Final Nondescrimination Regs for Qualified Plans

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations relating to the $200,000 compensation limit for tax-qualified retirement plans under section 401(a)(17) of the Internal Revenue Code of 1986. These regulations reflect changes made by the Tax Reform Act of 1986 and the Technical and Miscellaneous Revenue Act of 1988. These regulations provide guidance necessary to comply with the law and affect sponsors of, and participants in, tax-qualified retirement plans.

 EFFECTIVE DATE: These regulations are effective for plan years beginning on or after January 1, 1991, and are applied to those plan years except as set forth in section 1.401(a)(17)-1(d).

 FOR FURTHER INFORMATION CONTACT: David Fuller at 202-377-9372 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

STATUTORY AUTHORITY

This document contains final regulations under section 401(a)(17) of the Internal Revenue Code of 1986 (Code). These regulations conform the regulations to section 1106 of the Tax Reform Act of 1986 (TRA '86) and section 1011(d)(4) of the Technical and Miscellaneous Revenue Act of 1988. These regulations are issued under the authority contained in sections 401(a)(17) and 7805 of the Code.

 Proposed regulations under section 401(a)(17) were published in the Federal Register May 14, 1990(55 FR 19947). Written comments were received from the public on the proposed regulations. In addition, a public hearing on the proposed section 401(a)(17) regulations was held September 26, 27, and 28, 1990. After consideration of all of the written comments received and the statements made at the public hearing, the proposed regulations under section 401(a)(17) are adopted as modified by this Treasury Decision.

EXPLANATION OF PROVISIONS

OVERVIEW

Section 401(a)(17) of the Code provides an annual compensation limit for each employee under a qualified plan. This limit applies to a plan in two ways. First, a plan may not base contributions or benefits on compensation in excess of the annual limit. Thus, a plan does not satisfy section 401(a)(17) unless it provides that an employee's compensation in excess of the annual limit is not used in determining plan benefits or contributions for a plan year to which the annual limit applies. Second, the amount of an employee's annual compensation that may be taken into account in applying certain specified nondiscrimination rules under the Code is subject to the annual limitation. Thus, in determining the allocation rates for defined contribution plans and the accrual rates for defined benefit plans, an employee's compensation in excess of the annual limit is disregarded in applying those nondiscrimination rules. The annual compensation limit applies separately to each group of plans that is treated as a single plan for purposes of the applicable nondiscrimination requirement.

1. ANNUAL ADJUSTMENT OF COMPENSATION LIMIT

 The amount of the annual limit, which applies for plan years beginning after December 31, 1988, is $200,000 adjusted annually for calendar years after 1989 for increases in the cost of living at the same time and in the same manner as under section 415(d). The adjustment applies to plan years, or other 12-month periods used to determine compensation, commencing in the calendar year in which the adjustment is effective. In addition, any increase in the annual limit applies only to compensation taken into account for the year of the increase and subsequent years and does not apply to compensation for prior years that are used in determining an employee's benefit.

 Commentators suggested that the annual adjustments to the compensation limit apply for plan years ending in the year to which the limit applies as provided in the regulations under section 415(d) and further suggested that, once the limit is increased for a year, the adjusted limit should be permitted to be taken into account with respect to prior years as well. After careful consideration of these comments, the final regulations retain the rules provided in the proposed regulations. The Treasury and the Service continue to believe this result best implements the statute and Congressional intent as expressed in the Conference Report to TRA '86. See H.R. Rep. No. 99-841, Vol.II, 99th Cong., 2d Sess. 13-478(1986).

2. PROPORTIONAL REDUCTION IN LIMIT.

 Under the proposed regulations, a proportional reduction was required when a plan determines compensation on a period of time that contains fewer than 12 calendar months. The proposed regulations did not require proration solely because employees are covered under a plan for less than 1 full year if the plan formula for allocations or benefit accruals is based on compensation for a period of at least 12 months. The final regulations retain the proration rule in the proposed regulations. In addition, the final regulations clarify that no proration is required where the plan formula provides that the allocation or accrual for each employee is based on compensation for the portion of the plan year during which the employee is a participant.

3. MULTIEMPLOYER AND MULTIPLE EMPLOYER PLANS.

COMPENSATION LIMIT.

Several commentators requested guidance on the manner in which the compensation limit would apply where an employee worked for two or more unrelated employers who maintain the same multiple employer or multiemployer plan. In response to these comments, the final regulations provide that, in the case of multiple employer and multiemployer plans, the annual compensation limit applies separately with respect to the compensation received by an employee from each unrelated employer maintaining the plan rather than to the total compensation from all employers maintaining the plan. Thus, for example, during a year in which the compensation limit was $200,000, assume that an employee participating in a multiemployer plan was employed by three of the employers maintaining the plan and received compensation for a year of $75,000 from one employer maintaining the plan, $40,000 from another employer maintaining the plan, and $95,000 from the third employer. On these facts, the plan would be permitted to take into account the full $210,000 of the employee's compensation from the three employers for the plan year without violating section 401(a)(17).

CORRECTION OF PLANS MAINTAINED BY MORE THAN ONE EMPLOYER.

Multiple employer plans must satisfy section 401(a)(17) on an employer-by-employer basis. Failure to satisfy section 401(a)(17) with respect to any component of this testing process may result in disqualification of the plan for all participating employers. The final regulations, like the proposed regulations, do not provide an exception to this rule. However, where a multiemployer plan or a multiple employer plan fails to satisfy section 401(a)(17), in a proper case, the Commissioner could retain the plan's qualified status for innocent employers by requiring corrective and remedial action with respect to the plan, such as allowing the withdrawal of an offending employer, allowing a disqualifying defect to be cured within a reasonable period of time after the plan administrator has or should have knowledge of the disqualifying event or was otherwise notified by the Service of the disqualifying defects, or requiring plan amendments to prevent future disqualifying events.

