On April 5, 2007, the US Department of Treasury ("Treasury") issued final regulations (the "Final Regulations") under Section 415 ("Section 415") of the Internal Revenue Code of 1986, as amended (the "Code").1 The Final Regulations, intended to be comprehensive in nature, adopt many of the provisions that were contained in proposed Treasury regulations (the "Proposed Regulations") under Section 415 that were issued on May 25, 2005,2 with a significant number of additions, including some which reflect changes made to Section 415 by the Pension Protection Act of 2006 (the "PPA") or in response to concerns raised by commentators. By issuing the Final Regulations, the Treasury has not only updated its guidance to reflect recent developments in the law, but also has tied together a large number of loose ends by consolidating and updating much of its prior guidance.
Section 415 was added to the Code by the Employee Retirement Income Security Act of 1974, as amended (ERISA), in an effort to limit the amount of benefits that may be received under tax-qualified employee benefit pension plans3. Currently, there are separate limits applicable to defined benefit pension plans and defined contribution pension plans. Generally stated, for 2007,4 the maximum amount that a defined benefit pension plan may provide in annual benefits cannot exceed the lesser of (i) $180,000 or (ii) 100 percent of a participant's high three-year average "compensation" (as defined in Section 415). With respect to defined contribution plans, for 2007, contributions made to such plans may not exceed the lesser of (i) $45,0005 or (ii) 100 percent of a participant's "compensation."
Comprehensive Treasury regulations under Section 415 were last issued in 1981.6 Since such time, numerous federal laws have been enacted modifying Section 415; e.g., the Tax Reform Act of 1986 ("TRA '86") and the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), among many others. In addition to statutory changes, Section 415 has been affected by the issuance of a large number of Internal Revenue Service (IRS) pronouncements which serve to indicate the position of the IRS on matters relevant to Section 415; the Final Regulations generally incorporate such prior guidance, where still applicable.
The Final Regulations are over 200 pages (the preamble itself is over 60 pages) in length and contain a large number of highly detailed provisions. The purpose of this article is not to be exhaustive, but merely to highlight what we consider to be some of the more significant points that may be of interest to our clients. In each such case, for purposes of simplicity, the level of detail pertaining to such points has been kept to a minimum.
Significant Provisions Contained in the Final Regulations
- Definition of Compensation with Respect to Post-Separation Payments. Generally speaking, payments made subsequent to an employee's separation from employment do not constitute "compensation" for Section 415 purposes. In a departure from the IRS's prior position, the Final Regulations provide that certain post-separation payments are treated as compensation if they were received within the later of (i) two and one half months after the date of severance of employment or (ii) the end of the limitation year7 in which a participant's severance of employment occurred.8 The types of payments that fall into the two and one half-month exception include (i) salary, wages, overtime, shift differential, commissions, bonuses and similar amounts earned pre-separation, provided that such amounts would have been payable had the employee not terminated employment (such types of payments do not include what is normally thought of as severance pay) and (ii) accrued bona fide sick, vacation, and other leave that, in each case, would have been usable had the employee not terminated employment (provided that a plan provides that such payments are included in "compensation").9 Additionally, post-separation payments from a nonqualified unfunded deferred compensation plan fit into the two and one half- month exception, provided that (i) such payments would have been made at the same time had the employee not terminated employment (which implies that the payment must be of the same type that would have been distributed at the same time had the employee not terminated employment) and (ii) the plan provides that such payments are included in "compensation" for plan purposes.
- Compensation with Respect to Qualified Military Service and/or Disability. Under the Final Regulations, if a plan so provides, payments made with respect to "qualified military service" (as defined in the Code), or made as a result of total and permanent disability, may be included in "compensation" even beyond the two-and-a-half-month period, provided that certain conditions are met.
- Compensation Limited by Code Section 401(a)(17). For Section 415 purposes, the amount of compensation that may be taken into account is limited by Code Section 401(a)(17) (i.e., $225,000 for 2007). However, due to commentator concerns, a "grandfather" provision allows compensation in excess of the Code Section 401(a)(17) limit to satisfy the annual benefit limitations with respect to benefits accrued or payable at the end of the limitation year prior to the effective date of the Final Regulations, provided that the relevant plan provisions meeting the statutory and regulatory requirements in effect immediately prior to the effective date of the Final Regulations (i.e., April 5, 2007) were adopted and in effect prior to such date. (This "grandfather" provision generally affects only individuals who earn more than the Section 415 limit.)
- Non-Resident Aliens. The Final Regulations liberalize the rules regarding nonresident alien participants having no US source income. Under the Final Regulations, amounts paid as compensation to such nonresident aliens for services rendered generally constitute "compensation" for Section 415 purposes, even if such amounts are (i) excluded from gross income or (ii) not includable in the individual's gross income on account of the location of the services performed. The effect of this provision is that non-resident aliens having no US source income are not prohibited by Section 415 from participating in tax-qualified plans.
