EXAMPLES OF THE DEDUCTION LIMITATION FOR DEFINED BENEFIT PLANS

Rev. Rul. 84-62

ISSUE

How are the deductible limits under section 404(a)(1)(A)(iii) of the Internal Revenue Code determined for a defined benefit plan under the circumstances described below?

FACTS

An employer whose taxable year is the calendar year maintains a defined benefit plan with a calendar plan year. The plan was in existence on January 1, 1974, and became subject to section 404(a) of the Code on January 1, 1976. For the 1976 plan year, the funding method is the entry age normal cost method and the valuation rate is 5 percent.

The results of the valuations as of January 1 of 1976, and 1977 are summarized below.

                  JANUARY 1, 1976 VALUATION

As of January 1, 1977, the actuarial assumptions were changed. Included in that change was an increase in valuation rate from 5% to 6%.

                  JANUARY 1, 1977 VALUATION

Section 1.404(a)-14 of the Income Tax Regulations provides rules for determining the deductible limits for any defined benefit plan under section 404(a)(1)(A) of the Code.

Section 1.404(a)-14(c) of the regulations states that if the employer's taxable year coincides with the plan year, the deductible limit for the taxable year is the deductible limit for the plan year coinciding with the taxable year.

Section 1.404(a)-14(f) of the regulations states that subject to the full funding limitation, the deductible limit under section 404(a)(1)(A)(iii) of the Code is the normal cost of the plan, decreased by the limit adjustments of the negative amortization bases (such as a base for an experience gain) and increased by the limit adjustments of the positive bases (such as a base for an initial unfunded liability).

A. 1976 DEDUCTIBLE LIMIT

For 1976, the normal cost as of the first day of the plan year is $60,000. However, this amount must be adjusted by the limit adjustments of any 10-year amortization base.

(1) DETERMINATION OF 10-YEAR AMORTIZATION BASES

For a plan in existence prior to the effective date of section 404(a) of the Code, section 1.404(a)-14(j) of the regulations provides special rules for the determination of the amount of the initial 10-year amortization base.

Section 1.404(a)-14(j)(1) of the regulations states that the 10-year amortization base on the effective date of section 404(a) of the Code is the sum of all 10 percent bases existing immediately before section 404(a) became effective for the plan, determined under the rules of old section 404(a).

Section 1.404(a)-14(j)(3) of the regulations allows an employer to establish either a single initial base reflecting all prior 10 percent bases and the experience gain or loss for the immediately preceding period, or a separate base for the prior 10 percent bases and another for the experience gain and loss for the immediately preceding period. If a separate base for the experience gain or loss is established, the unamortized amount of the initial base is equal to the unfunded liability increased by the net experience gain or decreased by the net experience loss.

Section 1.404(a)-14(d)(2) of the regulations states that, in computing the unfunded liability of a plan for purposes of section 404 of the Code, contributions for a plan year that have not been previously deducted must be excluded from the plan assets.

In this case, assume the employer chose to establish two bases as of January 1, 1976: (1) a base with an original balance and an unamortized amount of $20,000 for the experience gain determined as of January 1, 1976, and (2) a separate base with an original balance of $800,000.

In the absence of the deduction carryover the unamortized amount of this latter base would have been equal to $600,000 (the $580,000 unfunded liability as of January 1, 1976, plus the $20,000 experience gain which has been taken into account in the separate base). However, because of the $10,000 carryover, the assets must be reduced by such carryover so that the unfunded liability, for purposes of section 404 of the Code, was $590,000. Therefore, the separate base for the prior 10 percent bases had an unamortized amount of $610,000 ($590,000 plus the $20,000 gain). The original amount of this base was $800,000 (the sum of the pre-ERISA 10 percent bases), and was unaffected by the carryover.

(Note the net of the unamortized amounts of the two bases is equal to the unfunded liability of the plan as adjusted for the carryover ($610,000 - $20,000 = $580,000 + $10,000).)

(2) DETERMINATION OF LIMIT ADJUSTMENTS FOR BASES

Section 1.404(a)-14(b)(3) of the regulations defines the limit adjustment with respect to any 10-year amortization base as the lesser of (i) the level annual amount necessary to amortize the base over 10 years using the valuation rate, or (ii) the unamortized balance of the base.