4. COMPENSATION OF SELF-EMPLOYED INDIVIDUALS SUBJECT TO THE LIMIT.

 The proposed regulations provided that the amount of compensation subject to the annual limit for a self-employed individual was determined by subtracting the deduction allowed by section 404 to the individual for contributions to the plan on the individual's behalf from the amount otherwise treated as compensation. This rule was not included in the final regulations because the result intended by the rule may be reached if a plan simply defines compensation of self-employed individuals used in the plan's allocation formula as earned income within the meaning of section 401 (c)(2). The subtraction described in the proposed regulations is included automatically in the determination of earned income. Therefore, instead of a specific rule applicable to self- employed individuals, the final regulations contain two examples illustrating the application of section 401(a)(17) to the compensation of self-employed individuals.

5. EFFECTIVE DATE AND TRANSITION RULES.

 Section 401(a)(17) is generally effective for plan years beginning on or after January 1, 1989. A special effective date is provided for collectively bargained plans. The final regulations under section 401(a)(17) are effective for plan years beginning on or after January 1, 1991. For plan years beginning before that date but on or after the date that section 401(a)(17) first applies to a plan, the plan must be operated in accordance with a reasonable, good faith interpretation of the requirements of section 401(a)(17). Whether compliance is reasonable and in good faith will be determined on the basis of all the facts and circumstances, including the extent to which the employer has resolved unclear issues in its favor. Reasonable, good faith interpretation will be deemed to exist, however, if a plan is operated in accordance with the proposed regulations published in the Federal Register on May 14, 1990, or these final regulations.

 A special effective date is provided for governmental plans within the meaning of section 414(d) to provide governments with adequate time to amend their plans to comply with section 401(a)(17). Thus, the regulations provide that governmental plans described in section 414(d) will automatically satisfy the requirements of section 401(a)(17) for plan years beginning before January 1, 1993.

 The final regulations provide, as in the proposed regulations, that the benefits or contributions accrued under a plan for plan years prior to the effective date of section 401(a)(17) are not subject to the annual compensation limit. Thus, an employee's allocations or benefit accruals prior to the 1989 plan year, that are based on compensation in excess of the annual compensation limit, need not reduce or affect the employee's allocations or benefit accruals in subsequent years.

 As provided in the proposed regulations, the final regulations provide generally that benefits or contributions accruing or allocated for plan years beginning on or after the section 401(a)(17) effective date may not take into account compensation for any plan year in excess of the annual compensation limit applicable to that plan year. The proposed regulations provided examples illustrating the application of this rule to a high average pay defined benefit plan. In determining the high average pay used in calculating accruals for plan years to which section 401(a)(17) applies, the example showed that there are three general options for implementing this rule. The first is to apply the plan benefit formula (after amendment to satisfy section 401(a)(17)) to all years of service. This method provides for a gradual wear-away of the pre-effective date benefit, the calculation of which took into account compensation exceeding the section 401(a)(17) annual limit. The second option is to apply the plan formula (after amendment to comply with section 401(a)(17)) only to years of service beginning on or after the section 401(a)(17) effective date and simply add those benefits to the benefits that accrued before the effective date. The third option combines the first two options such that the plan formula provides the employee with the larger of the two benefit amounts. All three methods essentially require the amount of an employee's accrued benefit as of the section 401(a)(17) effective date ("pre-effective date benefit") to be fixed.

 Commentators requested more guidance with respect to the transition rules than was provided in the examples in the proposed regulations. For example, they inquired whether adjustments were permitted to the pre-effective date benefits to take into account increases in the section 415 dollar limits and whether ad hoc cost- of-living adjustments were permitted to be made to the benefits of former employees whose benefits were originally calculated taking into account compensation in excess of the annual compensation limits.

 The final regulations generally retain the examples provided in the proposed regulations illustrating possible methods that may be used to transition into section 401(a)(17) compliance. In addition, the final regulations reflect modifications to coordinate the transition rules under section 401(a)(17) with the transition rules provided in the final regulations under section 401(a)(4) (issued simultaneously with these regulations). Thus, these final regulations incorporate the fresh-start rules in section 1.401(a)(4)-13(c) and (d) into the section 401(a)(17) transition rules to the extent applicable, with appropriate modifications.

 The fresh-start rules in the final section 401(a)(4) regulations generally parallel the examples in the proposed regulations under section 401(a)(17). Thus, under the section 401(a)(4) fresh-start rules, an employee's accrued benefit generally must be fixed ("frozen") as of a certain date selected by an employer ("fresh-start date"), and an employee's benefit accruals for plan years after that date must be determined under the formula in effect for that plan year applied either to years of service after the fresh-start date or all the employee's years of service. The fresh-start rules permit certain adjustments to be made to the frozen accrued benefit, including certain adjustments for increases in the employee's compensation, adjustments due solely to increases in the limits under section 415(d), and certain benefit accruals on behalf of former employees. Consistent with the final section 401(a)(4) regulations, the fresh-start rules in these final regulations also generally permit similar adjustments to be made to the pre-effective date benefit that are permitted to be made under the fresh-start rules to frozen accrued benefits to extent that they are consistent with the implementation of section 401(a)(17).

 Finally, in order to permit employers to implement changes required by TRA'86 and the related regulations in a consistent manner, the final regulations under section 401(a)(17) permit a fresh-start date not later than the last day of the last plan year beginning before January 1, 1992.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Administrator of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are Marjorie Hoffman and David Fuller of the Office of the Assistant Chief Counsel (Employee Benefits and Exempt Organizations), Internal Revenue Service. However, personnel from other offices of the Service and Treasury participated in their development.

LIST OF SUBJECTS IN 26 CFR 1.401-0 THROUGH 1.419A-2T

 Bonds, Employee benefit plans, Income taxes, Pensions, Reporting and recordkeeping requirements, Securities, Trusts and trustees.

Treasury Decision 8362

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 is amended by adding the following citation:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 * * * section 1.401(a)(17)-1 also issued under 26 U.S.C. 401(a)(17). * * *

Par. 2. A new section 1.401(a)(17)-1 is added to read as follows:

SECTION 1.401(a)(17)-1 LIMITATION ON ANNUAL COMPENSATION.

