Rev. Rul. 71-330

Advice has been requested whether a pension plan may qualify under section 401(a) of the Internal Revenue Code of 1954 if past service benefits are computed in the manner described below.

The plan provides a benefit of one percent of compensation for each year of participation in the plan. It also provides a past service benefit of one percent of compensation per year of service for employees who were employed before the effective date of the plan. The compensation used in determining current service benefits is the highest average compensation for any consecutive three-year period of participation under the plan. The compensation to be used in computing past service benefits is the average compensation for the three year period immediately preceding the establishment of the plan.

Section 401(a)(4) of the Code provides that in order for a plan to qualify there must be no discrimination in contributions or benefits in favor of employees who are officers, shareholders, supervisors or highly compensated.

Section 1.401-1(b)(3) of the Income Tax Regulations provides that a plan is not for the exclusive benefit of employees in general if, by any device whatever, it discriminates either in eligibility requirements, contributions, or benefits in favor of employees who are officers, shareholders, supervisors or highly compensated. Section 1.401-1(b)(3) of the regulations also points out that the law is concerned not only with the form of a plan but also with its effects in operation. For example, section 401(a)(5) of the Code specifies certain provisions which of themselves are not discriminatory. However, this does not mean that a plan containing these provisions may not be discriminatory in actual operation.

Thus, benefits computed at a uniform rate of compensation for all participants may be nondiscriminatory; but if compensation is adjusted to favor one or a select few, the plan may become discriminatory in operation. For example, under a 50 percent fixed benefit plan, a $25,000-a-year officer who fulfills all requirements for retirement would be entitled to an annuity of $12,500; but if shortly before retirement his compensation is increased to $50,000 per annum, his retirement annuity, computed on final salary, would be $25,000, or 100 percent of compensation before the increase, whereas others would be receiving only 50 percent.

Therefore, in any case where increases in compensation during the last three years of employment are taken into account for the purpose of computing benefits, provision is generally made that such benefits are to be based on compensation averaged over a period of at least three years. Similarly, in a pension plan which provides both past and future service credits, the past service credits may be computed on the average compensation for the three-year period immediately preceding the establishment of the plan.

Accordingly, it is held that the method of computing past service benefits does not prevent this plan from qualifying under section 401(a) of the Code. This Revenue Ruling is not applicable to a plan that is integrated with benefits provided under the Social Security Act. See section 3.01 of Rev. Rul. 69-4, C.B. 1969-1, 118.