Rev. Rul. 68-177

Advice has been requested whether the earned income of an owner-employee for taxable years beginning before January 1, 1968, is subject to the 30 percent limitation in applying the three-year averaging provisions of section 401(e)(3) of the Internal Revenue Code of 1954 to contributions made for taxable years beginning on or after January 1, 1968.

In 1968, an employer who is involved in a business in which both capital and personal services are material income-producing factors established a qualified pension plan that included an owner-employee. The plan, which is funded by means of insurance contracts, expressly requires that contributions thereunder be applied to pay premiums on the contracts.

Section 401(c)(2) of the Code, as originally enacted, referred to the definition of earned income in section 911(b) of the Code. This latter section provides that if personal services and capital are material income-producing factors, earned income is limited to 30 percent of the net profits from the trade or business. However, section 401(c)(2) of the Code was amended by section 204(c) of Public Law 89-809, C.B. 1966-2, 656, at 692, to delete the reference to section 911(b) of the Code and thereby remove the 30 percent limitation. This amendment is effective for taxable years beginning after December 31, 1967.

Section 401(e)(1) of the Code defines an excess contribution on behalf of an owner-employee. Section 401(e)(3) of the Code provides for an exception to this definition of excess contribution, if (1) employer contributions on behalf of an owner-employee are required to be applied to pay premiums on one or more annuity, endowment, or life insurance contracts; (2) the amount of such contribution exceeds the amount deductible under section 404; and (3) the amount of such contribution does not exceed the average of the amounts that were deductible under section 404 with respect to contributions made by the employer on behalf of such owner-employee under the plan for the most recent three taxable years of the employer, ending prior to the date the latest contract was entered into or modified to provide additional benefits, in which the owner-employee derived earned income from the trade or business with respect to which the plan is established.

Section 1.401-13(c)(4) of the Income Tax Regulations provides that taxable years of the employer preceding the taxable year in which a qualified plan is established are taken into account for determining the average of the amounts deductible under section 404 as if the plan had been in effect for those years.

If the plan in this case had been in effect for taxable years beginning before January 1, 1968, the amounts that would have been deductible under section 404 of the Code, for those years, would have been determined by applying the 30 percent limitation on earned income. With respect to the elimination of the 30 percent rule, Public Law 89-809 is applicable only to taxable years beginning after December 31, 1967, and makes no provision for a retroactive recomputation of earned income for prior years.

Accordingly, the earned income of the owner-employee for taxable years of the employer beginning before January 1, 1968, is subject to the 30 percent limitation in applying the three-year averaging provisions of section 401(e)(3) of the Code to contributions made for taxable years beginning on or after January 1, 1968.r