- Timing Rule for Annual Additions. Generally, annual additions are credited to participants' accounts within the limitation year in which allocations are made pursuant to the terms of the plan. The Final Regulations clarify that if, under the terms of the plan, an allocation is dependent upon the satisfaction of a condition (e.g., continued employment), then the annual addition is considered to be allocated during the limitation year in which such condition is satisfied. Additionally, the Final Regulations retain the rule that an employer contribution to a plan is generally not considered to be allocated to a participant's account unless it is actually made to the plan no later than 30 days after the due date (including extensions) of the sponsoring employer's tax return for the taxable year in which the limitation year ends.10
- High Three Years of Plan Participation. For defined benefit plans, average compensation for Section 415 purposes is determined based upon a participant's highest three years of service with the sponsoring employer(s). The Final Regulations reflect the PPA provision that eliminated the prior "active participation" rule contained in the Proposed Regulations for years beginning after December 31, 2005, meaning that all years of a participant's service (including years of service prior to plan participation) may now be taken into account in calculating average compensation over a participant's high three years.
- Cost of Living Adjustments (COLAS). In response to concerns by commentators that the Proposed Regulations did not adequately address situations where benefits that already have commenced under a defined benefit plan are increased periodically by plan amendments reflecting the cost-of-living adjustments, the Final Regulations provide two new safe harbors applicable to such plans, setting forth the circumstances under which they may be so amended. Very generally stated, the safe harbors prescribe complex calculations intended to ensure that the amount of increases do not exceed the applicable COLA increases under Section 415 (e.g., with respect to partial years).
- Early or Late Commencement of Benefits. Under Section 415, the defined benefit plan limit (i.e., $180,000 for 2007) must be adjusted with respect to benefits that are payable prior to age 62 or subsequent to age 65. Under the Final Regulations, generally, no adjustment is required to reflect mortality assumptions (i.e., the probability of a participant's death prior to age 62 or after age 65), if a forfeiture does not occur upon a participant's death prior to the annuity starting date. Additionally, the age-adjusted dollar limit generally does not decrease due to increases in the age of a participant, or the performance of additional services.
- Actuarial Assumptions. The Final Regulations generally simplify the calculations with respect to the conversion of benefit forms other than straight life annuities (i.e., benefit forms subject to Code Section 417(e)(3)) to other, actuarially equivalent benefit forms. Generally stated, solely with respect to benefit forms other than straight life annuities, such benefit forms may be converted based on the straight life annuity that would be payable at the same age under the plan, as opposed to the previous, more complex calculation.11 In this regard, the Final Regulations reflect the provisions of both the Pension Funding Equity Act of 2004 and the PPA, both of which impacted the actuarial assumptions that are to be used in calculating such equivalencies.
- Treatment of Benefits Paid Partially in the Form of a QJSA. Generally stated, the Final Regulations expand the rules stating that the survivor portion of any qualified joint and survivor annuity (QJSA) is not taken into account in determining the annual benefit for Section 415 purposes. Under the Final Regulations, benefits paid partially in the form of a QJSA and partially in another form are also subject to this rule; for example, if a benefit is paid partly in the form of a QJSA and partly in the form of a lump sum, the survivor portion of the QJSA is not taken into account for Section 415 purposes.12
- Plan Aggregation Rules. Very generally stated, the Final Regulations limit the extent to which benefits under plans maintained by predecessor employers must be aggregated, and add a rule generally prohibiting the "double counting" of a participant's benefit when applying the aggregation rules. Additionally, a new rule provides that, where a tax-qualified defined contribution plan is aggregated with a Code Section 403(b) tax-sheltered annuity contract, excess amounts (if any) are deemed to be attributable to the Section 403(b) annuity contract, as opposed to the tax-qualified plan.
The Final Regulations generally are effective for limitation years beginning on or after July 1, 2007 (i.e., for calendar year plans, the effective date is January 1, 2008).
Generally, most plans will need to be amended to comply with the Final Regulations no later than the sponsoring employer's tax return due date (including extensions) for the year in which the Final Regulations become effective (i.e., for calendar year plans, September 15, 2009).
However, changes to plans necessitated by the Final Regulations have been included in the 2007 IRS "cumulative list" of plan amendments that must be made prior to a filing for a favorable determination letter. Under IRS Revenue Procedure 2007-44, individually designed plans that are "Cycle C" plans (i.e., plans whose sponsoring employer's EIN ends in a "3" or an "8") must be amended to reflect changes included in the 2007 cumulative list. Therefore, such plans must be amended to reflect the Final Regulations on or before January 31, 2009 (which is prior to the general amendment date applicable to calendar year plans of September 15, 2009).13
As previously stated, the Final Regulations represent the first major consolidation of IRS guidance issued under Section 415 since 1981. Due to the highly technical nature of Section 415, and the vastly changing landscape attributable to the large number of statutory and other changes enacted or promulgated since such time, the Final Regulations are necessarily both lengthy and complex. For purposes of brevity and clarity, there are numerous provisions contained in the Final 415 Regulations that have not been addressed in this article that could be applicable to your plan(s). Proper interpretation and implementation of the Final Regulations as applied to a particular situation generally will require legal and, at times, actuarial consultation and advice. As always, White & Case would be happy to assist or advise you with respect to any specific issues regarding Section 415 and/or the Final Regulations applicable to your plan(s).