Final regulations under Internal Revenue Code (“Code”) section 415 were issued by the Internal Revenue Service (“IRS”) on April 5, 2007. These regulations generally reflect the proposed regulations that were issued on May 25, 2005 (see our June 2005 issue) but also include changes from the proposed regulations. Significant changes are discussed below. The final regulations are effective April 5, 2007, but generally apply to limitation years beginning on or after July 1, 2007 for non-governmental plans. Governmental plans are subject to a delayed effective date.

General

Code section 415 imposes annual limits on the amount of benefits that can be provided under a qualified defined benefit plan and limits the amount of employer contributions, employee contributions and forfeitures (i.e., annual additions) that can be provided under a defined contribution plan. Certain limitations under Code section 415 also apply to arrangements governed by Code section 403(b) and Code section 408(k) Simplified Employee Pensions (SEPs). In addition, the Code section 415 limitations apply to Code section 401(h) individual medical accounts that are part of a defined benefit plan and medical accounts for key employees established pursuant to Code section 419A(d)(1).

Definition of Compensation

The limitations under Code section 415 are generally based on a participant’s compensation, and the rules have always contained various definitions of compensation for purposes of applying the limitations. The final regulations provide for the inclusion in compensation of pre-tax elective deferrals under Code sections 401(k), 403(b), 457, 125 and 132(f)(4), and certain deemed amounts for totally disabled participants as defined under Code section 22(e)(3). The final regulations also modify the rules on compensation with respect to employees who are non-resident aliens.

Under both the proposed and final regulations, payments made after severance from employment are excluded from compensation, with some exceptions. The proposed regulations specified that certain compensation received following a severance from employment may be includible in compensation provided such payments are paid within 2½ months following the severance from employment. This compensation includes:

• payments that, absent a severance from employment, would have been paid to the employee while the employee continued in employment with the employer and that are regular compensation for services during the employee’s regular working hours, compensation for services outside the employee’s regular working hours (such as overtime or shift differential), commissions, bonuses, or other similar compensation; and
• payments for accrued bona fide sick, vacation, or other leave, but only if the employee would have been able to use the leave if employment had continued.

The final regulations retain these rules regarding payments made after severance from employment. However, they relax the timing requirements so that these post-termination payments are includible in compensation if they are paid by the later of 2½ months after the severance from employment or the end of the limitation year that includes the date of severance from employment.

Note that the final regulations require the plan to specifically provide for the inclusion of payments for accrued bona fide sick, vacation, or other leave in the definition of compensation if they are to be included. In addition, the final regulations permit a plan to specify that nonqualified deferred compensation plan payments that are received post-termination will be included in the definition of compensation, subject to the above timing rules, provided that the payment would have been made at the same time if the employee remained employed and only to the extent such payment is includible in the employee’s gross income.

In addition, as provided under the proposed regulations, the rules that exclude from compensation payments made after severance from employment do not apply to an individual who is performing qualified military service (as defined in Code section 414(u)(1)), and thus is not performing services for the employer. These payments cannot exceed the amount of compensation the individual would have earned if he or she were not performing military service.

Determination of High-3 Average Compensation

Under Code Section 415(b), a participant’s annual benefit from a defined benefit plan is limited to the lesser of the applicable dollar limit or the highest average of the participant’s compensation over three consecutive years of service. The proposed regulations contained two new provisions pertaining to calculation of a participant’s high-3 average compensation. The first provision, requiring active participation in the plan, has been eliminated from the final regulations pursuant to section 832 of the Pension Protection Act of 2006 (“PPA”). However, the final regulations retain the second provision, which specifies that compensation in excess of the Code section 401(a)(17) limit cannot be considered when calculating a participant’s high-3 average compensation. The final regulations indicate that if a participant who commences receiving benefits in 2006 had compensation in excess of the applicable Code section 401(a)(17) limit for years 2003, 2004 and 2005, the participant’s benefit under the plan is limited to $205,000 (the average of $200,000, $205,000 and $210,000 — the annual compensation limits for those years).

