Lost in the Clamor: Final Code '415 Regulations

Times have certainly changed. The U.S. Department of the Treasury ('Treasury') issued two sets of regulations in early April that impact employee benefits. The first set was final regulations addressing the benefit and contribution limits for qualified pension plans under Internal Revenue Code ('Code') '415. The second set, issued a week later, was final regulations governing nonqualified deferred compensation under Code '409A.

Back in 1981, when the last set of '415 regulations was promulgated, there was no question of which would have been bigger news. Qualified plans, and defined benefit plans especially, ruled the benefits world. Nonqualified deferred compensation was a sidelight. That is certainly not the case today. The new '415 regulations were totally lost in the clamor following the issuance of the new rules governing nonqualified deferred compensation plans. And that is not surprising, because nonqualified deferred compensation plans are where the money is (on many levels).

There are numerous reasons for this switch, but that is a subject for another day and another article. In the meantime, we cannot let the '415 regulations sneak out without some commentary on some of their elements.

Qualified plans have to satisfy the provisions of the Code and the provisions of the Employee Retirement Income Security Act of 1974 ('ERISA'), many of which are duplicative. However, the nondiscrimination standards and the benefit and contribution limits of '415 are only in the Code.

Section 415

For purposes of this article, there are two Code provisions that are most relevant ' '415 and '401(a)(17). Section 415 provides benefit limits for defined benefit plans and contribution limits for defined contribution plans. For defined benefit plans (which are plans that pay a monthly annuity at retirement based on years of service and sometimes compensation), the annual benefit may not exceed the lesser of $160,000 (indexed) and 100% of the participant's average compensation for his or her high three years. The indexed $160,000 figure is $180,000 in 2007. For defined contribution plans (which are individual account plans like 401(k) arrangements), the annual contribution may not exceed the lesser of $40,000 (indexed) and 100% of compensation. The indexed $40,000 figure is $45,000 in 2007.

Before the turn of the century (i.e., the 21st century), '415 included a combined limit applicable if the employer sponsored both a defined benefit plan and a defined contribution plan for the same employee. This limit (the so-called '415(e) limit) was eliminated for plan years beginning after 1999 because it was confusing and difficult to administer.

(Not relevant to today's article, but fascinating with respect to how certain numbers wind up in the law, is the story of how Congress wound up with a '415(e) combined limit of 1.4 times the individual plan limit. It is rumored that when it was suggested to the chairman of one of the Congressional committees considering ERISA that the combined limit should be 'one and a quarter,' he translated that as '1.4.')

Section 401(a)(17)

When Congress decided in the mid-1980s to limit the amount that highly compensated employees could receive from a qualified plan, it took a provision that applied only to very small plans and changed and expanded it to apply to all qualified plans. Under this provision, the annual compensation of each employee taken into account under the plan for any year could not exceed $200,000 (indexed). The indexed $200,000 figure (referred to as 'considered compensation') is $225,000 in 2007.

The Final Section 415 Regulations

Treasury and IRS last promulgated final '415 regulations in 1981. Since that time, Congress has amended '415 more than a dozen times (in the 1980s around every two years). Some of the changes cut back the limits and others increased them. The IRS dealt with this constantly changing law by issuing more than a dozen notices and revenue rulings. Finally, on July 5, 2005, Treasury and IRS proposed a comprehensive set of regulations combining all that had happened since 1981. After addressing comments and the further changes made in the Pension Protection Act of 2006 ('PPA'), they made those regulations final on April 5, 2007.

This article focuses on three issues addressed in the final regulations and in earlier 2007 guidance addressing a PPA 2006 change:

• The maximum lump sum benefit in a defined benefit plan;
• The interaction between the considered compensation limit and the benefits limit; and
• The rules for treating post-separation pay as compensation.

Defined Benefit Plan Maximum Lump Sum

The rules that would govern defined benefit plans in the future were quite uncertain for most of this century. It was only with the passage of the PPA that defined benefit plan sponsors had some certainty. Because of the long time it took for the PPA to pass, Congress had to enact temporary rules for 2004 and 2005 (the Pension Funding Equity Act of 2004 ('PFEA')). In the case of '415, the law had one set of rules for converting annuities to lump sums for plan years beginning before 2004, one set of rules for converting in 2004 and 2005 (under PFEA), and a third set of rules for converting starting in 2006. Unfortunately, the 2006-on rules, which were enacted in the PPA on Aug. 17, 2006 were effective retroactive to plan years beginning on or after Jan. 1, 2006.