(a) COMPENSATION LIMIT REQUIREMENT -- (1) IN GENERAL. In order to be a qualified plan, a plan must satisfy section 401(a)(17). Section 401(a)(17) provides an annual compensation limit for each employee under a qualified plan. This limit applies to a qualified plan in two ways. First, a plan may not base allocations, in the case of a defined contribution plan, or benefit accruals, in the case of a defined benefit plan, on compensation in excess of the annual limit. Second, the amount of an employee's annual compensation that may be taken into account in applying certain specified nondiscrimination rules under the Internal Revenue Code is subject to the annual limitation. These two limitations are set forth in paragraphs (b) and (c) of this section, respectively.

(2) ANNUAL COMPENSATION LIMIT. For purposes of this section, "annual compensation limit" means $200,000, adjusted annually by the Commissioner. The amount of the annual compensation limit is adjusted at the same time and in the same manner as under section 415(d). The base period for the annual adjustment is 1989; the first adjustment is effective on January 1, 1990; and the dollar increase in effect on January 1 is effective for any plan year beginning in the calendar year. For example, if a plan has a plan year beginning July 1, 1989, and ending June 30, 1990, the annual compensation limit in effect on January 1, 1989 ($200,000), applies to the plan for the entire plan year. In addition, if compensation for any plan year beginning prior to the effective date that section 401(a)(17) first applies to a plan is used for determining allocations or benefit accruals, or when applying any nondiscrimination rule, in any year subject to section 401(a)(17), then the annual compensation limit for that prior year is the annual compensation limit for 1989 ($200,000).

(b) PLAN LIMIT ON COMPENSATION -- (1) GENERAL RULE. A plan does not satisfy section 401(a)(17) unless it provides that the compensation taken into account for any employee in determining plan allocations or benefit accruals for any plan year is limited to the annual compensation limit. For purposes of this rule, allocations and benefit accruals under a plan include all benefits provided under the plan, including ancillary benefits.

(2) PLAN-YEAR-BY-PLAN-YEAR REQUIREMENT. For purposes of this paragraph (b), the limit in effect for the current plan year applies only to the compensation for that year that is taken into account in determining plan allocations or benefit accruals for the year. The compensation for any prior plan year taken into account in determining an employee's allocations or benefit accruals for the current plan year is subject to the applicable annual compensation limit in effect for that prior year. Thus, increases in the annual compensation limit apply only to compensation taken into account for the plan year in which the increase is effective. For example, if an employer has a defined benefit plan that bases benefits on the average of an employee's compensation for the three plan years during which the average of the employee's compensation is the highest, compensation for each of the plan years used in the average must be limited to the annual compensation limit in effect for the respective years.

(3) APPLICATION OF LIMIT TO A PLAN YEAR -- (i) IN GENERAL. For purposes of applying this paragraph (b), the annual compensation limit is applied to the compensation for the plan year on which allocations or benefit accruals for that plan year are based.

(ii) COMPENSATION FOR THE PLAN YEAR. A plan may determine compensation used in determining allocations or benefit accruals for a plan year based on compensation for the plan year. In this case, the annual compensation limit that applies to the compensation for the plan year is the limit in effect for the calendar year in which the plan year begins. Alternatively, a plan may determine compensation used in determining allocations or benefit accruals for the plan year for all employees on the basis of a 12-consecutive- month period, or periods, ending no later than the last day of the plan year. If compensation is based on these alternative 12-month periods, the annual compensation limit applies to compensation for each of those periods based on the annual compensation limit in effect for the respective calendar year in which each 12-month period begins.

(iii) COMPENSATION FOR A PERIOD OF LESS THAN 12-MONTHS -- (A) PRORATION REQUIRED. If compensation for a period of less than 12 months is used for a plan year, then the otherwise applicable annual compensation limit is reduced in the same proportion as the reduction in the 12-month period. For example, if a defined benefit plan provides that the accrual for each month in a plan year is separately determined based on the compensation for that month and the plan year accrual is the sum of the accrual for all months, then the annual compensation limit for each month is 1/12th of the annual compensation limit for the plan year. In addition, if the period for determining compensation used in calculating an employee's allocation or accrual for a plan year is a short plan year (i.e., shorter than 12 months), the annual compensation limit is an amount equal to the otherwise applicable annual compensation limit multiplied by the fraction, the numerator of which is the number of months in the short plan year, and the denominator of which is 12.

(B) NO PRORATION REQUIRED FOR PARTICIPATION FOR LESS THAT A FULL PLAN YEAR. Notwithstanding paragraph (b)(3)(iii)(A) of this section, a plan is not treated as limiting the compensation used in determining an employee's allocations or benefit accruals to a specified portion of the employee's annual compensation merely because the plan formula provides that the allocation or accrual for each employee is based on compensation for the portion of the plan year during which the employee is a participant in the plan. In addition, no proration is required merely because an employee is covered under a plan for less than a full plan year, provided that allocations or benefit accruals are otherwise determined using compensation for a period of at least 12 months.

(4) LIMITS ON MULTIPLE EMPLOYER AND MULTIEMPLOYER PLANS. For purposes of this paragraph (b), in the case of a plan described in section 413(c) or 414(f) (a plan maintained by more than one employer), the annual compensation limit applies separately with respect to the compensation of an employee from each employer maintaining the plan rather than the total compensation from all employers maintaining the plan.

(5) FAMILY AGGREGATION. [Reserved]

(6) EXAMPLES. The following examples illustrate the rules in this paragraph (b).

EXAMPLE 1. Plan X is a defined benefit plan and bases benefits on the average of an employee's high 3 consecutive years' compensation. Section 401(a)(17) applies to Plan X in 1989. Employee B's high 3 consecutive years' compensation prior to the application of the annual compensation limits is $215,000 (1989), $200,000 (1988), and $185,000 (1987). To satisfy this paragraph (b), Plan X cannot base plan benefits for Employee B in 1989 on compensation in excess of $195,000 (the average of $200,000 (B's 1989 compensation capped by the annual compensation limit), $200,000 (B's 1988 compensation), and $185,000 (B's 1987 compensation)). For purposes of determining the 1989 accrual, each year (1989, 1988, and 1987), not the average of the 3 years, is subject to the 1989 annual compensation limit of $200,000.