The final regulations also contain a grandfather provision with respect to pre-existing benefits under a defined benefit plan. A defined benefit plan will satisfy the Code section 415(b) limits with respect to a participant’s benefits accrued or payable as of the end of the limitation year immediately prior to the effective date of the final regulations provided that plan provisions that meet the requirements of statutory provisions, regulations and other published guidance in effect immediately prior the effective date of the final regulations were both adopted and in effect before April 5, 2007.

The final regulations also include a rule for calculating high-3 average compensation with respect to a participant who is employed for less than three consecutive years. In this case, the high-3 years of service are the actual number of consecutive years of service (including fractions) but not less than one year.

Another change from the proposed regulations pertains to rehires. The final regulations add a rule providing that if a participant has a severance from employment and is subsequently rehired by the employer, then the participant’s high-3 years of service is calculated by taking the period of time prior to severance from employment and adding it to the period of time after the participant is rehired, as if they were consecutive. Years during which the participant performs no service and receives no compensation from the employer are not counted.

Exclusion of Certain Contributions from Defined Benefit Plan Limitations

The final regulations retain the rule from the 1981 final regulations that, for purposes of the Code section 415(b) limitations, the annual benefit does not include the annual benefit attributable to mandatory employee contributions. If a defined benefit plan provides for voluntary employee contributions, that portion of the plan is treated as a defined contribution plan and is not considered in determining the annual benefit. Both mandatory and voluntary employee contributions to a defined benefit plan are treated as contributions to a defined contribution plan for purposes of the Code section 415(c) limitations.

In addition, the final regulations clarify that the annual benefit does not include the annual benefit attributable to rollover contributions or direct rollovers.

The final regulations also clarify that the following are disregarded when determining the annual benefit attributable to employee contributions under Code section 415(b):

• Contributions picked up by a governmental employer;
• Repayment of participant loans;
• Repayment of previously distributed amounts;
• Repayment of a withdrawal of employee contributions; and
• Certain other repayments.

No Adjustment for Differences in Payment Frequency

The final regulations provide that no adjustment to the Code section 415(b) dollar limitation is made on account of timing if a benefit is payable as a straight life annuity. The final regulations offer the following example:

• If the Code section 415(b) dollar limit for a limitation year is $180,000, a plan is not permitted to provide for 12 monthly payments of $15,583 (which is actuarially equivalent to an annual benefit of $180,000 payable on the first day of the year).

The adjustment made for delayed payments in the above example results in total payments for the year of $186,996 (nearly $7,000 in excess of the $180,000 limitation).

Adjustments continue to be required for early or late commencements (i.e., benefits that commence before age 62 or after age 65) in accordance with Treasury Regulations section 1.415(b)–1(a)(4).

Actuarial Assumptions Used to Convert Benefit to a Straight-Life Annuity

The final regulations contain a new method for calculating the actuarially equivalent straight life annuity for a form of benefit that is subject to Code section 417(e)(3), and a new simplified method for calculating the actuarially equivalent straight life annuity for a form of benefit that is not subject to Code section 417(e)(3).

Social Security Supplements

The final regulations clarify that social security supplements, although they may be an ancillary benefit, are included in determining the annual benefit under Code section 415(b)(2)(B) because they are payable upon retirement.

Multiple Annuity Starting Dates

A participant will have multiple annuity starting dates if:

• distributions have previously commenced under a plan that is aggregated for Code section 415 purposes with a plan under which that participant is currently accruing benefits; or
• a new distribution election for a distribution which has previously commenced is effective during the current limitation year.

If a participant has multiple annuity starting dates, then the Code section 415 limitations must be met as of each starting date taking into account benefits that have or will be provided at all of the annuity starting dates. The IRS received numerous comments on the multiple annuity starting dates provisions of the proposed regulations and is developing new proposed regulations on this topic.

