cost of living adjustments (including a safe harbor following such an adjustment), combining and aggregating plans, disqualification of plans and trusts, and the limitation year.

Comments; Effective Date
Written or electronic comments on the proposed regulations must be received by July 25, 2005. The IRS has scheduled a public hearing for August 17, 2005. The proposed effective date for the regulations is the plan’s limitation year beginning on or after January 1, 2007. Certain limited exceptions are provided relating to post-severance compensation and other compensation timing rules, certain changes in form of payment and certain corrective and clarifying changes in the regulations under Code section 457.

This article was originally published as an ASPPA asap 05–17