EXAMPLE 2. Assume the same facts as in EXAMPLE 1. Also assume that Employee B's compensation in 1990 is $230,000, and that the 1990 annual compensation limit is $209,200. Plan X cannot base plan benefits for Employee B in 1990 on compensation in excess of $203,067 (the average of $209,200 (B's 1990 compensation capped by the 1990 limit), $200,000 (B's 1989 compensation capped by the 1989 limit), and $200,000 (B's 1988 compensation)). In calculating plan benefits in 1990, the 1990 annual compensation limit applies to the 1990 year only. The 1989 year is capped by the 1989 annual compensation limit. Each year used in the average, including the 1988 plan year, is subject to the applicable annual compensation limit for that year.

EXAMPLE 3. Assume the same facts as EXAMPLE 1, except that Employee B's high 3 consecutive years' compensation prior to the application of the limits is $230,000 (1989), $220,000 (1988), and $210,000 (1987). To satisfy this paragraph (b), Plan X cannot base plan benefits for Employee B in 1989 on compensation in excess of $200,000 (the average of $200,000 (B's 1989 compensation capped by the 1989 annual compensation limit), $200,000 (B's 1988 compensation capped by the $200,000 annual compensation limit applicable to all years before 1989), and $200,000 (B's 1987 compensation capped by the $200,000 annual compensation limit applicable to all years before 1989).

EXAMPLE 4. Plan Z is a defined benefit plan that bases benefits on an employee's high consecutive 36 months of compensation ending within the plan year. Employee C's high 36 months are the period September 1989 to August 1992, in which Employee C earned $50,000 in each month. The annual compensation limit is $200,000, $209,200, and $222,220 in 1989, 1990, and 1991, respectively. To satisfy this paragraph (b), Plan Z cannot base plan benefits for Employee C on compensation in excess of $210,473 for the 1992 plan year. This amount is determined by applying the applicable annual compensation limit to compensation for each of the three 12-consecutive-month periods. The September 1989 to August 1990 period is capped by the annual compensation limit of $200,000 for 1989, the September 1990 to August 1991 period is capped by the annual compensation limit of $209,200 for 1990, and the September 1991 to August 1992 period is capped by the annual compensation limit of $222,220 for 1991. The average of these capped amounts is the annual compensation limit for determining benefits for the 1992 year.

EXAMPLE 5. (a) Employer X is a partnership. Employer X maintains Plan M, a profit-sharing plan that provides for an annual allocation of employer contributions of 15 percent of plan year compensation for employees other than self-employed individuals, and 13.0435 percent of plan year compensation for self-employed individuals. In order to satisfy section 401(a)(17), the plan provides that the plan year compensation used in determining the allocation of employer contributions for each employee may not exceed the annual limit in effect for the plan year. The plan year of Plan M is the calendar year. Plan M defines compensation for self-employed individuals (employees within the meaning of section 401(c)(1)) as the self-employed individual's net profit from self-employment attributable to Employer X minus the amount of the self-employed individual's deduction under section 164(f) for one-half of self-employment taxes. Plan M defines compensation for all other employees as wages within the meaning of section 3401(a). Employee A and Employee B are partners of Employer X and thus are self-employed individuals. Neither Employee A nor Employee B owns an interest in any other business. For the 1991 calendar year, Employee A has net profit from self-employment of $150,000, and Employee B has net profit from self-employment of $230,000. The deduction for each employee under section 164(f) for one-half of self- employment taxes is $5,123.

(b) The plan year compensation under the plan formula for Employee A is $144,877 ($150,000 minus $5,123). The allocation of employer contributions under the plan allocation formula for 1991 for Employee A is $18,897 ($144,877 (Employee B's plan year compensation for 1991) multiplied by 13.0435%). The plan year compensation under the plan formula before application of the annual limit under section 401(a)(17) for Employee B is $224,877 f($230,000 minus $5,123). After application of the annual limit, the plan year compensation for the 1991 plan year for Employee A is $222,220 (the annual limit for 1991). Therefore, the allocation of employer contributions under the plan allocation formula for 1991 for Employee B is $28,985 ($222,220 (Employee B's plan year compensation after application of the annual limit for 1991) multiplied by 13.0435%).

EXAMPLE 6. The facts are the same as in EXAMPLE 5, except that Plan M provides that plan year compensation for self- employed individuals is defined as earned income within the meaning of section 401(c)(2) attributable to Employer X. In addition, Plan M provides for an annual allocation of employer contributions of 15 percent of plan year compensation for all employees in the plan. The net profit from self-employment for Employee A and the net profit from self-employment for Employee B are the same as provided in EXAMPLE 5. However, the earned income of Employee A determined in accordance with section 401(c)(2) is $125,980 ($150,000 minus $5123 minus $18,897). The earned income of Employee B determined in accordance with section 401(c)(2) is $195,545 ($230,000 minus $5,123 minus $29,332). Therefore, the allocation of employer contributions under the plan allocation formula for 1991 for Employee A is $18,897 ($125,980 (Employee A's plan year compensation for 1991) multiplied by 15%). Employee B's earned income for 1991 does not exceed the 1991 annual limit of $222,220. Therefore, the allocation of employer contributions under the plan allocation formula for 1991 for Employee B is $29,332 ($195,545 (Employee B's plan year compensation for 1991) multiplied by 15%).

(c) LIMIT ON COMPENSATION FOR NONDISCRIMINATION RULES -- (1) GENERAL RULE. The annual compensation limit applies for purposes of applying the nondiscrimination rules under sections 401(a)(4), 401(a)(5), 401(l), 401(k)(3), 401(m)(2), 403(b)(12), and 410(b)(2). The limit also applies in determining whether an alternative method of determining compensation impermissibly discriminates under section 414(s)(3). This paragraph (c) provides rules for applying the annual compensation limit for these purposes. For purposes of this paragraph (c), "compensation" means the compensation used in applying the applicable nondiscrimination rule.