The conversion rules are important because '415 states the limit on benefits from a defined benefit plan in terms of a yearly annuity starting at normal retirement age. Thus, if the participant receives a lump sum payment, the amount paid as a lump sum under the plan provisions cannot be greater than the present value of the maximum annuity under '415. Because the comparison involves the maximum limit, the comparison only affects those ' like partners ' who are receiving large lump sum payments.

Before going on, we should take a short detour to basic mathematics. In determining the present value of a series of payments, the lower the interest rate the higher the present value. Therefore, in determining the maximum lump sum, the partner wants the plan to use as low an interest rate as possible in converting the annuity payments to a present value. However, the IRS does not want the partner to use too low an interest rate because that translates to the partner being able to get a higher lump sum without violating the '415 limits. Because of the potential for gaming, '415 provides limits on how low the interest rate can be. The Code also places limits on how high the interest rate can be so that plans don't use conversions to pay unreasonably low lump sums.

Without going through the full complicated history of the provision limiting the '415 interest rate, let's just say that the changes in the interest rate, combined with the expiring of the temporary rules and the retroactive impact of the new rules, resulted in some plans having already made distributions larger than permitted by the retroactive rules. Fortunately, the IRS provided relief in Notice 2007-7. While the most generous relief required action by March 15, 2007, a second and third relief method remain available. (The second is only available until Dec. 31, 2007.)

Compensation Limit

What a statute means is not always clear. The courts generally give agency regulations deference. How- ever, frequently the regulation position doesn't reflect a unanimous view of a provision's interpretation, and sometimes provisions are left deliberately ambiguous to be fought over another day.

Such is the case with the relationship between the benefit limits of '415 and the considered compensation limits of '401(a)(17). Most practitioners did not worry too much about the relationship. First, most interpreted comments made by the IRS as meaning that the IRS interpreted the Code as not applying the considered compensation limits to the benefit limits of '415. Second, and perhaps more significantly, the dollar limit under '415 for a defined benefit plan would in most cases be lower than any three-year averaging of the considered compensation limit applicable to the defined benefit plan since the considered compensation limit, which was $225,000 in 2007 and $220,000 in 2006, would usually average out to be greater than the defined benefit dollar limit in 2007 of $180,000 at age 65.

The catch is the 'age 65' in the previous sentence. The dollar benefit limit is age adjusted (i.e., limit increases with retirement age); the considered compensation limit is not. At approximately age 68, the dollar limit exceeds the considered compensation limit and the latter begins to govern the limit under '415. To the surprise of many practitioners, the proposed '415 regulations, and now the final, take the position that plans must worry about considered compensation for '415. The one concession the final regulations did make was to grandfather in benefits accrued or payable prior to the effective date under the final regulations.

Post-Separation Pay

The definition of 'compensation' under '415 is used for many employee benefit plan purposes. The difficulty that arises is how to treat compensation paid after separation but related to services before separation. The final regulations clarify and liberalize the rules as to when amounts received following severance from employment are considered compensation for purposes of '415. The final regulations allow post-severance payments for services to a former employer to be treated as compensation if they are paid by the later of 2 1/2 months after the severance from employment or the end of the limitation year that includes the date of severance. (A limitation year is the '415 measurement year and is frequently the same as a plan year.)

In some cases, however, the employer does or does not want to expand the definition of compensation. So the final regulations allow the plan some flexibility. For example, post-severance payments of accrued bona fide sick, vacation, and other leave are not included in compensation unless the plan specifically provides that they are. Further, a plan can specify that post-severance payments from a nonqualified deferred compensation plan are included in compensation if made within the 2 1/2-month/end of limitation year time frame.

The bad news about Code '415 is that it is a complicated area and fairly easy to make mistakes. The good news is that the IRS has a fairly extensive correction program for mistakes. Getting it right in the first place is a lot easier.

Stuart A. Sirkin joined Ernst & Young's National Tax Office in January 2007 as an executive director after retiring from the federal government. While in the government, he served in senior policy and technical positions with the Pension Benefit Guaranty Corporation, the IRS' Employee Plans Division, and the Pension and Welfare Benefit Administration (the predecessor to the Employee Benefit Security Administration) of the Department of Labor. During 2006 and 2007, Sirkin was on detail to the Senate Finance Committee working on the Pension Protection Act of 2006 and other employee benefit matters. He can be reached at stu.sirkin@ey.com.

