3943 / Is there a penalty if an employer contributes more to its qualified plan than it can deduct in a year?

Yes, if the plan is a defined contribution plan.

The penalty for making nondeductible contributions also applied to defined benefit plans until 2008. The employer is subject to a tax equal to 10 percent of the nondeductible amount (determined as of the close of the employer’s tax year) made to a defined contribution plan (e.g., a pension, profit sharing, or stock bonus plan, a simplified employee pension plan, or a SIMPLE IRA plan).¹

Nondeductible contributions are the sum of the amounts that the employer contributes to these plans in excess of the deduction limit for the taxable year plus the total amount of employer contributions for each preceding year that were not allowable as a deduction ( Q 3735, Q 3750, Q 3939, Q 3942).

Regulations provide two exceptions to this penalty, although they have little practical application. They reduce the nondeductible amounts by the sum of the portion of the amounts returned to the employer during the taxable year and the portion of the amounts that became deductible for a preceding taxable year or for the current year.² The amount allowable as a deduction for any taxable year is treated as coming first from carry-forwards from preceding taxable years, in chronological order, and then from contributions made during the taxable
year.³

Defined benefit plan contributions generally are disregarded in determining whether an employer has made nondeductible contributions.⁴ Contributions that are nondeductible solely because of the combined plan deduction limits are exempt from the excise tax to the extent of the greater of (1) the amount of contributions not exceeding 6 percent of compensation or (2) the sum of matching contributions under IRC Section 401(m)(4)(A) plus elective deferrals under IRC Section 402(g)(3)(A) ( Q 3760).⁵

Where amounts contributed in one year to satisfy the preceding year’s funding requirement under a conditional waiver would exceed the deductible limit for that prior year, the employer was permitted to report some of those contributions as contributions for the current year for deduction purposes and avoid the nondeductible contributions penalty.⁶

Although the IRC allows the amount of excess contributions to be reduced by the withdrawal of the excess contribution, there are several restrictions for the return of employer contributions to the employer ( Q 3839). Apparently, the penalty applicable to an excess contribution also is eliminated on plan termination because the plan no longer exists.

The excise tax does not apply in the case of a governmental plan or an employer that is exempt from income tax.⁷ To the extent that an employer has been subject to unrelated business income tax, this exception is inapplicable.⁸ Contributions by a tax-exempt employer that was part of a controlled group including at least one non-exempt employer were subject to the excise tax.⁹

If a self-employed individual contributes more than he or she is permitted to deduct in a year, the individual is subject to a tax penalty equal to 10 percent of nondeductible contributions under the plan determined as of the close of the individual’s tax year. In the case of a plan that provides contributions or benefits for self-employed individuals, this tax is payable by the employer, which is the sole proprietor or the partnership.¹⁰ Contributions required to meet the minimum funding standards are not subject to this tax even if the self-employed individual cannot deduct them because they exceed his or her earned income.¹¹