Rev. Rul. 57-77

Advice has been requested whether a trust forming part of an employees' profit-sharing plan will meet the qualifications of section 401(a) of the Internal Revenue Code of 1954, where the employer's contribution to the trust will be used to provide benefits allocated in proportion to the cost of providing units of retirement annuities in proportion to annual compensation and where the costs of such units are dependent upon the sex and age of the respective employee participants in the year of allocation and purchase, under a deposit administration group annuity contract.

An employer established a trusteed profit-sharing plan for the benefit of his employees. Contributions to the trust are made by the employer in an amount equal to ten percent of profits annually but limited to the amount deductible under Code. No contributions are made by the employees. Trust funds are invested by the trustee with an insurer under a deposit administration group annuity contract. Forfeitures and dividends are allocated among the remaining participants in accordance with the allocation formula.

The allocation formula provides two priorities as applied to each year independently. Under the first priority, there is allocated to each participant's account that proportion of the contribution which the cost of providing him with a monthly retirement benefit of one percent of the first $350 of his average monthly earnings, plus two percent of his average monthly earnings in excess of $350, bears to the total cost of providing such benefits for all participants, provided, however, if the annual contribution is more than sufficient to provide all participants with such benefits, only that part of the annual contribution necessary to provide such benefits shall be allocated as provided in the first priority. Second, the remainder of the annual contribution shall be allocated to each participant in the same proportion as the cost of providing such participant's account with a monthly retirement benefit of one percent of his average monthly earnings bears to the total cost of providing such benefits for all participants. The costs of all retirements benefits are dependent upon the sex and age of the respective employee participants in the year of allocation.

Section 401(a) of the Code provides, among other qualifications, that a trust created or organized in the United States and forming part of a profit-sharing plan of an employer for the exclusive benefit of his employees, or their beneficiaries, shall constitute a qualified trust if the contributions or benefits provided under the plan do not discriminate in favor of employees who are officers, shareholders, supervisors, or highly compensated employees. A plan shall not be considered discriminatory 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.

While there is nothing in the law, or regulations prescribed thereunder, requiring any particular formula or method or allocating trust funds among the participating employees, and formula, the operation of which results in the prohibited discrimination, will cause the plan to fail of qualification.

Section 1.401-4(a)(2)(iii) of the Income Tax Regulations states, in part, that benefits in a profit-sharing plan which vary by reason of an allocation formula which takes into consideration years of service, or other factors, are not prohibited unless they discriminate in favor of employees who are officers, shareholders, supervisors, or highly compensated. This principal is recognized in I.T. 3685, C.B. 1944, 324, which indicates a type of allocation formula which does not discriminate, and I.T. 3686, C.B. 1944, 326, which demonstrates a type of formula which does discriminate in favor of those employees for whom discremination should not exist. These rulings make clear that, in testing whether the nondiscrimination requirement is met in a profit-sharing plan, the criterion is the ratio which the employer contributions allocated to each group of employees bears to the compensation of the group, where the groupings are based upon compensation range.

In the instant case, since the allocation formula provides for an apportionment of the employer contributions, forfeitures, dividends, etc., in proportion to the cost of providing units of retirement annuities in proportion to compensation each year, where the costs of such units are dependent upon the age and sex of the respective employee participants, the result is that larger proportionate allocations, measured by current compensation, are made for older employees than for younger employees of the same sex.

In the pension plan, in which contributions are allocated in accordance with the cost of proportionate benefits, the employer undertakes to provide definite retirement benefits in proportion to compensation and/or service for each employee. If contributions to the plan are contined as intended, each employee who fulfills the requirements will receive his contemplated benefits. If the plan or contributions to it should terminate prematurely, resulting in discrimination in favor of the original older group of participants, a reallocation may be required in accordance with the provisions of Mimeograph 5717, C.B. 1944, 321, wherein the benefits of employees who are officers, shareholders, supervisors, or highly compensated, are restricted so as to limit the possibility of discrimination.

On the other hand, in a profit-sharing plan, since the employer contributions are geared to profits, there is no assurance that contributions will be continued. Therefore, there is no way of measuring what the ultimate retirement benefits will be. Also, there is no practical device, similar to Mimeograph 5717, supra , to correct discrimination in event of early termination or discontinuance of contributions. It may be argued, in the instant case, that each employee is provided with a retirement annuity in proportion to his average monthly compensation for each year that a contribution is made. However, the value of the retirement annuity purchased for the older employees is greatly in excess of the value to the younger employees. Only if the same relative contributions are continued fairly evenly each year is there any assurance that the ultimate benefits will take account of changes in compensation.

In a pension plan in which benefits are proportionate to compensation, failure to recognize increases in compensation in providing benefits will cause the plan to fail of qualification for the reasons given in Part 5(i) of Revenue Ruling 33, C.B. 1953-1, 267, at page 284. Since, in the type of profit-sharing plan here considered, there is no assurance that increases in compensation will be recognized in providing benefits, the benefits actually provided cannot be recognized as an acceptable criterion of nondiscrimination. Therefore, the alternative criterion, ratio of contributions to compensation, must be used.

Since the purpose of a profit-sharing plan is to provide for the participation in the employer's profits by his employees or their beneficiaries, it is the position of the Internal Revenue Service that the proper measure of discrimination is the allocation of the employer's contributions from profits, even though such allocated contributions may be accumulated for varying periods of years for employees of different ages. In making such tests, total regular compensation is used. Bonuses are includible if they are a part of the regular compensation.

Such a plan as here set out may qualify for a particular year but, in its operation, may fail to qualify in future years. Accordingly, it is held that a favorable advance determination will not be rendered in the case of a trust forming part of an employees' profit-sharing plan which provides that contributions to the trust will be used to provide benefits allocated in proportion to the cost of providing units of retirement annuities in proportion to annual compensation where the costs of such units are dependent upon the sex and age of the respective employee participants in the year of allocation and purchase.