Practical Law Practice Note

ILENE H.FERENCZY, ESQ.

FERENCZY BENEFITS LAW CENTER LLP, WITH PRACTICAL LAW EMPLOYEE BENEFITS & EXECUTIVE COMPENSATION

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Under the Internal Revenue Code (Code) certain sponsors of defined benefit pension plans that are covered by the Pension Benefit Guaranty Corporation (PBGC) may take a larger tax deduction for their plan contributions than sponsors of pension plans that are not covered by the PBGC. Under the Employee Retirement Income Security Act of 1974 (ERISA), pension plans established and maintained by a professional service employer that have never had more than 25 participants are exempt from PBGC coverage. This Practice Note provides an overview of the favorable tax treatment for certain small defined benefit plans and explains how the PBGC determines the professional status for those defined benefit plans. It also discusses practical implications of the PBGC rulings.

Under Section 404(a)(7) of the Internal Revenue Code (Code), sponsors of certain defined benefit pension plans that are covered by the Pension Benefit Guaranty Corporation (PBGC) are allowed to take a larger tax deduction for their plan contributions than sponsors of pension plans that are not covered by the PBGC (26 U.S.C. § 404(a)(7)).

However, under Section 4021(b)(l3) of the Employee Retirement Income Security Act of 1974 (ERISA), defined benefit plans established and maintained by a professional service employer that have never had more than 25 participants are exempt from PBGC coverage (29 U.S.C. §1321(b)(l3)). Those plans cannot take the larger deduction available to certain PBGC-covered plans.

In the absence of a PBGC ruling, it can be difficult to determine whether a pension plan is sponsored by a small professional employer and therefore exempt from PBGC coverage because the PBGC uses vague criteria to determine whether a plan sponsor is a professional.

This Practice Note:

• Explains the favorable tax treatment that the Code provides to certain small defined benefit plans.
• Explains how the PBGC determines the professional status for plan sponsors of defined benefit plans.
• Discusses examples of how the PBGC has applied those factors to specific plan sponsors.
• Discusses the practical implications of the PBGC rulings.

TAX DEDUCTION OF PLAN SPONSOR’S CONTRIBUTIONS FOR SPONSORS OF BOTH DEFINED BENEFIT PLANS AND DEFINED CONTRIBUTION PLANS

Certain PBGC-covered plan sponsors are permitted to deduct more each year than sponsors of similarly situated plans that are not PBGC-covered.

The maximum deductible amount for contributions to a defined benefit plan under Code Section 404(a)(1) (26 U.S.C. § 404(a)(1)) is different from the required minimum funding amount that an employer must contribute  to the plan (as determined by the plan’s actuary under Code Sections 412 and 430 (26 U.S.C.§§ 412 and 430)).  This produces a range of amounts that the employer may legally contribute that is anything between the minimum funding amount and the maximum deductible amount (see Practice Notes, Minimum Funding Standards for Defined Benefit Plans (W-001-0223) and Requirements for Qualified Retirement  Plans: Minimum Funding Requirements (3-506-6895)).

The deduction rules are different when an employer sponsors both a defined benefit and a defined contribution plan. Under Code Section 404(a)(7)(A), the maximum deduction for a contribution to a defined benefit plan not covered by the PBGC, in combination with a defined contribution plan, is the greater of:

•  Twenty-five percent of eligible compensation.
• The minimum funding requirement for the defined benefit plan. (26 U.S.C. § 404(a)(7)(A).)

However, an employer contribution to the defined contribution plan that is no greater than six percent of the compensation paid or accrued during the taxable year to the beneficiaries under the plan is fully deductible in addition to the defined benefit plan’s minimum funding requirement, which is also fully deductible, even if the total exceeds 25 percent of compensation (26 U.S.C. § 404(a)(7)(C)(ii)(l)). (This limit prevents an employer from contributing more than the minimum contribution to the defined benefit plan if the total deduction exceeds the 25 percent of compensation limitation.)