Cost-of-Living Adjustments

The final regulations provide that, for defined benefit plans, the adjusted dollar limit applies to current employees and may be applied to former employees and retirees who have a nonforfeitable right to accrued benefits, including those who have not yet begun to receive benefits. The proposed regulations provided that if a plan incorporates the Code section 415(d) cost-of-living adjustments by reference, when a distribution is increased only for the cost-of-living adjustment the distribution is treated as continuing to satisfy the Code section 415(b) requirements and is not subject to the rules on multiple annuity starting dates. The final regulations retain this safe harbor and provide two additional safe harbors for cost-of-living adjustments. Both new safe harbors provide for increasing benefits in direct proportion to the cost-of-living increase in the annual benefit limit. The first provides a formula for a single year adjustment and the second provides a formula for adjustment over multiple years.

Plan Aggregation Rules

The final regulations contain various changes to the plan aggregation rules and provide guidelines to be followed when plans that must be aggregated have overlapping limitation years. They modify the proposed regulations with regard to how defined benefit plan benefits are treated when benefits are transferred to another plan or a plan is terminated. The final regulations clarify that an employer’s plans must be aggregated with the plans maintained by a predecessor employer, even if the successor employer does not assume the predecessor’s plans. An employer is a successor employer if the employer continues all or part of the trade or business of the former entity. The final regulations also contain rules regarding when an employer will cease to be aggregated with another entity or entities, and rules for aggregating participation and service under the 10-year phase-in for defined benefit plans.

The final regulations retain the rule from the proposed regulations that multiemployer plans cannot satisfy the Code section 415 limitations separately with respect to benefits or contributions from each employer. Permissive disaggregation of multiemployer plans is no longer permitted; benefits and contributions attributable to a participant from all of the employers maintaining the multiemployer plan must be taken into account.

Miscellaneous Provisions

The final regulations provide that there will be no early retirement reduction for commencement of benefits prior to age 62 for a participant in a defined benefit plan of a state or local government or an Indian tribal government (or certain political subdivisions thereof) who is credited with at least 15 years of service for benefit accrual purposes as:

• a full-time employee of any police department or fire department of a state or local government or Indian tribal government (or a political subdivision thereof that provides police protection, firefighting services, or emergency medical services), or
• a member of the Armed Forces of the United States.

The final regulations also contain special rules for church plans.

Defined Contribution Plans — Restorative Payments

The final regulations provide that restorative payments are not counted as annual additions in any limitation year. Restorative payments are payments made to restore plan losses resulting from a fiduciary breach where there is a reasonable risk of liability for breach of fiduciary duty under Title I of ERISA (other than a failure to timely remit participant contributions). The final regulations add a new provision for losses resulting from a fiduciary breach where there is a reasonable risk of liability for breach of fiduciary duty under other applicable federal or state law. Restorative payments do not include payments to make up for market fluctuations, payments to cover early termination or redemption fees in the case of a change in investment funds, or other payments not made on account of a reasonable risk of liability for breach of fiduciary duty. For more information on restorative payments see IRS Revenue Ruling 2002–45.

Plan Amendment Timing

A qualified plan must now file for a determination letter once every five years. However, because a plan provision that results in a failure of the plan to satisfy the final regulations is a disqualifying provision, an interim amendment must be adopted (pursuant to Revenue Procedure 2007–44) by the end of the remedial amendment period described in Treasury Regulations section 1.401(b)–1. Therefore, in the case of a plan with a calendar year plan year and a calendar year limitation year that is sponsored by a nongovernmental employer with a calendar year tax year, the plan’s remedial amendment period with respect to the final regulations generally ends on the date prescribed by law for the filing of the employer’s income tax return (including extensions) for the 2008 taxable year.

However, plan amendments for changes made to Code section 415 by the PPA must be made by the last day of the first plan year beginning on or after January 1, 2009. An amendment for the 5.5% interest rate (for determining the actuarially equivalent straight life annuity for a form of benefit that is subject to Code section 417(e)) required by the Pension Funding Equity Act of 2004 must, under the provisions of that statute as amended by the PPA, be made by the last day of the first plan year beginning on or after January 1, 2008.