3735 / What is the maximum amount that an employer may deduct annually for contributions on behalf of employees to a qualified defined benefit pension plan?
The maximum annual limit on deductions by an employer, including a self-employed person, for contributions to a defined benefit pension plan is determined by an actuary who follows regulations that are structured to provide level funding over an employee’s tenure with the employer. An overview of the rules that an actuary follows appears below.
(1) The employer may deduct the amount needed to fund each employee’s past and current service credits distributed as a level amount or level percentage of compensation over the remaining period of his or her anticipated future service. If more than one-half of the remaining unfunded cost is attributable to three or fewer participants, the deduction of such 412(c) unfunded cost for them must be spread over at least five years.1
(2) The employer may deduct the plan’s normal cost for the year, plus an amount necessary to amortize the past service credits equally over 10 years.2 The “normal cost” is the level annual amount that would be required to fund the employee’s pension from his or her date of employment to his or her retirement date.3 The amortizable base is limited to the unfunded costs attributable to past service liability.
(3) In plan years beginning in 2006 or 2007, the employer could deduct a maximum of 150 percent of the plan’s unfunded current liability for the plan year ( Q 3742).4 In the case of a plan that has 100 or fewer participants, unfunded current liability does not include liability attributable to benefit increases for highly compensated employees ( Q 3930) resulting from a plan amendment that is made or that becomes effective, whichever is later, within the last two years.5
(4) In plan years beginning after December 31, 2007, the employer deduction may be determined by calculating the excess, if any, of (1) the funding target for the plan year plus (2) the target normal cost for the plan year and (3) a cushion amount, over (4) the value of plan assets (determined under IRC Section 430(g)(2)). The deduction limit will be the greater of this amount or the sum of the minimum required contributions under IRC Section 430 ( Q 3743).6
(5) A defined contribution plan that is subject to the funding standards of IRC Section 412 (e.g., a money purchase plan) is treated as a stock bonus or profit sharing plan for purposes of the deduction limits; thus, it is generally subject to a deduction limit of 25 percent of compensation.7
Planning Point: Note that an employer is not entitled to a current deduction for defined benefit plan contributions where those contributions are comprised of the employer’s own debt securities. When the employer makes a payment on the debt, the employer is entitled to deduct the amount paid at that time.8
In computing the deduction for a contribution to a defined benefit plan, no benefit in excess of the Section 415 limit may be taken into consideration. Note that, similarly, in computing the deduction for a contribution to a defined contribution plan, the contribution taken into account must be reduced by any annual additions in excess of the Section 415 limit for the year.9
In determining the deductible amount, the same funding method and actuarial assumptions must be used as those that are used for the minimum funding standard.10 The IRS has denied the deduction where it believes contributions are based on unreasonable actuarial assumptions.11 The question of what constitutes a reasonable actuarial assumption was once the subject of extensive litigation; after a steady stream of losses in the Tax Court and federal courts, the IRS announced its concession on the issues on which it lost in those cases.12
In computing the deduction under (1), (2), or (3) above, a plan may not take into consideration any adjustments to the Section 415 limits before the year in which the adjustment takes
effect.13
If the employer contributes more than the maximum deductible amount in any year, the excess amount may be carried over and deducted in succeeding years within the same limitations, even if the plan is no longer qualified in those succeeding years.14 (See Q 3713 for an excise tax on employer contributions that exceed the deduction limits.)
Note that in contrast, a contribution to a defined contribution plan in excess of the Section 415 limits ( Q 3868, Q 3728) may not be carried over and deducted in a subsequent year, even if the contribution is required under the minimum funding rules.15
If, in the case of a defined benefit plan, more than one plan year is associated with the taxable year of the employer due to a change in plan years, then the deductible limit for the employer’s taxable year must be adjusted as described in Revenue Procedure 87-27.16 If an employer transfers funds from one pension plan to another, the employer realizes income if the previous deduction resulted in a tax benefit.17
Fully insured defined benefit pension plans. In guidance for fully insured (Section 412(i)) plans ( Q 3812, Q 3813), the IRS also has stated that the portion of contributions attributable to “excess life insurance coverage” does not constitute “normal cost” and thus is not deductible.
Similarly, contributions to pay premiums for the disability waiver of a premium feature with respect to such excess coverage are not deductible. Instead, such amounts are carried over to later years, although they may be subject to a nondeductible contribution penalty ( Q 3943).
“Excess” coverage generally refers to contracts held on behalf of a participant whose benefit payable at normal retirement age is not equal to the amount provided at normal retirement age with respect to the contracts held on behalf of that participant, or contracts providing for a death benefit with respect to a participant in excess of the death benefit provided to that participant under that plan.18
1. IRC § 404(a)(1)(A)(ii).
2. IRC § 404(a)(1)(A)(iii); Treas. Reg. § 1.412(c)(3)-1(e)(3).
3. For an illustration, see Rev. Rul. 84-62, 1984-1 CB 121.
4. IRC §§ 404(a)(1)(A)(i), 404(a)(1)(D).
5. IRC § 404(a)(1)(D), as in effect for plan years beginning before January 1, 2008.
6. IRC § 404(o).
7. IRC § 404(a)(3)(A)(v).
8. IRS CCM 201935011.
9. IRC § 404(j)(1).
10. IRC § 404(a)(1)(A); Treas. Reg. § 1.404(a)-14(d).
11. TAM 9250002.
12. IR-95-43 (June 7, 1995); Vinson & Elkins v. Comm., 7 F.3d 1235 (5th Cir. 1993); Wachtell, Lipton, Rosen & Katz v. Comm., 26 F.3d 291 (2d Cir. 1994).
13. IRC § 404(j)(2); Treas. Reg. § 1.412(c)(3)-1(d)(i).
14. IRC §§ 404(a)(1)(E), 404(a)(2).
15. Notice 83-10, 1983-1 CB 536, F-1, F-3.
16. 1987-1 CB 769.
17. Rev. Rul. 73-528, 1973-2 CB 13.
18. See Rev. Rul. 2004-20, 2004-10 IRB 546.