Times have certainly changed. The U.S. Department of the Treasury ('Treasury') issued two sets of regulations in early April that impact employee benefits. The first set was final regulations addressing the benefit and contribution limits for qualified pension plans under Internal Revenue Code ('Code') '415. The second set, issued a week later, was final regulations governing nonqualified deferred compensation under Code '409A.

Back in 1981, when the last set of '415 regulations was promulgated, there was no question of which would have been bigger news. Qualified plans, and defined benefit plans especially, ruled the benefits world. Nonqualified deferred compensation was a sidelight. That is certainly not the case today. The new '415 regulations were totally lost in the clamor following the issuance of the new rules governing nonqualified deferred compensation plans. And that is not surprising, because nonqualified deferred compensation plans are where the money is (on many levels).

There are numerous reasons for this switch, but that is a subject for another day and another article. In the meantime, we cannot let the '415 regulations sneak out without some commentary on some of their elements.

Qualified plans have to satisfy the provisions of the Code and the provisions of the Employee Retirement Income Security Act of 1974 ('ERISA'), many of which are duplicative. However, the nondiscrimination standards and the benefit and contribution limits of '415 are only in the Code.

Section 415

For purposes of this article, there are two Code provisions that are most relevant ' '415 and '401(a)(17). Section 415 provides benefit limits for defined benefit plans and contribution limits for defined contribution plans. For defined benefit plans (which are plans that pay a monthly annuity at retirement based on years of service and sometimes compensation), the annual benefit may not exceed the lesser of $160,000 (indexed) and 100% of the participant's average compensation for his or her high three years. The indexed $160,000 figure is $180,000 in 2007. For defined contribution plans (which are individual account plans like 401(k) arrangements), the annual contribution may not exceed the lesser of $40,000 (indexed) and 100% of compensation. The indexed $40,000 figure is $45,000 in 2007.

Before the turn of the century (i.e., the 21st century), '415 included a combined limit applicable if the employer sponsored both a defined benefit plan and a defined contribution plan for the same employee. This limit (the so-called '415(e) limit) was eliminated for plan years beginning after 1999 because it was confusing and difficult to administer.

(Not relevant to today's article, but fascinating with respect to how certain numbers wind up in the law, is the story of how Congress wound up with a '415(e) combined limit of 1.4 times the individual plan limit. It is rumored that when it was suggested to the chairman of one of the Congressional committees considering ERISA that the combined limit should be 'one and a quarter,' he translated that as '1.4.')

Section 401(a)(17)

When Congress decided in the mid-1980s to limit the amount that highly compensated employees could receive from a qualified plan, it took a provision that applied only to very small plans and changed and expanded it to apply to all qualified plans. Under this provision, the annual compensation of each employee taken into account under the plan for any year could not exceed $200,000 (indexed). The indexed $200,000 figure (referred to as 'considered compensation') is $225,000 in 2007.

The Final Section 415 Regulations

Treasury and IRS last promulgated final '415 regulations in 1981. Since that time, Congress has amended '415 more than a dozen times (in the 1980s around every two years). Some of the changes cut back the limits and others increased them. The IRS dealt with this constantly changing law by issuing more than a dozen notices and revenue rulings. Finally, on July 5, 2005, Treasury and IRS proposed a comprehensive set of regulations combining all that had happened since 1981. After addressing comments and the further changes made in the Pension Protection Act of 2006 ('PPA'), they made those regulations final on April 5, 2007.

This article focuses on three issues addressed in the final regulations and in earlier 2007 guidance addressing a PPA 2006 change:

• The maximum lump sum benefit in a defined benefit plan;
• The interaction between the considered compensation limit and the benefits limit; and
• The rules for treating post-separation pay as compensation.

Defined Benefit Plan Maximum Lump Sum

The rules that would govern defined benefit plans in the future were quite uncertain for most of this century. It was only with the passage of the PPA that defined benefit plan sponsors had some certainty. Because of the long time it took for the PPA to pass, Congress had to enact temporary rules for 2004 and 2005 (the Pension Funding Equity Act of 2004 ('PFEA')). In the case of '415, the law had one set of rules for converting annuities to lump sums for plan years beginning before 2004, one set of rules for converting in 2004 and 2005 (under PFEA), and a third set of rules for converting starting in 2006. Unfortunately, the 2006-on rules, which were enacted in the PPA on Aug. 17, 2006 were effective retroactive to plan years beginning on or after Jan. 1, 2006.