The Code provides that the two-plan deduction limit under Code Section 404(a)(7), which applies when the defined benefit plan is exempt from PBGC coverage, does not apply if the defined benefit plan is PBGC-covered (26 U.S.C. § 404 (a)(7)(C)(iv)). Specifically, the deduction limit in Code Section 404(a)(7)(C)(iii)(l) does not apply if the employer sponsors a PBGC-covered defined benefit plan as well as a defined contribution plan. When the defined benefit plan is covered by the PBGC, the full permissible deduction under Code Section 404(a)(l) may be made for the defined benefit plan (not just the deduction for the minimum funding requirement), as well as any desired profit sharing contribution up to the deductible limit for a profit-sharing plan (generally, 25 percent of pay, plus any salary deferrals if the plan has a 40l(k) feature (26 U.S.C. §§ 404(a)(3) and 404(n))).

Therefore, if the defined benefit plan is subject to PBGC coverage, the employer’s potential deduction is much greater than for an employer with a defined benefit plan that is not PBGC-covered.

PBGC COVERAGE

A defined benefit plan is generally PBGC-covered unless an exemption applies. Plans that are exempt from PBGC coverage include:

• Governmental plans.
• Church plans (see Practice Note, Church Retirement Plans (W-002-8456)).
• Top-hat plans.
• Owner-only plans.
• Individual account (defined contribution) plans.
• Plans for nonresident aliens.
• Workers’ compensation plans.
• Plans of professional service employers that have always covered 25 or fewer active participants.

(29 u.s.c. § 1321(b).)

Most of the exceptions to PBGC coverage are straightforward. However, the exception for plans of professional service employers that have always covered 25 or fewer active participants is not as clear-cut, even though it is a common exception applied to plans of small, closely held companies (ERISA Section 4021(b)(13) (29 U.S.C. §1321(b)(13))).

Under ERISA, a “professional service employer” for purposes of the PBGC rules is:

• Any proprietorship, partnership, corporation, or other association or organization.
• Owned or controlled by professional individuals or by executors or administrators of provisional individuals.
• The principal business of which is the performance of professional service.

(ERISA § 4021(c)(2)(A) (29 U.S.C. § 1321(c)(2)(A)).)

A “professional individual” is defined by ERISA as including but not limited to:

• Physicians.
• Dentists.
• Chiropractors.
• Osteopaths.
• Optometrists.
• Other licensed practitioners of the healing arts.
• Attorneys at law.
• Public accountants.
• Public engineers.
• Architects.
• Draftsmen.
• Actuaries.
• Psychologists.
• Social or physical scientists.
• Performing artists.

(ERISA § 4021(c)(2)(B) (29 U.S.C. § 1321(c)(2)(B)).)

The phase “includes but is not limited to” provides an expansive definition of professional. It is difficult to know if a business owner or operator is a professional individual so that the company is considered a professional service employer whose defined benefit plan is not covered by the PBGC. Although there are no regulations that clarify this definition, the PBGC has issued several opinion letters. The general language used by the PBGC in these opinions states that, when determining whether an individual is a professional individual, the PBGC analyzes the services performed and the expertise required to perform them. The PBGC further stated that in these cases:

• A professional generally is someone providing services that require knowledge of an advanced type in a field of science or learning customarily acquired by a prolonged course of specialized intellectual instruction and study, as distinguished from general academic education and from an apprenticeship or from training in the performance of routine mental, manual, or physical processes.
• The rendering of professional services generally requires the consistent exercise of discretion and judgment in its performance and is predominantly intellectual in character.

(PBGC Opinion Letter 96-1,1996 WL 926114 (June 27,1996) (Opinion Letter 96-1), citing PBGC OL 79-12,1979 WL 6879 (Sept. 19,1979).)

