Rev. Rul. 65-266

Advice has been requested whether the benefits provided by an employer through trusts established for the benefit of participants in the two pension plans described below are comparable and do not discriminate in favor of persons enumerated in section 401(a)(4) of the Internal Revenue Code of 1954.

The employer is a partnership, without any "owner-employees," which has a number of common-law employees. The partnership established a unit benefit pension plan for its common-law employees and a money purchase pension plan for the partners. The partnership is an employer as to the partners by virtue of section 401(c)(1) and (4) of the Code as amended by section 2 of the Self-Employed Individuals Tax Retirement Act of 1962, Public Law 87-792, C.B. 1962-3, 89, at 90.

The employees' plan is noncontributory and provides that all employees, age 30 or more, with 1 year of service, who have commenced employment prior to age 55, are eligible to participate in the plan. The plan provides retirement benefits of 1 percent of the first $4,800 of annual salary averaged over the last 10 years of service plus 1 2/3 percent of such salary in excess of $4,800 times years of service not to exceed 30 years. The employees' plan further provides that benefits do not vest prior to retirement except upon death or plan termination.

The partners' plan provides for the same eligibility requirements as the employees' plan. Five percent of the employer's annual earned income is contributed to the partners' plan, to be allocated to each partner's account in the proportion each partner's share of earned income bears to the total earned income. The benefits are based on all funds accumulated in each partner's separate account. Vesting is immediate and full.

Section 1.401-11(d)(1) of the Income Tax Regulations provides, in part, that a self-employed individual, by reason of the contingent nature of his compensation, is considered to be a highly-compensated employee, and thus is a member of the group in whose favor discrimination is prohibited by section 401(a)(4) of the Code. Therefore, the partners' plan standing alone, cannot qualify under section 401(a) of the Code. However, if an employer has more than one plan for his employees, all plans may be considered together as constituting one plan in order to meet the qualification requirements of that section. See section 1.401-3(f) of the regulations and P.S. No. 27, dated September 2, 1944. According to section 1.401-11(b)(1) of the regulations, this combined plan will be considered to be a pension plan because it defines the compensation of the partners as their earned income while contribution on behalf of the common-law employees is independent of whether the partners have earned income or the amount thereof.

Because the employees' plan is of the unit benefit type, while the partners' plan is of the money purchase type, it is difficult to compare the benefits provided under each plan. Usually, in cases of this type, if it can be satisfactorily demonstrated that the contributions under the money purchase plan, on the basis of factors applicable to the unit benefit plan, do not result in the prohibited discrimination, the benefits under each plan may be accepted as similar. However, one of the factors to be considered in arriving at such a conclusion is that of vesting.

Plan benefits cannot be compared unless there is some provision insuring that these benefits are made available to eligible participants under the same conditions. There is no requirement for vesting prior to retirement or plan termination, with a limited exception in the case of a plan for self-employed individuals which includes owner-employees. See sections 401(a)(7) and 401(d)(2)(A) of the Code and Revenue Ruling 65-178, Part 5(c), page 94 at 120, this Bulletin. However, the difference between the immediate full vesting provided for partners under the instant partners' plan and the lack of such vesting provisions under the employees' plan constitutes discrimination of the type prohibited by section 401(a)(4) of the Code. This is so in this situation because under no circumstances will a participant in the partners' plan forfeit any of his benefits while a common-law employee may very well forfeit his benefits.

Section 1.401-11(d)(1) of the regulations further provides, that in determining whether the prohibited discrimination exists, the total employer contribution on behalf of a self-employed individual shall be taken into account regardless of the fact that only a portion of such contribution is allowed as a deduction.

Accordingly, it is held that where a partnership has two pension plans, one of the unit benefit type for common-law employees, the other of the money purchase type for partners, none of whom are "owner-employees," and where the benefits under the employees' plan do not vest prior to retirement, except upon death or termination of the plan, but the benefits under the partners' plan are fully vested immediately, then the disparity in the vesting provisions will cause the partners' plan to fail to qualify because of the prohibited discrimination within the meaning of section 401(a)(4) of the Code. The fact that a partner may be taxed on a portion of the employer's contribution, which under section 404(a)(10) of the Code is not allowable as a deduction, is to be disregarded in determining whether the plan's vesting provisions are discriminatory.