(2) PLAN-YEAR-BY-PLAN-YEAR REQUIREMENT. For purposes of this paragraph (c), when applying an applicable nondiscrimination rule for a plan year, the compensation for each plan year taken into account is limited to the applicable annual compensation limit in effect for that year, and an employee's compensation for that plan year in excess of the limit is disregarded. Thus, if the nondiscrimination provision is applied on the basis of compensation determined over a period of more than one year (for example, high average compensation) the annual compensation limit in effect for each of the plan years used in the average applies to the respective plan year's compensation taken into account in determining the average.

(3) PLAN-BY-PLAN LIMIT. For purposes of this paragraph (c), the annual limit applies separately to each plan (or group of plans treated as a single plan) of an employer for purposes of the applicable nondiscrimination requirement. For this purpose, the plans included in the testing group taken into account in determining whether the average benefit percentage test of section 1.410(b)-5 is satisfied are generally treated as a single plan.

(4) APPLICATION OF LIMIT TO A PLAN YEAR. The rules provided in paragraph (b)(3) of this section regarding the application of the limit to a plan year apply for purposes of this paragraph (c).

(5) LIMITS ON MULTIPLE EMPLOYER AND MULTIEMPLOYER PLANS. The rule provided in paragraph (b)(4) of this section regarding the application of the limit to multiple employer and multiemployer plans applies for purposes of this paragraph (c).

(d) EFFECTIVE DATE -- (1) STATUTORY EFFECTIVE DATE -- (i) GENERAL RULE. Except as otherwise provided in this paragraph (d)(1), section 401(a)(17) applies to allocations and benefit accruals for plan years beginning on or after January 1, 1989.

(ii) EXCEPTION FOR COLLECTIVELY BARGAINED PLANS. In the case of a plan maintained pursuant to 1 or more collective bargaining agreements between employee representatives and 1 or more employers ratified before March 1, 1986, section 401(a)( 17) applies to allocations and benefit accruals for plan years beginning on or after the earlier of --

(A) January 1, 1991, or

(B) The later of January 1, 1989, or the date on which the last of the collective bargaining agreements terminates (determined without regard to any extension or renegotiation of any agreement occurring on or after March 1, 1986). For purposes of this paragraph (d)(2)(ii), any extension or renegotiation of a collective bargaining agreement, which extension or renegotiation is ratified after February 28, 1986, is disregarded in determining the date on which the agreement terminates.

(iii) EXCEPTION FOR GOVERNMENTAL PLANS. Section 401(a)(17) is considered satisfied for plan years beginning before January 1, 1993, in the case of governmental plans described in section 414(d).

(2) REGULATORY EFFECTIVE DATE. This section 1.401(a)(17)-1 applies to plan years beginning on or after January 1, 1991. For plan years beginning before that date, and on or after the first day of the first plan year to which section 401(a)(17) applies, a plan must be operated in accordance with a reasonable, good faith interpretation of section 401(a)(17). Whether a plan is operated in accordance with a reasonable, good faith interpretation of section 401(a)(17) is generally determined based on all the relevant facts and circumstances, including the extent to which an employer has resolved unclear issues in its favor. A plan is deemed to be operated in accordance with a reasonable, good faith interpretation of section 401(a)(17) if it is operated in accordance with the terms of this section.

(3) PRE-EFFECTIVE DATE BENEFITS -- (i) IN GENERAL. For purposes of this paragraph (d), allocations or benefits accrued under a plan for plan years beginning before the statutory effective date applicable to the plan under paragraph (d)(1) of this section are not subject to the annual compensation limits.

(ii) ALLOCATIONS FOR YEARS BEFORE THE EFFECTIVE DATE. Allocations for plan years beginning before the statutory effective date applicable to the plan under paragraph (d)(1) of this section include all amounts allocated or treated as allocated to the account of an employee for those plan years, including employer contributions, forfeitures, elective contributions, employee contributions, and matching contributions, plus earnings, expenses, gains, and losses attributable to those amounts. In the case of a defined contribution plan subject to section 412, the amount of employer contributions treated as allocated for the plan year is the amount of employer contributions required to be allocated under the plan to the employee's account for the plan year, even if all or part of any required contribution is not actually made.

(iii) BENEFITS ACCRUED FOR YEARS BEFORE THE EFFECTIVE DATE. The benefits accrued for plan years beginning before the statutory effective date applicable to the plan under paragraph (d)(1) of this section by any employee are the employee's benefits accrued under the plan, determined as if those benefits had been frozen (as defined in section 1.401(a)(4)-12) as of the last day of the last plan year beginning before the statutory effective date, disregarding any amendments adopted after the date that the employee's benefits under the plan are treated as frozen. Thus, benefits accrued for those plan years do not include any benefits accrued under an amendment granting past service that is adopted after the date that the employee's benefits under the plan must be treated as frozen. Nonetheless, service for the employer after that date continues to be taken into account for purposes of determining an employee's nonforfeitable percentage and eligibility for benefits, rights, and features under the plan with respect to the benefits treated as frozen under this paragraph (d)(3)(iii).

(e) DETERMINATION OF POST-EFFECTIVE-DATE ACCRUED BENEFITS -- (1) IN GENERAL. The plan formula that is used to determine the amount of allocations or benefit accruals for plan years beginning on or after the statutory effective date must comply with section 401(a)(17). However, in determining whether an allocation or benefit accrual under the plan formula for plan years beginning on or after the statutory effective date satisfies section 401(a)(17), a plan is not required to take into account any allocations or benefit accruals described in paragraph (d)(3) of this section. This paragraph (e) provides rules for applying section 401(a)(17) in the case of section 401(a)(17) employees who accrue additional benefits in a plan year beginning on or after the statutory effective date. Paragraph (e)(2) of this section contains definitions used in applying this paragraph (e). Paragraphs (e)(3) and (e)(4) of this section explain the application of the fresh-start rules in section 1.401(a)(4)-13 to the determination of the accrued benefits of section 401(a)(17) employees.