This language provides two compelling factors for determining whether someone is a professional. A professional:

• Has something more than a high school diploma or possibly even a four-year college degree.
• Exercises discretion and judgment.

PBGC RULINGS

In the absence of specific guidance, reviewing how the PBGC has made its past decisions on these types of requests can be helpful. However, there are no published Opinion Letters dated after 2002 on the PBGC website, although  the website appears up-to-date through June 2016. Current rulings appear to be done in individualized letters to the applicant, without publication.

It is important to note that not all PBGC guidance is provided as a formal opinion letter and PBGC guidance may include informal email correspondence with the PBGC relating to the professional status of an individual.

RULINGS WHERE THE PBGC FOUND THAT THE OWNER WAS A PROFESSIONAL

In the following rulings, the PBGC found that the owner was a professional:

• In Opinion Letter 79-12, a municipal planning consultant was deemed to be a professional. The owner of the company was licensed by the State of New Jersey, which required that he or she have a degree in planning, engineering, or architecture, plus two years of experience. The consultant worked with development plans, land use studies, and housing surveys. No construction work was performed. (1979 WL 6879 (Sept. 19,1979).)
• In Opinion Letter 82-1, the PBGC looked at whether a licensed pharmacist was a professional, particularly when the pharmacy at which the pharmacist works sells many items other than prescription drugs. Noting that more than 50 percent of that pharmacy’s sales related to prescription drugs, the PBGC found that the principal business was the provision of professional services (1982 WL 21102 (Jan.19,1982) and also see PBGC Opinion Letter 82-18,1982 WL 21117 (June 9,1982).) Based on this opinion, as well as the analysis provided by the PBGC in another recent determination regarding a financial advisor’s status, it appears that the test for whether a company predominantly provides professional services is whether the professional services represent more than 50 percent of the activities or fees earned.
• In Opinion Letter 96-1, the PBGC looked at a company of economists with doctorates and certified public accountants involved in economic analysis, particularly in relation to international economics and accounting issues regarding transfer pricing. The plan sponsor argued that it qualified for the exemption as an economic consulting firm. The PBGC initially determined that the plan was not exempt from coverage under Title IV of ERISA, despite the fact that these individuals were highly educated, because there are no state licensing requirements for economists. The company requested reconsideration of the determination and provided additional information about the nature of the company’s work. On appeal, the PBGC determined that the company’s principal business is the performance of professional services under ERISA Section 4021(c)(2)(A)(ii) (29 U.S.C. §1321(c)(2)(A)(ii)) and therefore the plan was exempt from coverage under Title IV of ERISA. The dispositive factors included:
  • the consultants’ advanced education and work experience; and
  • the nature of the consultants’ analysis, which requires advanced knowledge and a consistent exercise of discretion and judgment.

(1996 WL 926114 (June 27,1996).)

• In Opinion Letter 97-2, the PBGC determined that licensed surveyors are professionals. The surveyors seeking this PBGC determination were licensed in Virginia and were principals in a Virginia professional incorporation. The PBGC determined that these licensed surveyors were professionals because:
  • licensed surveyors in Virginia must have graduate degrees in surveying or surveying technology and must pass a 16-hour state examination; and
  • the principals of this company, under Virginia law, were personally liable for negligence and maintained professional malpractice insurance.

(1997 WL 1189356 (Dec. 29, 1997).)

RULINGS WHERE THE PBGC FOUND THAT THE OWNER WAS NOT A PROFESSIONAL

In the following rulings, the PBGC found that the owner was not a professional:

• In Opinion Letter 80-12, a real estate broker was not a professional because the duties of a real estate broker, buying and selling real estate, or assisting others in buying and selling real estate, do not require a prolonged course of specialized intellectual instruction and are not predominantly intellectual in character (1980 WL 8808 (June 9,1980)).
• In Opinion Letter 98-1, a management consulting firm to Fortune 500 companies (whose owner had a degree from the University of London) was not a professional because the owner had neither an advanced degree nor state licensing obligations and the services provided were considered by the PBGC to be a “broad range” that did not require specialized knowledge of an advanced type (1998 WL 1181127 (Feb. 17,1998)).

