A recent IRS memorandum addresses the application of Internal Revenue Code section 415(c) contribution limits to DROP plans. http://www.irs.gov/pub/foia/ig/spder/TEGE-07-1114-0029%5b1%5d.pdf. The IRS memo is a welcome development because it reaches conclusions that generally do not disrupt the operation of DROPs, and it allows the IRS to process determination letter requests for DROP plans that have been pending for over six years in some cases.
A "DROP" is a feature of a defined benefit plan that allows an employee who is eligible to retire and receive a pension to continue working, while the pension payments the employee would receive if retired accumulate for future payment from the "DROP" account. Because the DROP creates an account within a defined benefit plan, it raises the question: are contributions to the DROP account subject to the contribution limits of Internal Revenue Code section 415(c)? Before this new memo, some IRS reviewers refused to issue favorable determination letters to governmental pension plans unless the plans were amended to state that all contributions to the DROP account are subject to the limits of Code section 415(c). This posed a serious problem for plans that credit a DROP account with annual defined benefit pension amounts exceeding the 415(c) limit. For example, a plan could not credit a DROP account with a participant's defined benefit pension of more than $52,000 in 2014, because that amount would exceed the 415(c) limit for 2014.
The IRS memo instructs IRS employees reviewing governmental DROP plans not to apply the limits of Code section 415(c) to a participant's defined benefit pension amounts that are credited to the DROP.
The IRS memo also explains how 415(c) limits apply to amounts other than a participant's defined benefit pension that may be credited to a DROP, such as employer or employee contributions to the DROP. Because employee and employer contributions to a DROP rarely, if ever, approach the limits of Code section 415(c), this aspect of the memo should not present obstacles to the administration of most DROP plans.
Although this recent IRS memo states that it "is not a pronouncement of law," it offers a workable solution to the complexities of applying Code section 415(c) to governmental pension plan DROP provisions.
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