(2) DEFINITIONS. For purposes of this paragraph (e), the following definitions apply:

(i) "Statutory effective date" means the first day of the first plan year beginning on or after the statutory effective date applicable to the plan under paragraph (d)(1) of this section.

(ii) "Section 401(a)(17) employee" means an employee with accrued benefits in plan years beginning before the statutory effective date that were determined taking into account compensation that exceeded the annual compensation limit for any year.

(iii) "Section 401(a)(17) fresh-start date" means a fresh-start date as defined in section 1.401(a)(4)-12 not earlier than the last day of the last plan year beginning before the statutory effective date and not later than the last day of the last plan year beginning before January 1, 1992 (or January 1, 1993, in the case of governmental plans described in section 414(d)).

(iv) "Section 401(a)(17) frozen accrued benefit" means the accrued benefit for any section 401(a)(17) employee frozen (as defined in section 1.401(a)(4)-12) as of the last day of the last plan year beginning before the statutory effective date, determined in the same manner as provided in paragraph (d)(3)(iii) of this section.

(3) APPLICATION OF FRESH-START RULES -- (i) GENERAL RULE. In order to satisfy section 401(a)(17), the plan must determine the accrued benefit of each section 401(a)(17) employee by applying the fresh-start rules in section 1.401(a)(4)-13(c). The fresh-start rules must be applied using a section 401(a)(17) fresh-start date and using the plan benefit formula after amendment to comply with section 401(a)(17) and this section as the formula applicable to benefit accruals in the current plan year.

(ii) FRESH START FOR SECTION 401(a)(17) EMPLOYEES ONLY. The fresh-start rules in section 1.401(a)(4)-13(c) may be applied in accordance with paragraph (e)(3)(i) of this section to determine the accrued benefits of all section 401(a)(17) employees in the plan but not the accrued benefit of other employees in the plan in lieu of applying the rules to determine the benefits of all employees in the plan as otherwise required under the consistency rule in section 1.401(a)(4)-13(c)(ii).

(iii) CONSISTENCY RULES IN SECTION 1.401(a)(4)-13(c) AND (d) -- (A) GENERAL RULE. In applying the fresh-start rules of section 1.401(a)-13(c) and (d) to section 401(a)(17) employees, the consistency rules of those sections govern, unless otherwise provided. Thus, for example, if the plan is using a fresh-start date applicable to all employees and not adjusting frozen accrued benefits under section 1.401(a)(4)-13(d) for employees other than section 401(a)(17) employees, frozen accrued benefits may not be adjusted for section 401(a)(17) employees after the fresh-start date under section 1.401(a)(4)-13(d) or this paragraph (e) either. Notwithstanding the foregoing, if the fresh-start rules provided in paragraph (e)(3)(i) of this section are applied to determine benefits of section 401(a)(17) employees only, the consistency rules in section 1.401(a)(4)-13(c) and (d) are applied as if the section 401(a)(17) employees were the only employees in the plan. For example, if the fresh-start rules are applied using the section 401(a)(17) fresh- start date to determine benefits of section 401(a)(17) employees only, the same formula in section 1.401(a)(4)-13(c)(2), (c)(3), or (c)(4) must be applied to determine the accrued benefits of all section 401(a)(17) employees in the plan after the section 401(a)(17) fresh-start date.

(B) DETERMINATION OF ADJUSTED ACCRUED BENEFIT. If the fresh- start rules of section 1.401(a)(4)-13(c) and (d) are applied to determine the benefits of all employees after a fresh-start date, the plan will not fail to satisfy the uniformity requirement of section 1.401(a)(4)-13(c)(5) merely because the plan makes the adjustment described in section 1.401(a)(4)-13(d)(5) and (d)(6) to the frozen accrued benefits of employees who are not section 401(a)(17) employees, but does not make the adjustment to the frozen accrued benefits of section 401(a)(17) employees. In addition, the plan does not fail the uniformity requirement of section 1.401(a)(4)-13(c)(5) merely because the plan makes the adjustment described in section 1.401(a)(4)-13(d)(6) for section 401(a)(17) employees on the basis of the old compensation fraction (as required by paragraph (e)(4)(iii) of this section), but for employees who are not section 401(a)(17) employees on the basis of the new compensation fraction or the reconstructed compensation fraction.

(4) PERMITTED ADJUSTMENTS TO FROZEN ACCRUED BENEFIT OF SECTION 401(a)(17) EMPLOYEES -- (i) GENERAL RULE. Except as otherwise provided in paragraphs (e)(4)(ii) and (iii) of this section, the rules in section 1.401(a)(4)-13(c)(5) permitting certain adjustments to frozen accrued benefits apply to section 401(a)(17) frozen accrued benefits.

(ii) OPTIONAL FORMS OF BENEFIT. After the section 401(a)(17) fresh-start date, a plan may be amended to provide a new optional form of benefit or to make an optional form available with respect to the section 401(a)(17) frozen accrued benefit provided that the optional form of benefit is not subsidized. An optional form is not subsidized only if it is the actuarial equivalent of the employee's accrued benefit using a reasonable interest rate and reasonable mortality assumptions. A standard interest rate and a standard mortality table (as defined in section 1.401(a)(4)-12) are deemed to be reasonable for this purpose.

(iii) DETERMINING ADJUSTED SECTION 401(a)(17) ACCRUED BENEFIT -- (A) FRESH START AS OF STATUTORY EFFECTIVE DATE. For purposes of section 1.401(a)(4)-13(d), if the plan uses a section 401(a)(17) fresh-start date that is the last day of the last plan year beginning before the statutory effective date, the section 401(a)(17) frozen accrued benefit of each section 401(a)(17) employee may be adjusted in accordance with section 1.401(a)(4)-13(d)(6), if applicable, with the following modifications --

(1) The adjustment must be made using the old compensation fraction described in section 1.401(a)(4)-13(d)(6)(i)(A).

