On March 14, 2007, the Internal Revenue Service (“IRS”) released Notice 2007–28 (“Notice”) providing guidance concerning the changes made by the Pension Protection Act of 2006 (“PPA”) to the deduction limits under Section 404 of the Internal Revenue Code (“Code”). Some changes to the deduction limits made by the PPA are effective for tax years beginning after December 31, 2005, while others are effective for tax years beginning after December 31, 2007. The Notice does not address the rules that will be effective in 2008 and later tax years. The changes that are addressed by the Notice are those which are effective now. These changes include both an increase in the deduction limits applicable to single employer and multiemployer defined benefit plans, and changes to the combined deduction limit applicable to employers that sponsor one or more defined benefit plans and one or more defined contribution plans.
Tax Year versus Plan Year
The Notice clarifies the application of these changes if the tax year of the employer differs from the plan year of the relevant plan. In such circumstances, the deduction limit is permitted to be determined:
- for the plan year beginning in the tax year;
- for the plan year ending in the tax year; or
- based on a weighted average of the limits for each of those two plan years.
For example, assume an employer has a calendar year tax year and sponsors a defined benefit plan with a plan year ending June 30. The employer can determine the deduction limit for its 2006 tax year under the new rules with reference to either the plan year beginning July 1, 2006 or the plan year ending June 30, 2006; in the alternative, it can use the weighted average of the limits determined with respect to both plan years.
Deduction Limits for Defined Benefit Plans
The PPA provides that the maximum amount that an employer may deduct for contributions is 150 percent of current liability in the case of a single employer defined benefit plan or 140 percent of current liability in the case of a multiemployer defined benefit plan. The Notice provides that, for this purpose, the limit is determined as of the valuation date for the plan and is adjusted for any interest earned through the earlier of the end of the plan year or the end of the taxable year of the employer. The Notice also provides that an employer no longer has the option of using the weighted average interest rate for 30-year Treasury securities to calculate the current liability. Instead, all employers must use the weighted average interest rate for corporate bonds.
In the case of any defined benefit plan that has 100 or fewer participants for the plan year, unfunded current liability for deduction purposes generally does not include any liability arising from a plan amendment made within the past two years which provides greater benefits to any highly compensated employee (“HCE”). The Notice elaborates on this rule by providing that the adoption of a new plan is treated as a plan amendment if any HCE covered under the newly adopted plan was covered by another defined benefit plan of the employer within the past two years. Thus, if an HCE was covered by a defined benefit plan of the employer at any time during 2004 or 2005, and the employer established a new plan during the 2006 taxable year which covers that HCE, the new plan would be considered a plan amendment for these purposes.
Combined Plans Deduction Limit
The PPA relaxed the deduction limitation on contributions by an employer that has a defined benefit and defined contribution plan that both cover at least one of the same employees. Generally, the contribution deduction for combined plans is limited to the greater of 25 percent of compensation or the amount required to meet the minimum funding requirement of the defined benefit plan (but no less than its unfunded current liability). In determining this combined plan limit, the PPA excludes multiemployer plans from consideration. Thus, under the new rule, if either plan is a multiemployer plan, separate deduction limits for contributions to defined contribution plans and defined benefit plans apply. The PPA further relaxed the combined plan limit by providing that it only applies to the extent employer contributions exceed six percent of compensation. According to the Notice, when employer contributions to a defined contribution plan exceed the six percent threshold, the deduction limit applies to the total employer contributions to both the defined benefit plan and the defined contribution plan, less six percent of the compensation of the participants in the defined contribution plan. The Notice clarifies that when calculating employer contributions to a defined contribution plan for purposes of the combined plan limit, elective deferrals made by the plan participants are excluded, but matching or nonelective contributions made by the employer are included.
The Notice provides unexpected guidance with respect to the application of the combined plan limit when employer contributions to the defined contribution plan do not exceed the six percent threshold. Some originally interpreted the PPA to provide that if employer contributions do not exceed six percent of compensation, the combined limit does not apply to either plan. The Notice takes a different position by providing that, under these circumstances, while the deduction limit does not apply to any employer contributions to the defined contribution plan, it continues to apply to employer contributions to the defined benefit plan. It is yet to be seen how this interpretation by the IRS will impact an employer’s ability to take advantage of the increased 150% of current liability deduction limit.
Future Changes in Deduction Limits
This article only discusses the changes made by the PPA that are effective for tax years beginning after December 31, 2005. There are significant changes to the deduction limits under Section 404 of Code effective for tax years beginning after December 31, 2007, on which the IRS is expected to provide guidance. We will update you on these rules when the related guidance is issued by the IRS. Please contact our office if you have any questions.