October 12, 2023
By: Melanie N. Aska
The IRS periodically issues tax-related “Issue Snapshots” that can be of interest to employers and practitioners alike.
A recent “Issue Snapshot” discusses the timing rules that govern the deductibility of retroactive employer contributions and the allocation of those contributions to participant accounts under a new 401(k) plan established after the end of the employer’s taxable year.
Overview: Four Separate Code-Based Timing Rules
Several different sections of the Internal Revenue Code (the Code) apply in determining whether a retirement plan may be retroactively established for an employer’s taxable year and whether plan contributions made after taxable year-end are allocable to and deductible in the prior year. For a 401(k) plan, four separate Code-based timing rules apply for purposes of:
- Establishing the plan;
- Making elective deferrals to the plan;
- Making deductible employer profit-sharing or matching contributions to the plan; and
- Allocating contributions to employees’ accounts under the plan.
The Issue Snapshot summarizes all four Code-based timing rules:
First Timing Rule: Establishing a Plan. A plan must be established before contributions can be made or deducted. Before the SECURE Act (SECURE 1.0), enacted on December 20, 2019, an employer wishing to establish a retirement plan had to adopt a written plan document no later than the last day of the plan’s initial plan year. SECURE 1.0 amended the Code, effective for taxable years beginning after December 31, 2019, to permit an employer to establish a retirement plan retroactively, provided the employer adopted the new plan by the due date, including extensions, for filing the employer’s federal income tax return for the taxable year of adoption, and the employer elected to treat the plan as having been adopted as of the last day of that prior taxable year.
Example. A calendar-year employer could decide in March of 2024 to establish a retirement plan retroactively for the 2023 calendar year. If the employer establishes the plan prior to the due date, including extensions, of the employer’s 2023 tax return, the Code allows the employer to establish the plan, enabling employees to receive contributions on account of 2023 compensation. The employer would also be entitled to a deduction on its 2023 tax return.
Second Timing Rule: Making Elective Deferrals. A cash-or-deferred arrangement (CODA) is an arrangement under a 401(k) plan which allows eligible employees to make an election between receiving cash compensation or deferring compensation into the plan.
Under the general timing rule, an eligible employee can make a cash-or-deferred election only with respect to an amount of compensation that is not currently available to the employee on the date of his or her election. Compensation is considered “currently available” if it has already been paid or if the employee is currently able to receive the cash at his or her discretion. Accordingly, under the general timing rule, a CODA must be established before compensation can be deferred, and retroactive elective deferrals generally are not permitted. A CODA is considered “established” as of the later of the date the CODA is adopted or effective.
An exception to this general timing rule is available for new single-member 401(k) plans. Effective for plan years beginning after the December 29, 2022 enactment date of the SECURE 2.0 Act (SECURE 2.0), an individual who owns the entire interest in an unincorporated trade or business, and who is the only employee of that trade or business, can adopt a new 401(k) plan after the end of the taxable year and, for the first year only, can elect to defer into that plan net earnings from self-employment in the prior year as late as the due date for the individual’s tax return for that taxable year (determined without regard to any extensions).
Third Timing Rule: Making Deductible Profit-Sharing or Matching Contributions. An employer generally is permitted to deduct profit-sharing or matching contributions made after the close of the employer’s taxable year but before the due date of the employer’s tax return for that year, including extensions. Although the Code limits the employer’s deduction to contributions in the taxable year when paid, the employer is deemed to have paid contributions on the last day of the preceding taxable year if certain conditions are met. Retroactive payment is assumed if the employer treats the contribution as having been made in that taxable year for allocation purposes and actually pays the contribution to the plan not later than the due date of the employer’s tax return, including extensions. This rule applies to both cash and accrual basis employers.
Example. If the due date of an employer’s calendar-year 2023 Form 1040 or Form 1120 is April 15, 2024, with an extended due date of October 15, 2024 (after the automatic 6-month extension), the employer has until October 15, 2024, to make a 2023 profit-sharing contribution and deduct it on the employer’s 2023 tax return. If the employer files its 2023 tax return on June 1, 2024, the employer would still have until October 15, 2024, to make the profit-sharing contribution and deduct it on the employer’s 2023 tax return. Even if the employer files on or before April 15, 2024, the employer will still have until October 15, 2024, the employer’s extended due date, to make deductible profit-sharing contributions for 2023.
Matching contributions are employer contributions made on account of employee contributions or elective deferrals. Because matching contributions are tied to deferrals, they cannot be made on account of compensation earned after the end of the taxable year.
Fourth Timing Rule: Timing of Allocations to Participants’ Accounts. Employer contributions are not treated as credited to a participant’s account for a particular Code Section 415 limitation year unless the contributions are actually paid to the plan no later than 30 days after the extended due date of the employer’s tax return. Although the employer contributions can be allocated to participants if paid within 30 days after the end of that period, they cannot be deducted unless they are paid to the plan before the end of that period. Employer contributions paid to the plan and allocated after the extended due date of the employer’s tax return would be deductible in the following plan year, subject to the Code’s deduction limits.
Example. If the extended due date for the employer’s 2023 Form 1120 is October 15, 2024, the employer would have until November 14, 2024 (30 days after that extended due date), to make the contribution and allocate it to the 2023 plan year participants. However, although the employer contribution can be treated as a 2023 annual addition for Code Section 415 purposes if allocated to participants by November 14, 2024, the contribution would not be deductible on the employer’s 2023 tax return because the contribution was not paid to the plan by the October 15, 2024 extended due date for the employer’s 2023 tax return. However, the employer contribution would be deductible on the employer’s 2024 tax return, provided that, when combined with any other 2024 contributions deducted for the 2024 plan year, it does not exceed the Code’s deduction limits (25% of compensation) for 2024.
Additional Guidance in the IRS Issue Snapshot
The IRS’s Issue Snapshot includes five helpful examples that illustrate the above-described timing rules. The Issue Snapshot also includes several “issue indicators” or “audit tips,” one of which advises that plan documents should be reviewed to ensure that they are being followed in operation. For example, if the plan document provides that a contribution will not be made beyond the due date of the employer’s tax return, then a contribution paid to the plan beyond that time, although permissibly treated as an annual addition under Code Section 415 in the prior year, would not follow plan terms. Employer contributions that are made after the time prescribed by the plan document could constitute operational failures that would need to be corrected in accordance with applicable correction principles.
If you have any questions, please contact Melanie N. Aska at maska@murthalaw.com or 617.457.4131.
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