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"Active participation" plus IRA deductibility every third year.

A planning opportunity exists to time profit-sharing contributions in such a way that contributions can be made for even/plan year but avoid the "active participation" taint for participants even/ third year.

Sec. 219(g){5} limits individual retirement account {IRA} deductibility in years in which an individual is an active participant in an employer plan. Notice 87-16 provides guidance on determining active participation. Generally, for defined contribution plans, an individual is active if employer or employee contributions or forfeitures are allocated to such individual's account for the plan year ending with or within the individual's tax year. Under this rule, if an employer made a discretionary profit-sharing contribution for every plan year, the participants would be considered active every year.

However, Notice 87-16 contains a special rule providing an opportunity for certain discretionary profit-sharing plans. If no amount attributable to forfeitures, employer contributions or employee contributions has been allocated to an individual's account by the last day of a particular plan year, and contributions to the plan are purely discretionan/, such individual shall not be an active participant for the tax year in which such plan year ends. If, however, after the end of such plan year, the employer contributes an amount for such plan year, an individual to whose account an allocation is made shall be an active participant for the tax year in which the contribution is made.

If this special rule was not further limited, an opportunity would exist to avoid the "active" taint every other year simply by doubling up contributions even/ other year. For example, assuming a calendar year discretionary profit-sharing plan adopted effective Jan. 1, 1992 (with no forfeitures or employee contributions), making both the 1992 and 1993 contributions in 1993 and both the 1994 and 1995 contributions in 1995 would make the participants "active" for 1993 and 1995 but not for 1992 or 1994.

This every-other-year plan is defeated by the further limitation contained in A-26 of Notice 87-16, which provides that, when contributions to a discretionary profit-sharing plan for two plan years are made in one calendar year, the contributions for the later plan year are deemed to be made in the next tax year. This leads to the "even/third year" planning opportunity, illustrated in the table shown above.

This planning opportunity will not apply when there are forfeitures being reallocated or employee contributions {including Sec. 401{k} contributions) being allocated in the otherwise inactive years. Although not entirely clear, it appears that forfeitures "taint" the participants in the plan year in which they are allocated (i,e. the year for which they appear on the participant's benefit statementl and not the following year {in which the allocation work is done]. To avoid disruption from forfeitures, the clients who might be best suited to use this "every third year" tax plan would be employers who already have fully vested plans or who would consider fully vesting the participant's accounts.

With respect to employee contributions, generally the inclusion of a Sec. 401(k) feature effectively solves the "active participation" problem for nonhighly compensated employees; they can then use the Sec. 401{k} feature as an IRA substitute. However, the actual deferral percentage (ADP) test often precludes similar utilization by the highly compensated group. From John M. Peterson, CPA, Goodman @ Company, Norfolk, Va.
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Author:Peterson, John M., Jr.
Publication:The Tax Adviser
Date:Aug 1, 1992
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