The Internal Revenue Code limits deductions for contributions to a 401(k) Plan to 25% of the compensation (limited to $255,000 for 2013) of plan beneficiaries, plus the amount of elective deferrals made by employees participating in the 401(k) arrangement. The IRS recently ruled privately that a plan does not include the compensation of a participant who is only eligible for the elective deferral portion of the plan (i.e., not benefiting under the nonelective or matching portions of the plan). The IRS concluded that since elective deferrals are not considered in applying the deduction limits, a participant who is only benefiting under the elective deferral portion of the plan should be disregarded when determining which employees are beneficiaries under the plan for purposes of applying the deduction limits.
IRS regulations do not define who is a beneficiary under the plan for deduction purposes, nor are there any cases interpreting how this rule, which was enacted in 2001, should be applied.
However, in this case, the most conservative position is certainly not the only supportable position. While the Code §404 regulations do not define “beneficiary” for purposes of deduction, Treas. Reg. §1. 410(b)-3(a)(2)(i ) states that for coverage purposes a participant is “benefiting” from a 401(k) plan if the participant is eligible to defer to the plan. However, the history of this change to a 25% deduction limit suggests the IRS position may not be the correct one. It provides as follows:
For purposes of the deduction limits, compensation means the compensation otherwise paid or accrued during the taxpayer year to the beneficiaries under the plan, and the beneficiaries under a profit sharing or stock bonus plan are the employees who benefit under the plan with respect to the employer’s contribution. An employee who is eligible to make elective deferrals under a section 401(k) plan is treated as benefiting under the arrangement even if the employee elects not to defer.
In support of the final sentence, the legislative history refers to the IRS regulations determining who must be covered by a plan. Those regulations state that a participant is considered benefiting under a plan if he or she is eligible to defer to the plan. However, the specific provision that excludes elective deferrals from the 25% deduction limit does not discuss the issue of which employees are beneficiaries. In the private letter ruling, the IRS considered the coverage rule and rejected its application to determining the deduction limit.
A private letter ruling has no precedential value. Neither taxpayers nor the IRS can cite it in court, other than the specific taxpayer who received the ruling. However, such rulings do reflect IRS position and are frequently used for guidance when there is no authoritative guidance. Under the circumstances, the most conservative position to take in tax planning is to disregard the compensation of employees who are eligible to defer, but not to receive employer contributions, in calculating the deduction limit. An employer could reasonably take the more aggressive position, recognizing that the IRS may challenge that position.
Fortunately, the ruling has limited application; that is, only to plans where an employee is making salary deferrals but not receiving any allocation of employer matching or non-elective contributions. This might be the case, for example, where a plan has a one-year wait to receive employer contributions but allows an employee to make elective deferrals immediately, or after a waiting period of less than one year.