Rev. Rul. 59-153

Advice has been requested concerning a method of adjusting for "gains" in determining the deductible limits of an employer's contribution to a pension trust under section 404(a)(1)(C) of the Internal Revenue Code of 1954.

An employer established an employees' pension plan and trust which meets the requirements of section 401(a) of the Code and is exempt under section 501(a) of the Code. The plan provides, among other things, that the costs are to be calculated under the "Entry Age Normal Method." Under this method, annual (or normal) costs are determined as a level percentage of payroll as indicated in section 1.404(a)-6 of the Income Tax Regulations. The excess of total cost over the present value of future normal costs and employee contributions is treated as past service cost. The difference between the past service cost as of the valuation date and assets at that date is the unfunded past service cost. Deductible limits under the plan are determined under section 404(a)(1)(C) of the Code.

Referring to the determination of deductible limits for contributions to employees' pension trusts under section 404(a)(1) of the Code, section 1.404(a)-3(b) of the regulations states in part, that, in any case, in determining the costs and limitations, an adjustment shall be made on account of any experience more favorable than that assumed in the basis of limitations for prior years. Unless such adjustments are consistently made every year by reducing the limitations otherwise determined by any decrease in liability or cost arising from experience in the next preceding taxable year which was more favorable than the assumptions on which the costs and limitations were based, the adjustment shall be made by some other method approved by the Commissioner. Such decreases in liability or cost are generally referred to as "gains." The occurrence of "gains" indicates that previous costs were overestimated. If the factors and assumptions used as a basis for determining costs and deductible limits in prior years are acceptable, the adjustment for "gains" required by the regulations take the place of a retroactive revision of costs and deductions for prior years, which would otherwise be required when "gains" arise.

For the purpose of the adjustments required by the regulations, the amount of "gains" arising in any year is determined as the excess of the expected over the actual unfunded cost at the end of the year. Where deductions are determined under section 404(a)(1)(C) of the Code, the unfunded cost means the unfunded past service cost (including any unfunded cost of supplementary and previous membership credits), and the expected unfunded cost at the end of the year is equal to:

(1) the sum of (a) the unfunded cost at the beginning of the year, plus (b) normal cost for the year, plus (c) interest on item (a) for one year, and (d) interest on item (b) from the date it is assumed to be due to the end of the year, where items (b), (c) and (d) are based on the factors and assumptions used in determining item (a), less

(2) the sum of (a) contributions made during the year, plus (b) interest on such contributions from the dates of contribution to the end of the year at the rate used in item (1).

Where costs are determined by the entry age normal method, as in this case, the adjustment for gains is generally made by deducting the amount of gains arising in any year from the next year's deductible limit under section 404(a)(1)(C) of the Code as determined before reference to such "gains." In the method under consideration and outlined below, "gains" arising in any year are not always applied directly in this manner, but instead are first reduced by the sum, for all prior years including the year in which the gains arise, of each year's excess of (a) deductible limit determined without regard to the existence of deductible contributions over (b) amount deducted, to the extent that such sum has not already been used as an offset to gains.

The limit in (a) in the preceding paragraph is equal to normal cost plus ten percent of the "special ten percent base" less any required adjustment for gains. The "special ten percent base" is equal to the discounted value (discounted back to the date the past service liability was originally included in the plan) of the unfunded past service cost at the valuation date in the current taxable year, and of any employer contributions toward past service cost before the valuation date. For this purpose, the employer contribution toward past service cost in any year is considered equal to the excess of the employer contribution in that year (to the extent that it did not produce overfunding of liabilities) over the normal cost for the year. Where the normal cost applicable to a taxable year is not all funded on the due date assumed in determining the cost, the normal cost includes interest on unfunded portions thereof accruing from the assumed due date to the date such portions are funded (but not beyond the end of the taxable year) and should be reduced by discount for any portions funded in advance of the assumed due date.

The method of adjusting for gains is outlined as follows:

(1) Gains during the current year.

(2) Balance carried forward from prior years as offset to gains (Item (8) below of prior year).

(3) Tax deductible limit for current year (equal to limit under section 404(a)(1)(C) of the Code as determined before adjustment for gains, and without regard to existence of deductible employer contributions, less Item (7) for previous year).

(4) Total contribution (including carryover under section 404(a)(1)(D)) deductible in current year subject to tax deductible limit.

(5) Tax deductible contribution allowable for current year (smaller of Item (3) and Item (4)).

(6) Total offset to be applied to gains arising in current year, for determination of tax deductible limit in succeeding year (equal to Item (2) plus Item (3) less Item (5), but not less than zero).

(7) Adjustment for gains to be applied in succeeding year against tax deductible limit as determined before adjustment for gains (equal to Item (1) less Item (6) but not less than zero).

(8) Balance to be carried forward to following year as offset to gains arising in that year (equal to Item (6) less Item (1) but not less than zero).

The use of this method of adjusting for gains is reasonable in plans where the employer's liability has not been substantially reduced, since the aggregate deductions for years through the current taxable year will not exceed the aggregate of the limitations for each of such years as adjusted for gains. Where the employer's accrued liability has been substantially reduced, as, for example, by amendment or by automatic reduction of plan benefits due to an increase in Social Security benefits used as an offset in the plan's benefit formula, a further adjustment will generally be required in applying the method outlined above, in order that the cumulative deductible limits will correspond to the reduced liability under the plan.

Accordingly, where plan costs are determined by the entry age normal method, the foregoing constitutes an acceptable adjustment for gains if used consistently in conjunction with the limitations of section 404(a)(1)(C) of the Code provided, as noted above, the employer's liability has not been substantially reduced. However, in accordance with sections 1.404(a)-3 and 1.404(a)-6 of the Regulations, no deduction will be allowed for contributions which, together with other assets of the fund, result in overfunding the cost of service credits up to the end of the taxable year.