(2) The numerator of the old compensation fraction in section 1.401(a)(4)-13(d)(6)(i)(A) must be determined after applying the section 401(a)(17) compensation limit for the current plan year, and the denominator of the fraction must be determined as of the last day of the last year before the statutory effective date without regard to the section 401(a)(17) compensation limit.

(B) FRESH STARTS AFTER STATUTORY EFFECTIVE DATE. For purposes of section 1.401(a)(4)-13(d), if the plan uses a section 401(a)(17) fresh-start date or any other fresh-start date that is later than the last day of the last plan year beginning before the statutory effective date, the adjusted accrued benefit (within the meaning of section 1.401(a)(4)-13(d)) for each section 401(a)(17) employee must be determined after the fresh-start date under the following bifurcated method --

(1) Determine the section 401(a)(17) employee's frozen accrued benefit in accordance with section 1.401(a)(4)-13(c)(1)(i) as of the fresh-start date.

(2) Determine the employee's section 401(a)(17) frozen accrued benefit adjusted in accordance with paragraph (e)(4)(iii)(A) of this section, if applicable, through the fresh-start date.

(3) Subtract from the frozen accrued benefit determined in paragraph (e)(4)(iii)(B)(1) of this section the employee's adjusted section 401(a)(17) frozen accrued benefit determined in paragraph (e)(4)(iii)(B)(2) of this section. This is the employee's post- effective date frozen accrued benefit.

(4) Adjust the employee's pest-effective date frozen accrued benefit in accordance with section 1.401(a)(4)-13(d)(6) under the normal rules applicable to employees who are not section 401(a)(17) employees. Thus, in determining the numerator and the denominator of the fraction used to adjust the post-effective date frozen accrued benefit, the annual compensation limit under section 401(a)(17) applies.

(5) Adjust the section 401(a)(17) frozen accrued benefit in paragraph (e)(4)(iii)(B)(2) of this section in accordance with section 1.401(a)(4)-13(d)(6), as modified by paragraph (e)(4)(iii)(A) of this section.

(6) The adjusted accrued benefit of the section 401(a)(17) employee after the fresh-start date is the sum of the amounts in paragraphs (e)(4)(iii)(B)(4) and (5) of this section.

(5) EXAMPLES. The following examples illustrate the rules in this paragraph (e).

EXAMPLE 1. (a) Plan Y is a calendar year defined benefit plan providing an annual benefit for each year of service equal to 2 percent of compensation averaged over an employee's high 3 consecutive calendar years' compensation. Plan Y is not a collectively bargained plan or a governmental plan. As of the close of the last plan year beginning before January 1, 1989 (i.e., the 1988 plan year), Employee A, with 5 years of service, had accrued a benefit of $25,000 which equals 10 percent (2 percent multiplied by 5 years of service) of average compensation of $250,000. Effective for plan years after December 31, 1988, Plan Y is amended to provide that in determining an employee's benefit, compensation taken into account is subject to the annual compensation limit under section 401(a)(17), and that, for section 401(a)(17) employees, the employee's accrued benefit is the greater of the employee's benefit under the plan formula after the plan formula is amended to comply with section 401(a)(17) as applied to the employee's total years of service, and the employee's accrued benefit as of December 31, 1988, determined as though the employee terminated employment on that date without regard to any plan amendments after that date. Employer X decides not to amend Plan Y to provide for the adjustments permitted under section 1.401(a)(4)-13(d)(6) to the accrued benefit of section 401(a)(17) employees as of December 31, 1988.

(b) Under Plan Y's formula, Employee A's accrued benefit at the end of 1989 is $25,000, which is the greater of Employee A's accrued benefit as of the last day of the 1988 plan year ($25,000), and $24,000, which is Employee A's benefit based on the plan's formula applied to Employee A's total years of service ($200,000 multiplied by (2 percent multiplied by 6 years of service)). The formula of Plan Y applicable to section 401(a)(17) employees for calculating their accrued benefits for years after the section 401(a)(17) fresh-start date is the formula in section 1.401(a)-13(c)(3) (formula with wear-away). The fresh-start formula is applied using a benefit formula that satisfies section 401(a)(17) and this section and is applied using December 31, 1988, as the section 401(a)(17) fresh-start date. Thus, Plan Y, as amended, satisfies paragraph (e)(3)(i) of this section.

EXAMPLE 2. Assume the same facts as in Example 1, except that the plan formula provides that effective January 1, 1989, for section 401(a)(17) employees, the employee's benefit will equal the sum of an employee's accrued benefit as of December 31, 1988 (determined as though he terminated employment on that date and without regard to any amendments after that date), and 2 percent of compensation averaged over an employee's high 3 consecutive years' compensation times years of service taking into account only years of service after December 31, 1988. Thus, under Plan Y's formula, Employee A's accrued benefit at the end of 1989 is $29,000, which is Cal to the sum of $25,000 (Employee A's accrued benefit at the end of 1988) plus $4,000 ($200,000 multiplied by (2 percent multiplied by 1 year of service)). The formula of Plan Y applicable to section 401(a)(17) employees for calculating their accrued benefits for years after the section 401(a)(17) fresh-start date is the formula in section 1.401(a)-13(c)(2) (formula without wear- away). The fresh-start formula is applied using a benefit formula' for the 1989 plan year that satisfies section 401(a)(17) and this section and is applied using December 31, 1988, as the section 401(a)(17) fresh-start date. Thus, Plan Y, as amended, satisfies paragraph (e)(1) of this section.

EXAMPLE 3. Assume the same facts as in EXAMPLE 1, except that the plan formula provides that effective January 1, 1989, an employee's benefit equals the greater of the plan formulas in EXAMPLE 1 and EXAMPLE 2. Thus, under Plan Y's formula, Employee A's accrued benefit at the end of 1989 is $29,000, which is Dual to the greater of $25,000 and $29,000. The formula of Plan Y applicable to section 401(a)(17) employees for calculating their accrued benefits for years after the section 401(a)(17) fresh-start date is the formula in section 1.401(a)-13(c)(4) (formula with extended wear-away). The fresh- start formula is applied using a benefit formula for the 1989 plan year that satisfies section 401(a)(17) and this section and is applied using December 31, 1988, as the section 401(a)(17) fresh-start date. Thus, Plan Y, as amended, satisfies paragraph (e)(1) of this section.

