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Under the minimum participation requirements of Code § 401(a)(26), a defined benefit plan generally must benefit at least 50 employees or 40 percent of all employees, whichever is less. The IRS takes the position that an employee must receive a "meaningful benefit" in order to be counted toward the required number of employees. Under the best of circumstances, compliance with these rules can be a problem for some professional firms and smaller employers. In recent years, many such employers have adopted, or considered adopting, plan designs that use a normal retirement age that is younger than age 65. The problems these employers can have with the minimum participation rules may have been exacerbated by a recent, yet-to-be-published Tax Advice Memorandum ("TAM").
Whether a plan benefit is "meaningful" in the IRS' view is based on a facts and circumstances test. In June of 2002, the IRS adopted a safe-harbor rule: If the annual accrued benefit is at least 0.5% of pay, it will be considered to be meaningful. Many plans specify a normal retirement age of 65. In that case the plan's accrued benefit is the annual annuity commencing at 65. The IRS has and will continue to consider a benefit of 0.5% of pay commencing at an age 65 normal retirement age to be "meaningful."
In the TAM, the IRS National Office considered how the meaningful benefit rule applied to a plan that had a normal retirement age of 50. The taxpayer had argued before the IRS Field Actuary that the plan provided a meaningful benefit for a participant when the benefit projected to commence at age 65 was at least 0.5% of pay per year of service. However, the Field Actuary took the position that the 0.5% of pay benefit had to commence at age 50. And the IRS National Office upheld the Field Actuary's position.
It is fair to say that practitioners had widely understood that the facts and circumstances nature of the rule would mean that the correct answer in the case before the IRS should have been:
A meaningful benefit is provided if the benefit commencing at the normal retirement age of 50 is the actuarial equivalent of a 0.5% of pay benefit commencing at age 65.
It would seem that a benefit commencing at age 50 that is the actuarial equivalent of a 0.5% of pay benefit commencing at age 65 is every bit as meaningful as the age 65 benefit. And the IRS has (at least up to now) issued favorable Determination Letters to plans that applied this actuarial equivalent concept—even when a detailed disclosure of the concept was made in the request for the Determination Letter.
This change in IRS position could have a serious impact on the employer's cost. If the concept of actuarial equivalence will no longer be recognized by the IRS—and, therefore, the benefit commencing at age 50 has to be 0.5% of pay—the value of a benefit commencing at age 50 (and the cost to the plan sponsor) will be about 33% greater than that of the benefit commencing at age 65. Similar cost increases could be expected for defined benefit plans that use other normal retirement ages younger than 65.
The taxpayer's argument to the IRS Field Actuary was not described in detail in the TAM—and the IRS did not discuss why the concept of actuarial equivalence would not apply. It could be that the argument based on actuarial equivalence was not made—and was not considered by the IRS National Office.
Given the importance of using normal retirement ages younger than 65 for unrelated plan design reasons (such as to implement phased retirement), we expect that the IRS will get push back over this potential change in position from the benefits firms that provide services to professional firms and small employers. They will likely urge the IRS National Office to apply an actuarial equivalent concept in this context. It must also be kept in mind that the 0.5% of pay level is just a "safe harbor" invented by the IRS, has never been issued as a final regulation, and has not yet been considered by the courts.