Section 1.404(a)-14(j)(2) of the regulations states that in the case of a plan in existence before the effective date of section 404(a) of the Code, the level annual amortization of the initial base is calculated using the original balance of the remaining bases (under old section 404(a) rules).

In accordance with the above regulations the limit adjustment for each base must be calculated as the amount necessary to amortize the base over 10 years at the valuation rate (unless such amount is more than the unamortized amount of the base). The level annual amortization amounts, assuming payments due at the end of each year, are $2,590 for the gain base and $103,604 for the initial base. The calculations yielding these figures may be expressed as ($20,000 / a(10) 5%) and ($8000,000 / a(10) 5%), respectively, where a (10) 5% is the present value of an annuity of $1 per year payable at the end of each year for 10 years, assuming 5 percent interest. For the initial base, the $800,000 amount amortized equals the original balance of the remaining 10 percent bases under the rules of old section 404(a) of the Code.

(3) DETERMINATION OF 1976 DEDUCTIBLE LIMIT

Section 1.404(a)-14(f)(3) of the regulations states that, regardless of the actual time when contributions are made, the normal cost and the limit adjustments used in calculating the deductible limit shall be computed as of the earlier of (i) the last day of the plan year used to compute the dedictible limit for the taxable year, or (ii) the last day of that taxable year.

In this case the plan year and the tax year coincide with the calendar year. The deductible limit was calculated as of the end of the plan year as the normal cost with interest to the end of the plan year ($60,000 x 1.05 or $63,000), plus the level annual amortization of the initial base ($103,604), minus the level annual amortization of the experience gain base ($2,590), or $164,014. Therefore, the $110,000 contribution made on January 1, 1976, and the $10,000 carryover existing on January 1, 1976, were deductible in the 1976 tax year.

B. 1977 DEDUCTIBLE LIMIT

For 1977, the normal cost as of the first day of the plan year is $70,000. However, as was the case for the 1976 normal cost this amount must be adjusted by the limit adjustments of any 10-year amortization base to determine the deductible limit for the year.

(1) DETERMINATION OF 10-YEAR AMORTIZATION BASES

As of January 1, 1977, the two bases in existence for 1976 continue to exist. Furthermore, two new bases must be established.

Section 1.404(a)-14(g)(1) of the regulations states that in the case of a plan valued by the use of an immediate gain type of funding method, a 10-year amortization base must be established in any plan year equal to the net experience gain and loss required under section 412 of the Code to be determined with respect to that plan year. Section 4 of Rev. Rul. 81-213, 1981-2 C.B. 101, requires that an experience gain base be established for purposes of section 412 of the Code in this situation. Therefore, for computing the deductible limit, a new experience gain base of $36,500 is established as of January 1, 1977.

Section 1.404(a)-14(g)(2) of the regulations states that if an amortization base is required to be established under section 412 of the Code for a change in unfunded liabilities due to a change in actuarial assumptions, then a 10-year amortization base must also be established for purposes of section 404. Assuming that such a base would be required under section 412 because of the change in assumptions as of January 1, 1977, an additional $100,000 10-year amortization base would be established.

(2) DETERMINATION OF THE UNAMORTIZED AMOUNTS OF THE PRIOR BASES

Section 1.404(a)-14(h)(3) of the regulations defines the unamortized amount of a base as of any valuation date as the unamortized amount of the base as of the prior valuation date plus interest at the valuation rate from the prior valuation date to the current valuation date, minus the contribution allocated to the base. Section 1.404(a)-14(h)(4) defines the contribution allocated to a base as the total contribution for all bases multiplied by a ratio. The numerator of the ratio is the level annual amortization for that base and the denominator is the sum of such amounts for all bases. Section 1.404(a)-14(h)(6) defines the contribution for all bases as the total deduction (including a carryover deduction) for the prior year, plus interest on the actual contribution for the prior year (whether or not deductible) at the valuation rate for the period between the date as of which the contributions were credited under section 412 of the Code and the current valuation date, plus interest on the carryover (if available at the beginning of the year) at the valuation rate for the period between the current the prior valuation dates, minus the normal cost with interest at the valuation rate from the date as of which the normal cost is calculated to the current valuation date.