In other opinion letters, the PBGC declined to extend professional status to:

• Insurance agents (PBGC Opinion Letter 76-106,1976 WL 4965 (Sept. 3,1976)).
• Public relations and advertising consultants (the lack of a prolonged course of specialized intellectual instruction was specifically mentioned as the determining factor, although the PBGC noted that these positions required a high degree of skill (PBGC Opinion Letter 80-13, 1980 WL 8809 (June 20,1980))).
• Foresters, even though the job involved timber cruising, forest consulting, logging supervision, and land appraising and required a high degree of skill (PBGC Opinion Letter 80-14,1980 WL 8816 (June 20,1980)).
• Boat pilots (PBGC Opinion Letter 80-15,1980 WL 8810 (June 20,1980)).
• Opticians (PBGC Opinion Letter 80-9,1980 WL 8805 (June 9, 1980)).
• Food brokers (PBGC Opinion Letter 80-10,1980 WL 8806 (June 9, 1980)).
• Artists or designers doing advertising layouts (PBGC Opinion Letter 80-11,1980 WL 8807 (June 9,1980)).
• Embalmers and funeral directors (PBGC Opinion Letter 78-21,1978 WL 5741(Sept. 19,1978)).

In several of these opinion letters, the PBGC acknowledged that high degrees of skill were involved, but that did not equate to the level of study and instruction that makes someone a professional.

CONCLUSIONS FROM PUBLISHED PBGC GUIDANCE

The PBGC published guidance does not provide any consistency on which a plan sponsor can rely. While the PBGC is concerned about the length and complexity of study, it is reasonable to conclude that state licensing is likely to make the PBGC lean toward professional status. However, many licensed individuals with significant technical training were not found to be professionals by the PBGC.

The PBGC’s ruling that the management consultant with the degree from University of London was not a professional seems to indicate that a bachelor’s degree is not enough and a post-graduate degree may be required by the PBGC (PBGC Opinion Letter 98-1, 1998 WL 1181127 (Feb. 17, 1998)).

It is hard to discern how the PBGC determines whether an individual is a professional. For example, it seems reasonable to conclude that a real estate broker, insurance agent, optician, or funeral director does not involve primarily mechanical and nonintellectual activities, with little to no exercise of discretion. A real estate broker offers buyers a view of houses for sale, while an insurance broker sells guaranteed investment contracts and annuities. However, the PBGC ruled that both real estate brokers and insurance brokers are not professionals. Among many businesses, the level of discretion differs only slightly but the PBGC does not have consistent rulings.  This can be seen in a recent PBGC determination (see Recent PBGC Determination: Investment  Advisor).

RECENT PBGC DETERMINATION: INVESTMENT ADVISOR

Recently, the PBGC determined that an investment advisor is a professional. In this case, the investment  advisor sponsored both a defined benefit plan and a 40l(k) plan. During an IRS audit of the retirement plans, the IRS examiner  took the position that the defined benefit plan was not PBGC-covered and the sponsor was not entitled to the full deduction taken for the relevant years. The examiner argued that the plan sponsor was an investment advisor and investment advisors were professionals.

The facts in this case were that the owner of the company:

• Had Series 6, 7, 22, 24, and 63 licenses to sell securities and an insurance license.
• Was registered to sell securities in 30 states.
• Became an advisor approximately 30 years ago.
• Had no college degree, although the owner did obtain the designation of Certified Financial Planner (CFP) in the 1980s, after taking five or six classes (amounting to the equivalent of approximately 18 hours of semester credit) and a multiple­-choice examination that was much less robust than current CFP examinations. (The current examination is made up of two three-hour segments.)
• Has clientele composed of high net worth individuals and retirement plans.
• Is an ERISA investment advisor fiduciary.
• Conducts services involved in making investment recommendations, for which the owner uses both the owner’s expertise as a licensed advisor and the owner’s 30 years of experience. A large part of the owner’s ongoing services for the owner’s clients involves maintaining the proper ratio of the various investments in the selected portfolio, by rebalancing them as dividends, interest, and other earnings are received and expenses are paid. This process is fairly mechanical in nature once the investment portfolio is established and is commonly performed by the client’s administrative employees with the aid of an Excel spreadsheet.