The conversion rules are important because '415 states the limit on benefits from a defined benefit plan in terms of a yearly annuity starting at normal retirement age. Thus, if the participant receives a lump sum payment, the amount paid as a lump sum under the plan provisions cannot be greater than the present value of the maximum annuity under '415. Because the comparison involves the maximum limit, the comparison only affects those ' like partners ' who are receiving large lump sum payments.

Before going on, we should take a short detour to basic mathematics. In determining the present value of a series of payments, the lower the interest rate the higher the present value. Therefore, in determining the maximum lump sum, the partner wants the plan to use as low an interest rate as possible in converting the annuity payments to a present value. However, the IRS does not want the partner to use too low an interest rate because that translates to the partner being able to get a higher lump sum without violating the '415 limits. Because of the potential for gaming, '415 provides limits on how low the interest rate can be. The Code also places limits on how high the interest rate can be so that plans don't use conversions to pay unreasonably low lump sums.

Without going through the full complicated history of the provision limiting the '415 interest rate, let's just say that the changes in the interest rate, combined with the expiring of the temporary rules and the retroactive impact of the new rules, resulted in some plans having already made distributions larger than permitted by the retroactive rules. Fortunately, the IRS provided relief in Notice 2007-7. While the most generous relief required action by March 15, 2007, a second and third relief method remain available. (The second is only available until Dec. 31, 2007.)

Compensation Limit

What a statute means is not always clear. The courts generally give agency regulations deference. How- ever, frequently the regulation position doesn't reflect a unanimous view of a provision's interpretation, and sometimes provisions are left deliberately ambiguous to be fought over another day.

Such is the case with the relationship between the benefit limits of '415 and the considered compensation limits of '401(a)(17). Most practitioners did not worry too much about the relationship. First, most interpreted comments made by the IRS as meaning that the IRS interpreted the Code as not applying the considered compensation limits to the benefit limits of '415. Second, and perhaps more significantly, the dollar limit under '415 for a defined benefit plan would in most cases be lower than any three-year averaging of the considered compensation limit applicable to the defined benefit plan since the considered compensation limit, which was $225,000 in 2007 and $220,000 in 2006, would usually average out to be greater than the defined benefit dollar limit in 2007 of $180,000 at age 65.

The catch is the 'age 65' in the previous sentence. The dollar benefit limit is age adjusted (i.e., limit increases with retirement age); the considered compensation limit is not. At approximately age 68, the dollar limit exceeds the considered compensation limit and the latter begins to govern the limit under '415. To the surprise of many practitioners, the proposed '415 regulations, and now the final, take the position that plans must worry about considered compensation for '415. The one concession the final regulations did make was to grandfather in benefits accrued or payable prior to the effective date under the final regulations.

Post-Separation Pay

The definition of 'compensation' under '415 is used for many employee benefit plan purposes. The difficulty that arises is how to treat compensation paid after separation but related to services before separation. The final regulations clarify and liberalize the rules as to when amounts received following severance from employment are considered compensation for purposes of '415. The final regulations allow post-severance payments for services to a former employer to be treated as compensation if they are paid by the later of 2 1/2 months after the severance from employment or the end of the limitation year that includes the date of severance. (A limitation year is the '415 measurement year and is frequently the same as a plan year.)

In some cases, however, the employer does or does not want to expand the definition of compensation. So the final regulations allow the plan some flexibility. For example, post-severance payments of accrued bona fide sick, vacation, and other leave are not included in compensation unless the plan specifically provides that they are. Further, a plan can specify that post-severance payments from a nonqualified deferred compensation plan are included in compensation if made within the 2 1/2-month/end of limitation year time frame.

The bad news about Code '415 is that it is a complicated area and fairly easy to make mistakes. The good news is that the IRS has a fairly extensive correction program for mistakes. Getting it right in the first place is a lot easier.

Stuart A. Sirkin joined Ernst & Young's National Tax Office in January 2007 as an executive director after retiring from the federal government. While in the government, he served in senior policy and technical positions with the Pension Benefit Guaranty Corporation, the IRS' Employee Plans Division, and the Pension and Welfare Benefit Administration (the predecessor to the Employee Benefit Security Administration) of the Department of Labor. During 2006 and 2007, Sirkin was on detail to the Senate Finance Committee working on the Pension Protection Act of 2006 and other employee benefit matters. He can be reached at stu.sirkin@ey.com.