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IRS Clarifies Meaning of Plan “Contribution” for Tax Deduction Purposes

02.03.20

When is an employer contribution to a retirement plan truly a contribution eligible for a tax deduction under ERISA Section 404(a)? Although this might seem like a rhetorical question, it was deemed worthy enough to warrant a ruling by the U.S. Supreme Court. The IRS also addressed the matter in a chief counsel memorandum (CCM). The issue can arise when a plan sponsor does something more complicated than simply transfer corporate funds from its own bank account to that of the retirement plan trust in a straightforward manner.

The case

The Supreme Court addressed the issue in Don E. Williams Co. v. Commissioner. The 1977 opinion involved a company that was seeking a tax deduction for contributing a secured promissory note to its profit sharing plan trust.

The Court ruled that “a promissory note cannot properly be equated with a check, since a note … is still only a promise to pay.” In contrast, “a check is a direction to the bank for immediate payment, is a medium of exchange, and is treated, for federal tax purposes, as a conditional payment of cash.”

The IRS memo

Building on that case, in August 2019, the IRS CCM laid out how it might address several comparable scenarios. But remember that, because the IRS deems CCMs only to be “general legal advice,” you can’t cite one as legal precedent.

The CCM provided a pair of tests that must be applied on a “facts and circumstances” basis to determine whether an employer has truly made a contribution to a retirement plan that warrants a tax deduction for that contribution under ERISA Sec. 404(a). First, the court will determine whether the employer has made an “outlay of assets,” followed by an inquiry into whether the retirement plan trust can take full advantage of whatever the employer has contributed.

Outlay of assets test. To have an outlay of assets, the employer “must experience … a reduction in assets.” As noted, the Supreme Court didn’t consider giving a promissory note to the plan as a reduction in assets.

But what if the promissory note was secured by collateral? In the Don E. Williams case, the plan sponsor argued that, because the promissory note was fully secured, it was the equivalent of a contribution. But as the IRS memo states, “It is irrelevant whether the employer’s promissory note is secured, because the provision of collateral is not payment and does not transform the promise into an actual payment within the meaning of Sec. 404(a).”

“Take full advantage” test. In this test, the “degree of encumbrance on the asset restricting the trustee’s flexibility to use it to best fit the needs of the plan” is critical, and determined by facts and circumstances. According to the CCM, an “employer who retains significant control over the contributed asset has not actually made a payment to the trust, because no amount is irrevocably set aside for the plan.”

Draw the line

Ideally, your company’s liquidity will never be strained to the point where you’re tempted to push the envelope on the definition of a “contribution” to your retirement plan. But if that happens, thanks to the CCM, you should have sufficient guidance to know where the line is drawn.

Some CCM examples

The IRS’s chief counsel memorandum (CCM; see main article) provided several examples of contributions and whether they fit into the ERISA Section 404(a) definition. For example, scenarios described in the CCM that wouldn’t make the cut as an ERISA 404(a) contribution for deduction purposes include:

Publicly traded debt. This wouldn’t pass the test because, even with the added liquidity of a traded security, it still just represents a promise to pay and not an actual payment.

Book entry. Merely designating a liability on your books on an accrual basis without a corresponding transfer of assets isn’t a contribution.

Assets in escrow. Even if a contribution is in cash, if that cash is held in escrow and the plan cannot immediately access it, no deduction can be taken.

Less clear-cut examples in which all the facts and circumstances must be taken into account, according to the CCM, include the employer retaining the option to buy back assets contributed to the trust for a price deemed fair by another fiduciary. The same applies to assets contributed to the trust when the trust retains the option to sell them back to the plan sponsor at fair market value.