Henricks, Martin, Thomas & Zollars, Ltd.
Certified Public Accountants

Posted on the web by Henricks, Martin, Thomas & Zollars, Ltd., Certified Public Accountants in Phoenix, Arizona.

The following document was issued by the IRS in 1987 and describes the rules involved for determining if an individual is a an active participant in an employee benefit plan. This portion of Notice 87-16 remains the most significant guidance on applying those rules, which can impact the ability of employees to deduct an IRA contribution on their personal return.

Note that certain portions (like those dealing with married filing separate filing status) no longer reflect the current law. You should verify any conclusions you reach after reading this document with a competent tax professional if you aren't skilled at conducting tax research.

If you have additional questions on this issue, you can engage us to provide additional advice on these issues by emailing us at htmzcpas@getnet.com or by calling us at (602) 955-8530.

I. DEDUCTIBLE CONTRIBUTIONS TO IRAs

A. ACTIVE PARTICIPANT STATUS

An individual who is not an active participant in a retirement arrangement specified in section 219(g)(5) of the Code may make a deductible IRA contribution for the taxable year of up to the lesser of $2,000 ($2,250 for spousal IRAs) or 100% of compensation. An individual who is married and files a joint federal income tax return will be treated as an active participant if such individual's spouse is an active participant.

Section 219(g) of the Code provides that if an individual is an active participant in such a retirement arrangement for a taxable year, the $2,000 ($2,250 for spousal IRAs) dollar limit on the individual's deduction may be reduced or eliminated for such year. Accordingly, the first step in determining the permissible IRA deduction for a year is to determine active participant status for the taxable year.

For purposes of the IRA deduction rules, an individual shall be an "active participant" for a taxable year if either the individual or the individual's spouse (with whom the individual files a joint tax return) actively participates in any of the following:

1) a qualified plan described in section 401(a) of the Code,

2) an annuity plan described in section 403(a) of the Code,

3) a plan established for its employees by the federal, state or local government or by an agency or instrumentality thereof (other than a plan described in section 457 of the Code),

4) an annuity contract or custodial account described in section 403(b) of the Code,

5) a simplified employee pension described in section 408(k) of the Code, or

6) a trust described in section 501(c)(18) of the Code.

See Questions Al through Al4 for active participant rules that apply to all plans.

In determining when an individual is an active participant in retirement arrangement for a taxable year, different rules are applied, depending upon whether the retirement arrangement is a defined benefit or a defined contribution plan.

Defined Benefit Plan Rule

In the case of a defined benefit plan, an individual who is not excluded under the eligibility provisions of the plan for the plan year ending with or within the individual's taxable year shall be an active participant in the plan, regardless of whethe r such individual has elected to decline participation in the plan, has failed to make a mandatory contribution specified under the plan or has failed to perform the minimum service required to accrue a benefit under the plan. For example:

An individual is a calendar year taxpayer who is not excluded from participation under the provisions of a defined benefit plan with a July 1 to June 30 plan year. The individual separates from service on December 31, 1987. Because the individual is not excluded under the plan's eligibility provisions for the plan year ending in such individual's 1988 taxable year, such individual shall be an active participant for the 1988 taxable year.

See Questions Al5 through Al8 for defined benefit plan active participant rules.

Defined Contribution Plan Rule

Generally, in the case of a defined contribution plan, an individual shall be an active participant if employer or employee contributions or forfeitures are allocated to such individual's account with respect to a plan year ending with or within the individual's taxable year. For example:

Company B sponsors a money purchase pension plan with a plan year ending on June 30. The plan provides that contributions must be allocated as of the last day of the plan year. On December 31, 1987, an individual employed by the Company separates from service. The contribution for the plan year ending on June 30, 1988 is not made until February 15, 1989, when the Company files its corporate return. In this case, the individual is an active participant for such individual's 1988 taxable year.

A special rule applies to certain plans in which it is impossible to determine whether or not an amount (other than earnings) will be allocated to an individual's account for a given plan year. If, with respect to a particular plan year, no amount attributable to forfeitures, employer contributions or employee contributions has been allocated to an individual's account by the last day of the plan year, and contributions to the plan are purely discretionary for the plan year, such individual shall not be an active participant for the taxable year in which such plan year ends. If, however, after the end of such plan year, the employer contributes an amount for such plan year, an individual to whose account an allocation is made shall be an active participant for the taxable year in which the contribution is made.

Contributions shall be treated as purely discretionary for the plan year if, as of the end of the plan year, the employer is not obligated under the law or terms of the plan to make a contribution for the plan year, and whether or not contributions are made to the plan is ultimately dependent upon the employer's decision or factors within the control of the employer. Contributions are not purely discretionary merely because they are dependant on profits.

