PPA Defined Benefit (DB)and Defined Contribution (DC) Deduction Limit
Rev. 12/15/06, Rev. 01/17/07, Rev. 03/30/07, E-mail Alert 2007-23

DB/DC Deduction Limit
The Pension Protect Act (PPA) modification of the 25% combined Defined Benefit/Defined Contribution (DB/DC) limit allows for a potential increased deduction by employers. Employers who sponsor both DB and DC plans covering the same participants now may make an employer contribution of up to 6% of their participants' compensation to the DC plan in addition to the contribution necessary to fund their DB plan. This will allow the total contribution to exceed the previous 25% combined plan deduction limit.

It is important to note that DB plans that are not covered by the PBGC will continue to be subject to the 25% combined deduction limit. Employee elective deferrals continue to be excluded from the deductible contribution calculation (while remaining fully deductible by the employer).

Example
A Doctor age 59 employing two younger NHCEs has a defined benefit plan and a deferral-only 401(k) plan (since deferrals are not included in the deduction limit). Due to the size of the doctor's plan, it is exempt from PBGC coverage.

According to PPA, the allowable deduction limit may exceed the 25% limit that applies to combined DB and DC plans if no more than 6% of compensation is contributed to the DC plan. Therefore, the employer decides to add an enhanced safe harbor matching contribution formula of $/$ on the first 6% deferred. (Note that the DB numbers are hypothetical and not based on actual actuarial calculations.)

Prior to PPA, the Doctor would have been limited to a tax deduction of $78,000 for the DB. (The greater of 25% or the DB minimum funding requirement.) After PPA, the deduction for employer contributions increases to $96,000 with the allowance of a 6% defined contribution plan deduction. Of the additional $18,000 contribution made to the DC plan, the Doctor's portion is $13,500.

Top-heavy resolution
The plans in the above example are both top-heavy. However, because the safe harbor plan only permits deferrals and safe harbor matching contributions, it is exempt from top-heavy requirements. Although the DB plan would not similarly be exempt, in this fact set, the amount of the enhanced match satisfies the DB top-heavy benefit accrual requirement when contributed as an allocation to the DC plan. Note that if participants did not defer at least 5%, then they would have to receive a top-heavy minimum under the DB plan.

PPA’s Deduction Rules for an Employer with Both a DB/DC Plan

DB Plan Not Covered by the PBGC
Effective for 2006, these employers maintaining bot++h DB and DC plans are still subject to the 25% combined plan deduction limit. However, these employers may make a contribution of up to 6% of compensation to their DC plan without the amount being counted towards the 25% limit.

DB Plan Covered by the PBGC
Effective for plan years starting in 2008, for employers with DB plans covered by the PBGC, these plans are no longer subject to the 25% combined DB/DC deduction limit rules. Therefore, DB plans covered by the PBGC may take a deduction for the minimum funding amount even when it exceeds 25% of compensation AND the employer may also take a deduction of up to 25% of compensation for the DC plan.

NOTE: With limited exceptions, most defined benefit plans are covered by Title IV of ERISA and the PBGC. The exceptions are plans of "professional service employers" with 25 or fewer active participants and plans covering only substantial owners and no common law employees.

IRS Notice 2007-28

Notice 2007-28 reiterates that the combined defined benefit plan and defined contribution plan deduction limit is the greater of the 25% DC deduction limit or the DB minimum-funding requirement; and that as of 2006, if the DB limit exceeds the 25% DC limit, an employer may still deduct a DC contribution of up to 6% of compensation. Further, in determining the maximum deductible contribution under combined limit multiemployer plans are excluded from the calculation.

The notice also confirms that 401(k) plans are included in the deduction calculation to the extent that matching and/or nonelective employer contributions are made. However, if a 401(k) plan's contributions are limited to elective deferrals only, such a plan is excluded from the deduction calculations.

The notice explains how to handle the situation where the plan year and the employer's taxable year are not the same. The employer has been provided with three alternatives to determine the allowable deduction when this occurs:

• the deductible limit may be determined for the plan year beginning in the taxable year, or
• the deductible limit may be determined for the plan year ending in the taxable year, or
• a weighted average of the above alternatives may be used.

The deduction limits and applicable law in effect for the applicable taxable year will apply in each instance.

The notice contains two examples of this concept.

When calculating the deductible limit under the 2006 changes, the deductible limit is determined as of the valuation date for the plan year, and it is adjusted for earnings to the earlier of the end of plan year or the end of taxable year of the employer. (This example is found in Treas. Reg. §1.404(a)-14(f)(3).)

For plans with 100 or fewer participants, the unfunded current liability will not include liability attributable to benefit increases for HCEs resulting from a plan amendment adopted or that became effective within the last two years. If a new plan is adopted, it will not treated as a plan amendment if the employer did not maintain a DB plan that covered an HCE during the last two years who is now covered by the new plan. For example, if an HCE was not covered by a DB plan in 2005 or 2004, a new plan established during 2006 would not be penalized by this rule.

Additional changes to allowable deductions for DB funding include the replacement of the current liability limitation under 404(a)(1)(D) with a limitation based on 150% of current liability. Strangely enough, until this Notice was issued, few if any practitioners thought that any employer contribution to the DC plan, even amounts under 6% would cause the loss of the ability to use the 150% limit instead of the current limit. In fact, the situation seems to be even worse. If the employer has a $1,000,000 eligible payroll and a minimum funding requirement of $250,000, but a full funding limitation of $350,000 (without regard to the new 150% rule) it appears under the Notice that the employer could only deduct the $250,000 minimum and any DC contribution up to 6% of compensation ($60,000). It seemingly makes no sense to have a rule that just because the employer maintains a DC plan, even one to which it contributes negligible amounts, that the employer can't deduct more than the greater of minimum funding requirement or 25% of compensation, if it could afford in a given year to increase the plan's funding ratio. This interpretation seems to go against what Congress was trying to achieve in PPA. Hopefully, the IRS will reconsider it position or Congress will correct this as part of any technical corrections legislation it takes up.

In addition 404(a)(1)(F) option to use the permissible 30-year rate range instead of the permissible corporate rate range has been eliminated.

The notice defers addressing the PPA deduction changes that are effective as of the 2008 plan year to guidance that will be issued at a later date.