If the sponsor is a professional, his plan is subject to the exemption from PBGC coverage for plans maintained by “a professional service employer” that has never covered more than 25 participants (ERISA 4021(b)(l3) (29 u.s.c. §1321(b)(l3))).

The PBGC initially determined that the financial advisor is a professional. The financial advisor appealed the PBGC’s ruling, noting the following:

• PBGC opinions are clear that an advanced course of study is a significant portion of the analysis. In the case of the financial advisor, the advisor did not have any kind of college education, much less an advanced degree. Although the advisor’s years of experience are substantial, where the PBGC reviewed situations in which the significant expertise of the individual was experiential rather than educational, the PBGC generally ruled that the individual was not a professional. Of special interest was the fact that the real estate broker, seeming to be substantially similar to an investment advisor, was found to be a nonprofessional (PBGC Opinion Letter 80-12,1980 WL 8808 (June 9,1980)).
• Much of the work involves rebalancing portfolios and making stock trades. Therefore, there was significant income produced from non-advisory activities.
• The advisor did not perform investment management services, where he would have discretionary management authority over the account. He instead makes recommendations and his clients decide on their portfolios.
• A portion of the advisor’s income (admittedly less than 50 percent) came, not from financial advisory work, but from other services and insurance sales.

Even though 68 percent of the Forms 5500 for defined benefit plans filed in 2015 by employers with fewer than 25 employees and with an industry code for investment advisors or insurance sales reflected that the plan was covered by the PBGC, on appeal, the PBGC again ruled that the investment advisor was a professional.

The PBGC cited the following in support of its determination:

• The extensive period during which the advisor had been in the investment business and the years of experience he had accumulated.
• The fact that the advisor is a CFP.  The CFP Board’s website states that, “CFP professionals have completed extensive training and experience requirements and are held to rigorous ethical standards.” The website also discusses “professional and competent financial planning.”
• The affluence of the majority of the advisor’s clientele and the fact that the PBGC presumed that high net worth individuals would command professional expertise from their financial advisors.
• The fact that the advisor is an ERISA fiduciary, which carries a certain risk of penalties or losses if he engages in wrongdoing.
• The governmental licensing, oversight, and continuing education requirements of the CFP credential.
• The significant financial organizations with which the advisor is affiliated.
• How the advisor and the business are represented on the advisor’s website (including the statement, “Our staff consists of experienced professionals”) and on the advisor’s Form ADV, Part 2B.
• The fact that the advisor charges its clients a flat fee for services. The intellectual nature of the advisor’s practice, compared to those who perform a “routine mental, manual, or physical process.”

The PBGC analogized the advisor’s activities to areas it had found to be professional, such as economists, surveyors, and urban planners, rather than fields that it had previously determined were not professional, such as real estate and insurance sales, optician work, and management consulting.

WHY THE PBGC’S DETERMINATION RAISES CONCERNS

Several of the factors noted by the PBGC in its determination on appeal are subjective in nature. The PBGC’s approach raises issues regarding the factors that confer professional status. For example, would the determination have been different if:

• The advisor’s clientele was middle or lower class.
• The advisor maintained a more pedestrian website.
• The advisor was new to the industry, but provided the same services.

