In June, the IRS released guidance (confirming its prior position on this issue) blocking one corporate tax strategy to accelerate the deductibility of 401 (k) salary deferrals and matching contributions that are attributable to compensation paid after the end of the tax year. But another strategy was given the “okay.” The prior position blocked a tax deduction technique where an employer — with a plan year that overlapped the employer’s tax year –attempted to deduct salary deferrals and matching contributions relating to compensation paid after the end of the tax year. The IRS previously disallowed this technique in its Industry Specialization Program Coordinated Issue Paper (9/5/95) and Revenue Ruling 90-105.
Regulations permit an employer to deduct contributions paid into a qualified retirement plan in one of three ways: (1) the plan year that commences in the tax year, (2) the plan year that ends in the employer’s tax year, or (3) a prorata split reflecting the overlap. These regulations require that the employer apply the selected method in subsequent years (unless consents to a change of method) and that the employer liability be identified as of the end of the tax year. Of course, contributions must be deposited into the plan by the due date of the sponsor’s tax return.
The regulations do not specifically address how these rules apply to 401(k) plans. Prior to Rev. Rul. 90-105 an employer with a calendar tax year (say, December 31, 1989), could establish a 401(k) plan with a fiscal year of December 1, 1989 to November 30, 1990. In this factual situation, a taxpayer with a 401(k) plan could have deducted contributions made after the end of the tax year as basically salary deferrals – or next year’s compensation. Rev. Ruling 90-105 prohibited this advance deduction for compensation and matching contributions related to the deferrals under the theory that the liability for the contributions could not be identified as of the employer’s tax year-end. Only the deduction for profit sharing contributions under a 401(k) plan that were made after the tax year would be permitted.
The current strategy, addressed in Rev Rul 2002-46, seeks to fix a specific dollar liability prior to the close of the tax year. Two approaches to establishing this liability are discussed in the new revenue ruling. In the first, the employer would, through a board resolution, commit to fund contributions attributable to participants’ compensation for services performed after the end of the employer’s tax year. Those contributions, if not met with salary deferrals and matching contributions, would be made through profit sharing contributions. With the second, the employer actually funds the liability before the end of the tax year. If either version of the strategy works, the employer would be able to deduct contributions attributable to participants’ compensation performed after the end of the employer’s tax year.
Here is how the first strategy was described in Rev Rul 2002-46. In June 2001, the employer amends its 401(k) plan to provide for its Board of Directors to set a minimum contribution for a plan year, to be met with elective deferrals, matching contributions and profit-sharing contributions. The Board, before the close of the tax year (June 30, 2001), adopts a resolution pursuant to this plan amendment, establishing a minimum contribution of $8 million for the 2001 calendar plan year. By the last day of the 401(k) plan’s 2001 plan year (December 31, 2001), the employer had made contributions of $3.8 million for elective deferrals and matching contributions for the period prior to June 30, 2001 and $4.2 million for elective deferrals and matching contributions for the period between July 1, 2001 and December 31, 2001. In this way the employer would deduct the full $8 million on its June 30, 2001 corporate tax return.
In the ruling the IRS disallowed amounts relating to compensation earned after June 30, 2001 ($4.2 million in deferrals and matching contributions on the June 30, 2001 return). The $4.2 million deduction would be allowable for the following tax year. But the Service ruled in Notice 2002-48 that where the full $8 million in the example was fully contributed by June 30, 2001, it would be fully deductible, even if it related to compensation earned after the tax year. thus, pre-paid contributions made before the end of the employer’s tax year are deductible for that tax year, even when such contributions are attributable to compensation earned after the end of the tax year. The IRS states in Notice 2002-48 that it will not challenge the deductibility of (1) employer contributions to a cash or deferred arrangement, (2) matching contributions to a defined contribution plan, or (3) prepayments combined with a guaranteed minimum contribution, when the contributions are made before the end of the tax year in anticipation of deferrals and matches to occur after the end of the tax year. However, merely guaranteeing the amount of contributions for an overlapping plan year, if attributable to compensation earned after the tax year, is not enough to qualify them as deductible in that tax year under Rev Rul 2002-46.
Gregory E. Matthews, CPA,
Matthews Benefit Group, Inc.
St. Petersburg, Florida