FSA 200107012: New Standard for Deducting Qualified Plan Contributions?

Under Sec. 404, employer contributions to a qualified plan that are "otherwise deductible" under Chapter 1 of the Code are deductible in the tax year paid. Field Service Advice (FSA) 200107012 sets forth a curious interpretation of the "otherwise deductible" requirement.

In the FSA, the IRS denied deductions taken by an accrual-basis taxpayer for contributions to a Sec. 401(k) plan, because the contributions were allocable based on compensation earned after the close of the tax year in which the deduction was claimed. The Service reasoned that, for a qualified plan contribution to be "otherwise deductible" under Sec. 162 or 212, the contribution must satisfy the Sec. 461 deduction-timing rules. Under the provision, an accrual-basis taxpayer cannot take a deduction until all events have occurred that fix the liability. When an expense (such as compensation) relates to the performance of services, the all-events test is not satisfied until economic performance occurs. Because the contribution at issue was allocable to services performed after the close of the tax year in which the deduction was sought, the IRS held that the all-events test was not met.

Defining "Otherwise Deductible"

The result reached in FSA 200107012 seems curious for two reasons. First, it appears questionable whether the "otherwise deductible" language of Sec. 404(a) is intended to incorporate the Sec. 461 timing rules. A better reading of the statute may be that Sec. 404(a) sets forth a general rule regarding the type of contributions that may be deductible by an employer (i.e., contributions to stock bonus, pension, profit-sharing or annuity plans), while the paragraphs beneath Sec. 404(a) set forth the timing and amount of the permitted deduction (depending on the type of plan contribution).

Read this way, the initial issue is whether the contribution is a type otherwise deductible under Chapter 1 of the Code. An employer contribution to a qualified plan should be otherwise deductible under Sec. 162 or 212 because it is an ordinary, necessary and reasonable expense. Continuing this approach, assuming the contribution is otherwise deductible under Chapter 1, an employer then must determine when the contribution is deductible. Under Sec. 404(a)(1)(3), qualified plan contributions are deductible "in the year paid."

FSA 9922005 had agreed that the otherwise deductible language did not require a qualified plan contribution to satisfy the Sec. 461 rules to be deductible under Sec. 404. The FSA noted that, prior to the Tax Reform Act of 1986, Sec. 404(a) did not contain the otherwise deductible language, instead providing that contributions would be deductible under Sec. 404 if they satisfied the conditions of either Sec. 162 or 212 (i.e., if they were ordinary, necessary and reasonable). According to the legislative history, Sec. 404(a) was amended to include the otherwise deductible language to clarify the deduction timing rules for nonqualified deferred compensation arrangements; Congress wanted to preclude taxpayers from asserting that deferred compensation is attributable to capitalizable compensation expenses and, thereby, accelerating the timing of the deduction. Put simply, the statutory changes were intended to address potential abuses in the nonqualified deferred compensation area; they were not intended to alter the meaning of Sec. 404(a) as applied to qualified plans, by incorporating Sec. 461 principles.

Further, the result reached in FSA 200107012 (that services must be performed before a qualified plan contribution is deductible) has been rejected in court decisions. For example, in Plastic Engineering and Manufacturing Co., 78 TC 1187 (1982), the IRS took the position that the annual deduction limit for qualified plan contributions should be prorated for the plan's first, short-plan year, because plan participants did not perform 12 full months of service during that time. The Service argued that contributions in excess of a prorated limit necessarily would relate to future services, and as such would not be deductible under Sec. 162 and therefore not otherwise deductible under Sec. 404(a).

The Tax Court rejected this argument, finding that there is no requirement in Sec. 404(a) that contributions relate to specific services performed prior to the close of the tax year. The court concluded that the requirement that contributions be for services actually rendered "is meant only to insure that those employees, for whom these pension benefits being acquired represent additional compensation, must actually provide service in order to earn the right thereto." In other words, the requirement that contributions be deductible otherwise, and thus generally "for services actually rendered," does not mean services must be performed in (or before) the tax year for which the deduction is claimed. Rather, it is a requirement that the crediting or allocation of benefits attributable to the contributions ultimately must be based on the performance of services; see also GCM 34962.

Timing Rules

The second curiosity of FSA 200107012 is that, even if the timing rules of Sec. 461 do apply to qualified plan contributions, a deduction for such contributions would be appropriate at the time the contribution is made, regardless of whether related services have been performed. For an expense to be deductible under Sec. 461, all events must occur to establish the fact of the liability, the amount of the liability must be determined with reasonable accuracy and economic performance must occur (Regs. Sec. 1.461-1(a)(2)). A contribution to a qualified trust, in itself, should establish a liability and the amount thereof. According to Rev. Rul. 74-468, "th[e] need to incur a liability for [a qualified plan] contribution is not present where a properly authorized contribution is actually paid to the...trust in the year for which the deduction is claimed." Consequently, the only remaining hurdle to deductibility should be whether there has been economic performance under Sec. 461(h). Regs. Sec.1.461-4 provides that "[e]xcept as otherwise provided in any Internal Revenue regulation, revenue procedure, or revenue ruling, the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under section 404." Because economic performance should be deemed to have occurred, the all-events test should be deemed satisfied and contributions to the trust should be deductible when made.

From Nancy Caplette, J.D., and Will Sollee, J.D., Washington, DC