The determination also gives rise to these inquiries:

• Should the PBGC’s decision that real estate brokers are not professionals (PBGC Opinion Letter 80-12 (1980 WL 8808 {June 9, 1980))  be changed, because real estate brokers are now claiming in TV commercials that they are housing professionals?
• Can doctors, lawyers, public accountants, architects, and other classic “professionals” be differentiated from the careers of other business  owners and operators, such as financial advisors?

This ruling’s emphasis on subjective considerations means that the results here do not lend themselves to extrapolation to another plan sponsor. Rather than clarifying the analysis to determine whether someone is a professional, this ruling calls into question the professional status of many others that previously were likely not to fall within PBGC coverage. For example, whether:

• A third-party administrator (TPA) is a professional, even though there is no state or federal licensing requirement or need to obtain a college degree.
• The analysis must change if the TPA undertakes to be a fiduciary under ERISA Section 3(16) (29 U.S.C. § 1002(16)) by providing services as an ERISA-defined plan administrator.
• Professional status is conceded if a TPA firm obtains a designation from the Center for Fiduciary Excellence (CEFE X).
• A commercial real estate broker that provides advice regarding investment-based properties is more likely to be a professional than someone selling houses.
• The size of the real estate being offered is determinative, so that someone selling middle-class homes is less professional than someone selling in the high-rent district.
• There is a public trust issue. For example, food service employees have a type of “fiduciary” responsibility to diners. That could raise an issue of whether a chef is a professional.
• Under  the subjective factors used by the PBGC in the investment advisor’s appeal, a restauranteur in Beverly Hills with a culinary degree, a licensed nutritionist at a school, or an owner of multiple McDonalds franchises are professionals.

CLOSURE:  PBGC WEBSITE “SOFT GUIDANCE”

In September of 2017, the PBGC indicated in the “What’s New” section on its website that it has a new webpage that deals with PBGC coverage issues. The webpage now has a section on “small professional service plans.” This section outlines what constitutes a “professional service” employer and specifically notes that financial advisors are not one of the defined professionals listed in the statute, so an analysis of various factors is required. On the webpage, the PBGC states that it determines on a case-by-case basis whether a person in an occupation not listed in the statute is a professional and lists factors including (among others) subjective standards, such as years of work experience, educational background (which is separate from the education required for the position), and public trust and ethical standards.

PRACTICAL IMPLICATIONS OF THE PBGC’S RULINGS

There are several practical implications of the PBGC’s rulings in this area, including the recent investment advisor ruling.

If there is any doubt that a plan is PBGC-covered because of the “professionalism” of the field of practice, the plan sponsor may apply to the PBGC for an individualized ruling (29 C.F.R . § 4000.3). However, those rulings are typically subjectively decided.

It is unlikely that a plan, particularly a small plan, will ever actually collect any benefits from the PBGC due to a plan insolvency, because the law provides that the PBGC may seek restitution for these payments from the business owner (29 U.S.C. §1367).

Therefore, it is more common for a closely held business owner to absorb any plan insufficiency, rather than to take advantage of the PBGC’s insuring of benefits. This means that the payment of PBGC premiums is often wasted for small plans, with very little opportunity to collect on the insurance. As a result, PBGC coverage is generally viewed by employers as an obligation and not a benefit and many employers would prefer to avoid PBGC coverage.

However, the tax deduction available to small, PBGC-covered defined benefits plans makes PBGC coverage advantageous to their sponsors. If a small defined benefit plan is coupled with a defined contribution plan, PBGC coverage provides the ability to take advantage of significantly larger tax deductions for an employer’s contributions to the defined benefit plan. There may be a big difference between permitted deductions for PBGC-covered plans and plans that are not covered by the PBGC. Therefore, resolving the issue of PBGC coverage may be critical to a plan sponsor.

If the PBGC determines that a defined benefit plan is not covered by the PBGC, the plan sponsor should request a refund of premiums paid to the PBGC. This is something of a consolation prize, as the value of the lost tax deduction is likely to be much larger than the refunded premiums, but the premiums should still be sought.

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