Rev. Rul. 74-142

Advice has been requested whether, under the circumstances described below, the method of funding the pension benefits prevents the pension plan from qualifying under section 401(a) of the Internal Revenue Code of 1954.

A professional service corporation established a pension plan for the benefit of all its employees. The plan provides a retirement benefit of 60 percent of the career average compensation of each participant and all benefits are fully vested when accrued. A participant's normal retirement date is the later of his 65th birthday or the date on which he has 10 years of participation in the plan. The restrictions of section 1.401-4(c) of the Income Tax Regulations were incorporated in the plan. At the inception of the plan the shareholder-employee was 60 years of age and the only other employee was 52 years of age.

Because of this difference in ages and the differences in their compensation, 90 percent of the contributions are applied to fund the benefits of the shareholder-employee. The shareholder-employee's total compensation, including contributions to the pension plan, did not exceed reasonable compensation.

Section 401(a) of the Code provides for the qualification of a pension plan that meets the requirements of that section. Under that section a qualified plan is one in which there is no discrimination in contributions or benefits in favor of employees who are officers, shareholders, supervisors, or highly compensated. However, section 401(a)(5) provides that a plan shall not be considered discriminatory within the meaning of section 401(a)(3)(B) or (a)(4) merely because the contributions or benefits of or on behalf of the employees under the plan bear a uniform relationship to the total compensation, or the basic or regular rate of compensation, of such employees.

Section 1.401-1(b)(2) of the regulations provides that the term "plan" implies a permanent, as distinguished from a temporary, program. Thus, although the employer may reserve the right to change or terminate the plan, and to discontinue contributions thereunder, the abandonment of a plan for any reason other than business necessity within a few years after it has taken effect will be evidence that the plan from its inception was not a bona fide program for the exclusive benefit of employees in general. Especially will this be true if, for example, a pension plan is abandoned soon after pensions have been fully funded for persons in favor of whom discrimination is prohibited under section 401(a) of the Code. The permanency of the plan will be indicated by all of the surrounding facts and circumstances. See also section 2.02 of Rev. Rul. 69-25, 1969-1 C.B. 113.

Section 3.01 of Rev. Rul. 69-25 states that there is a presumption that a newly established plan is being established in good faith as a permanent program, unless there is clear evidence to the contrary in the facts and circumstances surrounding the adoption of the plan. Therefore, Rev. Rul. 69-25 states that, in most cases, the issue of intended permanence is resolved in favor of the taxpayer at the time of the adoption of the plan.

Section 401(a)(4) of the Code does not require a ceiling or similar limitation on the proportion of the total contributions or benefits that may be provided for a shareholder-employee if the benefits to be provided bear a uniform relationship to compensation and the plan is not otherwise discriminatory. See Rev. Rul. 71-255, 1971-1 C.B. 125, which holds that a plan is not discriminatory merely because the benefits thereunder are based on current compensation, 80 percent of which is paid to a shareholder-employee.

In this case, although benefits for each employee will equal 60 percent of his career average compensation, the shareholder-employee's benefit will normally be funded over a period of ten years whereas the common-law employee's benefit will be funded over a period of 13 years. For that reason alone, the annual contributions necessary to fund the benefits for the shareholder-employee will be greater as a percentage of his compensation than the annual contributions necessary to fund the benefits for the common-law employee. However, this difference alone is not sufficient to overcome the presumption that the plan is being established in good faith as a permanent program under which the benefits ultimately provided to all participants will be nondiscriminatory.

Accordingly, under the circumstances, the method of funding the pension benefits in this case does not prevent the plan from qualifying under section 401(a) of the Code.