Good Planning or Pension Manipulation?

A front page article in the August 4th edition of the Wall Street Journal outlines a method by which companies are transferring portions of their non-qualified deferred compensation obligations of senior executives into their qualified plans. As reported by the Journal: “In recent years, companies from Intel Corp. to CenturyTel, Inc. collectively have moved hundreds of millions of dollars of obligations for executive benefits into rank-and-file pension plans. This lets companies capture tax breaks intended for pensions of regular workers and use them to pay for executives’ supplemental benefits and compensation.”

In order for a pension plan to qualify for favorable tax treatment (current deduction of employer contributions and tax-deferral on any investment gains), the plan must meet certain requirements set forth in the Internal Revenue Code, including the requirement that neither contributions nor benefits under the plan discriminate in favor of highly compensated employees. According to the Journal article, “benefits consultants market sophisticated techniques to help companies do just that, without running afoul of IRS rules against favoring the highly paid.”

There are significant tax advantages if a company can provide more of an executive’s pension under a qualified plan rather than a non-qualified deferred compensation arrangement. In Intel’s case, according to the Journal, it contributed $187,000 to the qualified plan to fund $200,000 of its deferred compensation liability. The ability to immediately deduct the $187,000 allowed Intel to save $65,000 in taxes according to the Journal. While these benefits were being provided under a non-qualified deferred compensation arrangement, Intel would not be entitled to a tax deduction until the benefits were actually received by an executive.

The pension system in the United States is a voluntary system and unless an employer deems it to be in its best interest to establish a plan, it will not do so. Therefore, the tax system provides incentives for employers to establish plans for their employees, including the highly compensated employees. The anti-discrimination and other rules set forth in the Code are designed to assure that the non-highly compensated received adequate benefits vis-à-vis the highly compensated before an employer qualifies for the tax advantages of a qualified plan. The program outlined in the Journal article may very well be reasonable. The IRS should examine this practice to determine whether it violates the anti-discrimination rules. If it does, the IRS should eliminate it administratively or request Congress to pass clarifying legislation. For example, Congress enacted IRC Section 401(a)(19) in order to prevent a perceived abuse of the comparability procedures for testing compliance with the nondiscrimination rules.