The calculation of the unamortized portion of the bases as of 1/1/77 is as follows:

A deduction carryover of $10,000 existed as of January 1, 1976. Two contributions were made for the 1976 plan year, $110,000 paid on January 1, 1976, (bearing interest from that date), and $20,000 paid on June 1, 1977, but deemed paid on December 31, 1976, for the purpose of section 412 of the Code. As stated in the facts, the latter contribution was not deductible in 1976. Therefore $120,000 was considered available for possible deduction in 1976 ($110,000 contribution + $10,000 carryover). That amount was less than the 1976 deductible limit of $164,014, and the deduction taken was $120,000.

The contributions for all bases were computed, in accordance with section 1.404(a)-14(h)(6) of the regulations, as follows:

      (1)   Total 1976 deduction          $120,000

                           Initial    Experience

(Note that the total unamortized amount of the prior bases as of 1/1/77 ($556,500) equals the expected unfunded liability as of the same date after adjustment for the undeducted $20,000 contribution ($536,500 + $20,000 = $556,500). Also, the total unamortized amount of all the bases as of 1/1/77 ($556,500 - $36,500 + $100,000 = $620,000) equals the unfunded liability of the plan after adjustment for the undeducted $20,000 contribution ($600,000 + $20,000 = $620,000).)

(3) REDETERMINATION OF LIMIT ADJUSTMENTS FOR PRIOR BASES

Section 1.404(a)-14(h)(8) states that when the interest rate is changed a new level annual amortization must be calcualted for each base. The annual amortization must be the level amount necessary to amortize the unamortized amount of a base over the remaining amortization period using the new interest rate. The remaining amortization period of a base is the number of years at the end of which the unamortized amount would be zero if the contributions with respect to that base equaled the limit adjustment each year.

The level annual amortizations of the two bases existing on January 1, 1976, are redetermined, in accordance with the above-referenced section of the regulations, as follows:

                                  Initial      Experience

(4) DETERMINATION OF LIMIT ADJUSTMENTS FOR NEW BASES

The limit adjustments for the new bases established in 1977 are (-$4,959) for the $36,500 experience gain base and $13,587 for the $100,000 base established due to a change in assumptions. These limit adjustments are equal to a 10 year amortization at 6 percent interest, assuming payments at the end of the year.

(5) DETERMINATION OF 1977 DEDUCTIBLE LIMIT

As was the case with 1976, the deductible limit for 1977 is calculated as of the end of the plan year. This limit is the normal cost with interest to the end of the plan year ($70,000 x 1.06 = $74,200), plus the limit adjustments for the positive bases ($106,904 + 13,587 = $120,491), minus the limit adjustments for the negative bases ($2,713 + 4,959 = $7,672), or $187,019. (6) DETERMINATION OF DEDUCTIBLE LIMIT USING SINGLE COMBINED AMORTIZATION BASE FOR 1977

As an alternative to computing the 1977 deductible limit as described above, the four 10-year amortization bases could have been combined and offset into a single base and the normal cost adjusted by a single limit adjustment attributable to that base.

Section 1.404(a)-14(i) of the regulations describes an acceptable method for combining and offsetting the 10-year amortization bases for the purposes of section 404 of the Code. This method requires that:

(1) the unamortized amount of the single base is the net of the unamortized amounts of the combined bases;

(2) the remaining amortization period of the single base is the average of the remaining amortization periods of the bases weighted by the absolute value of the unamortized protion of the bases; and

(3) the level annual amortization is the amount obtained by dividing the amount in (1) by an annuity certain at the valuation rate for the period defined in (2).

The existing four bases would be combined and offset as of January 1, 1977, in accordance with these rules. The characteristics of the four bases are shown below:

                            Remaining     Absolute value of

           (a) = (575,885 x 6.7) + (19,385 x 9.6) +

The deductible limit would then be calculated as the normal cost with interest to the end of the plan year ($70,000 x 1.06 = $74,200) plus the limit adjustment for the single base ($106,164), or 180,364.

EFFECT ON OTHER DOCUMENTS

This revenue ruling obsoletes Rev. Ruls. 55-411, 1955-1 C.B. 303; 57-89, 1957-1 C.B. 169; and 70-30, 1970-1 C.B. 109.