Deductions Under Code §404
Rev. 06/22/06, E-mail Alert 2006-12

An employer’s plan year does not match its fiscal year. The rule of thumb to remember is that an employer may only deduct contributions based on compensation that is actually paid during the employer’s taxable year.

If the employer's fiscal year is different from the Plan Year, Internal Revenue Code §404 states that the contribution is deductible in the tax year that ends with or within the taxable year of the trust. However, the employer may only deduct contributions based on compensation that is actually paid during the employer's tax year.

Example. An employer has a fiscal year ending June 30; however its 401(k) plan uses the calendar year as its plan year. The employer received an extension to March 15, 2006 to file its tax return for the fiscal year ending June 30, 2005. On that tax return, the employer claimed a deduction for the entire amount of elective deferrals and matching contributions contributed to the plan during the 2005 calendar year. Although all of the contributions had been made by December 31, 2005 in accordance with plan terms, the IRS disallowed the deduction for any contributions based on compensation earned after June 30, 2005, the last day of the employer's tax year [see Revenue Ruling 90-105].

Mapping out the dates in this example:

• July 1, 2004 to June 30, 2005 = Employer's 2004 Fiscal Year
  
• Jan. 1, 2005 to Dec. 31, 2005 = 401(k) Calendar/Plan Year 2005
  
• Employer Deduction for Matching Contributions May Be Taken Only for Matching Contributions Based on Compensation Paid from July 1, 2004 to June 30, 2005.

Thus, the IRS disallowed the deduction for the matching contributions on compensation paid between July 1, 2005 and Dec. 31, 2005.