Exempt employer's excise tax for nondeductible contributions to qualified plan.

The IRS has ruled in Letter Ruling 9304033 that a tax-exempt employer with an unrelated business income tax liability could be subject to the Sec. 4972 excise tax on nondeductible contributions even though it derived no tax benefit from the contributions--but only to the extent the contributions were attributable to employees involved in generating unrelated business income. The ruling also addressed how much of the nondeductible contribution the employer could get back from the plan.

Company, a Sec. 501(c)(3) tax-exempt organization, maintained a qualified defined benefit plan for its employees. The plan included language stating that contributions were conditioned on their deductibility. For 1989, Company made contributions to the plan totaling $227,730. However, sometime after making these contributions, Company was advised by its actuarial consultant that the maximum deductible contribution for 1989 was zero.

Company also reported unrelated business taxable income (UBTI) of $27,809 and paid unrelated business income tax (UBIT) of $4,171 for 1989. Company did not claim any part of its $227,730 plan contributions as a deduction in calculating its UBTI, and did not allocate contributions between employees involved in exempt operations and those involved in income-producing operations.

Company requested a ruling that the Sec. 4972 excise tax on nondeductible contributions did not apply to a tax-exempt employer with UBTI if the employer did not deduct its pension contributions. Company also requested, under Rev. Proc. 89-35, a ruling that the contributions would be nondeductible if claimed as a deduction, so that those amounts could be returned to Company under Rev. Rul. 77-200. (Note: Rev. Proc. 89-35 has since been superseded by Rev. Proc. 90-49; Rev. Rul. 77-200 has since been superseded by Rev. Rul. 91-4.)

Sec. 4972 imposes a 10% excise tax on nondeductible contributions to qualified plans that are not returned to the employer by the due date of the employer's tax return. Employers that have, at all times, been tax exempt are generally exempt from this excise tax (Sec. 4972(d)(1)(b)). The legislative history of Sec. 4972 indicates that Congress did not intend to deny this exemption entirely when a tax-exempt employer has been subject to unrelated business income tax: "Under rules to be prescribed by the Secretary, this exception does not apply to the extent that the employer has been subject to UBIT or has otherwise derived a tax benefit from the qualified plan." (Emphasis added.) (S. Rep. No. 100-445, at 70.) The Treasury, however, has not yet issued any rules addressing this issue.

Despite the absence of Treasury guidance, the Service ruled that to the extent Company was subject to UBIT or otherwise derived a tax benefit from the plan, its plan did not fall within the Sec. 4972(d)(1)(b) exception for plans maintained by exempt employers. Thus, since Company did not otherwise derive a tax benefit from the plan (for instance, by taking a deduction for the plan contributions against its unrelated business income (UBI)), only those contributions attributable to employees involved in generating UBI were subject to the 10% Sec. 4972 excise tax. To determine the amount attributable to such employees, the IRS took the total nondeductible contributions for 1989 ($227,730) and multiplied that by a fraction, the numerator of which was the salaries and wages attributable to such employees and taken as a deduction for 1989 ($5,317) and the denominator of which was the total annual compensation of the employees participating in the plan ($150 million). Under this formula, only $8.07 was subject to the 10% excise tax. The IRS considered that amount de minimis and thus declined to apply the tax.

An employer generally cannot withdraw the nondeductible portion of a contribution (Rev. Rul. 91-4). This prohibition against withdrawing funds is a qualification requirement under Sec. 401(a)(2), which requires that all principal or income be used for the exclusive benefit of the employees or their beneficiaries. Section 403(c)(1) of the Employee Retirement Income Security Act of 1974 (ERISA) contains a similar prohibition against diversion of plan assets.

Withdrawal of contributions is allowed under ERISA Section 403 and Rev. Rul. 91-4 if --the contribution is made by reason of a mistake of fact; --the contribution is conditioned on initial qualification of the plan and the plan does not qualify; or --the contribution is conditioned on its deductibility under Sec. 404.

To withdraw amounts based on the nondeductibility of contributions, the Service takes the position that the disallowance of the deduction must be made by the IRS. This precludes an employer from determining that the contribution is not deductible and withdrawing amounts previously paid into the plan. Under Rev. Rul. 91-4, the maximum amount that may be withdrawn is the excess of the amount contributed over the amount that would have been contributed had the contribution been limited to the amount deductible after any disallowance by the Service.

Rev. Proc. 89-35 provided a procedure under which employers could obtain such an IRS disallowance for defined benefit plan contributions made for plan years beginning in 1988, or made to satisfy the Sec. 412(m) quarterly contributions requirement for the first plan year beginning after Dec. 31, 1988. Rev. Proc. 90-49 provides such a procedure for contributions made to satisfy the quarterly contributions requirement for plan years beginning on or after Jan. 1, 1990.

The Service ruled in Letter Ruling 9304033 that a deduction of an exempt employer subject to UBIT could be disallowed under Rev. Proc. 89-35 and, thus, returned to the employer, only to the extent the contribution was attributable to employees involved in generating UBI. Thus, $8.07 was the total amount that theoretically could be disallowed under Rev. Proc. 89-35. Since that amount was de minimis, the IRS determined that no part of Company's 1989 contributions could be returned to Company.