EXAMPLE 4. Assume the same facts as in EXAMPLE 3. As of December 31, 1995, Employee A's average annual compensation under the plan compensation formula, disregarding the amendment to comply with section 401(a)(17) is Dual to $300,000. Assume that the annual compensation limit is adjusted to $260,000, $270,000, and 280,000 for plan years beginning on or after January 1, 1993, 1994, and 1995, respectively. The compensation that may be taken into account for the 1995 plan year cannot exceed $270,000 (the average of $260,000, $270,000, and $280,000). Therefore, at the end of December 31, 1995, the amount using formula with wear-away would be $64,800 ($270,000 multiplied by (2 percent multiplied by 12 years of service)). The amount using formula without wear-away would be $62,800 which is equal to $25,000 (Employee A's section 401(a)(17) frozen accrued benefit) plus $37,800 ($270,000 multiplied by (2 percent multiplied by 7 years of service)). Thus, because Employee A's accrued benefit is being determined using formula with extended wear-away, the accrued benefit is equal to the greater of the two amounts. Employee A's accrued benefit at the end of 1995 is $64,800.

EXAMPLE 5. (a) Assume the same facts as in EXAMPLE 4, except that Plan Y satisfies section 1.401(a)(4)-13(d)(2) through (d)(5) and that the amendment to Plan Y effective for plan years beginning after December 31, 1988, also provided for adjustments in accordance with section 1.401(a)(4)-13(d)(6) to the frozen accrued benefit of section 401(a)(17) employees. No other fresh-start date applies to the calculation of benefits under Plan Y.

(b) The numerator of Employee A's old compensation fraction is $270,000 (the average of Employee A's annual compensation for 1993, 1994, and 1995, as limited by the respective annual limit for each of those years). The denominator of Employee A's old compensation fraction determined in accordance with the modification in paragraph (e)(4)(iii)(A)(2) of this section is $250,000 (the average of Employee A's high 3 consecutive year's annual compensation as of December 31, 1988, determined without regard to section 401(a)(17)). Therefore, Employee A's old compensation fraction is $270,000/$250,000. Employee A's adjusted section 40l(a)(17) frozen accrued benefit adjusted through December 31, 1988, is $27,000 (($270,000 divided by $250,000) multiplied by $25,000). Therefore, the accrued benefit using the formula without wear-away would also be $64,800 ($27,000 (Employee A's adjusted section 401(a)(17) accrued benefit) plus $37,800 ($270,000 multiplied by (2 percent multiplied by 7 years of service))).

EXAMPLE 6. (a) Assume the same facts as in EXAMPLE 2 (example illustrating formula without wear-away), except that as of December 31, 1991, Employer X amends Plan Y to increase benefits to 3 percent of each employee's average annual compensation using the average of the 5 consecutive calendar years out of the last 10 consecutive calendar years during which the average of the employee's compensation is the highest. (After amendment, Plan Y satisfies the requirements of section 1.401(a)(4)-3(b)(3).) Employer X applies the fresh- start rules in section 1.401(a)(4)-13(c) using the formula in section 1.401(a)(4)-13(c)(2) (formula without wear-away) to all employees. Plan Y satisfies the requirements of section 1.401(a)(4)-13(d)(2) through (5) and the amendment increasing benefits also provides for the frozen accrued benefit of each employee to be adjusted in accordance with section 1.401(a)(4)- 13(d)(6) using the new compensation fraction in section 1.401(a)(4)-13(d)(6)(i)(B). In applying the new compensation formula, Plan Y provides that average annual compensation will be determined using the plan's compensation formula. However, Plan Y provides that the adjusted accrued benefits of section 401(a)(17) employees are to be determined using the bifurcated method in paragraph (e)(4)(iii)(B) of this section. Employee A's calendar year compensation exceeds the section 401(a)(17) limit for every year through 1992. Assume that the annual limit for 1992 is $245,000.

(b) Employee's A's frozen accrued benefit as of December 31, 1991, determined under the fresh-start rules of section 1.401(a)(4)-13(c)(2) (formula without wear-away) is $37,628 ($25,000 plus $12,628 (($210,473 (the average of $200,000, $209,200, and $222,220) multiplied by 2 percent) multiplied by 3 years)). Employee A's frozen accrued benefit adjusted through December 31, 1992, determined in accordance with paragraph (e)(4)(iii)(B) of this section is calculated as follows:

(1) Employee A's post-effective date frozen accrued benefit is $12,628 ((Employee A's frozen accrued benefit as of December 31, 1991) ($37,628) minus (Employee A's section 401(a)(17) frozen accrued benefit ($25,000))).

(2) The numerator of Employee A's new compensation fraction is $215,284 (the average of $200,000, $200,000, $209,200, $222,220, and $245,000). The denominator of Employee A's new compensation fraction is $206,284 (the average of $200,000, $200,000, $200,000, $209,200, and $222,220).

(3) Employee A's post-effective date frozen accrued benefit adjusted through December 31, 1992, is $13,179 (($215,284 divided by $206,284) multiplied by $12,628).

(4) Employee A's section 401(a)(17) frozen accrued benefit adjusted through December 31, 1992, remains $25,000. The old compensation fraction determined in accordance with the modification in paragraph (e)(4)(iii)(A) of this section is less than one ($225,473 (the average of $209,200, $222,220, and $245,000) divided by $250,000).

(5) Employee A's adjusted accrued benefit as of December 31, 1992, equals $38,179 (the sum of the amounts from paragraphs (b)(3) and (b)(4) of this EXAMPLE).

(f) ADDITIONAL RULES. The Commissioner may, in revenue rulings, notices, and other guidance of general applicability, provide any additional rules that may be necessary or appropriate concerning the annual limits on compensation under section 401(a)(17).