For example:

An individual covered by a profit-sharing plan separated from service on December 31, 1987. The plan year runs from July 1 to June 30. Under the terms of the plan, employer contributions, if any, shall be made at the complete discretion of the Board of the Directors and shall be contributed to the plan prior to the due date for filing the employer's tax return. Such contributions are allocated as of the last day of the plan year, and allocations are made to the accounts of individuals who have any service during the plan year. As of June 30, 1988, no employer or employee contributions had been made that are allocated to the June 30, 1988 plan year, and no forfeitures had been allocated within the plan year. In addition, as of such date, the employer was not obligated to make a contribution for such plan year and it was impossible to determine whether or not a contribution would be made with respect to the plan year. On December 31, 1988, the Board of Directors agreed to contribute a specified amount to the plan, with respect to the plan year ending June 30, 1988; on February 15, 1989, such contribution was made to the plan. As a result of the amount allocated to such individual,s account as of June 30, 1988, the individual is an active participant in the plan for the 1989 calendar year but not for the 1988 year.

See Questions Al9 through A26 for the defined contribution plan rules.

GENERAL ACTIVE PARTICIPANT QUESTIONS

Al: How will an employer report active participant status for a taxable year?

A: An individual's employer (or former employer) must inform an individual of active participant status for the taxable year of the individual. This status must be reported on a Form W- 2.

A2: If an individual is not an active participant, but such individual's spouse is an active participant, will the individual be treated as an active participant?

A: If the couple files a joint federal income tax return for the applicable year, active participation by either spouse will cause both spouses to be treated as active participants. But see Question A3.

A3: If an individual is married but files a separate tax return, will active participation by his or her spouse affect the individual's active participant status?

HMTZ Note: This answer is no longer the correct answer. Congress changed the law after a year to remove this option.
A: No. Section 219(g)(4) of the Code provides that a married individual who files a separate tax return is considered single for purposes of determining active participant status. Thus, if the individual is not an active participant. the fact that his or her spouse is an active participant will not limit such individual's IRA deduction.

A4: If a married individual obtains a divorce during his or her taxable year (and does not remarry during such year), is the individual considered an active participant merely because the former spouse is an active participant for the year?

A: No. Marital status is determined as of the end of the year. Thus, if the individual is not married at the end of the year, the fact that his or her former spouse is an active participant will not cause the individual to be treated as an active parti cipant. Similarly, if an individual marries during the year, and the individual's new spouse is an active participant, the individual shall be treated as an active participant for the entire year if the couple files a joint tax return.

A5: If a married individual dies during a taxable year and is an active participant for such taxable year, will the survivor be treated as an active participant for purposes of section 219(g) of the Code?

A: Yes. In the taxable year of death, active participation is determined as if the deceased spouse was still alive. Thus, if the deceased spouse was an active participant for the taxable year of death and a joint return is filed for the taxable year of death, the survivor will also be treated as an active participant. In such a case, the applicable dollar limitation for AGI purposes is $40,000. (See I. B., below.) For taxable years following the taxable year of death, the deceased spouse's status as an active participant in the year of death has no effect on the survivor's status as an active participant because the survivor is not treated as married to the deceased spouse for purposes of the active participation rules. However, for AGI purposes, in th ose cases in which the survivor meets the filing status requirements under section 2(a) of the Code, the survivor will use the same $40,000 applicable dollar limitation used by married taxpayers filing jointly.

A6: An individual has an amount deferred for a taxable year in a plan described in section 457 of the Code. Does participation in such a plan cause the individual to be an active participant?

A: No. Section 219(g)(5) of the Code specifically exempts unfunded deferred compensation plans described in section 457 of the Code from the definition of relevant plans for purposes of determining who is an active participant. Participation in any ret irement plan established by a state or local government, other than a plan described in section 457 of the Code, is active participation for purposes of section 219(g)(5) of the Code.

A7: Is an individual who is covered under Social Security or Railroad Retirement (Tier I or Tier II) an active participant?

A: No. Under Section 219(g)(5), neither Social Security nor Railroad Retirement (Tier I and Tier II) is a retirement arrangement for purposes of determining active participant status.

A8: Is a retired individual who is receiving pension annuity payments an active participant?

A: No. An individual will not be treated as an active participant merely because the individual receives benefits under a retirement arrangement described in section 219(g)(5) of the Code.

A9: If an individual is ineligible for benefit accrual in a retirement plan that is integrated with Social Security solely because the compensation of that individual is below the integration level or because the full benefit will be offset by Social S ecurity, is the individual an active participant?

A: No. In the case of a defined benefit plan, an individual who is not excluded under the eligibility provisions of the plan, but who is nonetheless ineligible to accrue a benefit under a plan because compensation is below the integration level or whos e benefit will be fully offset by social security for the plan year ending with or within the taxable year, shall not be an active participant in such plan. (Note: This is an exception to the general rule applicable to defined benefit plans, and it is lim ited to the facts set forth in the preceding sentence.) Similarly, in a defined contribution plan, if an individual is ineligible for an allocation in a plan year because the individual's compensation is below the integration level, such individual shall not be an active participant for the taxable year with or within which such defined contribution plan year ends.

A10: Is an individual who makes employee contributions to a qualified plan described in section 219(g)(5) an active participant?

A: Yes. If an individual makes either voluntary or mandatory employee contributions to a plan, such individual shall be an active participant for the individual's taxable year containing the end of the plan year in which the contributions are allocated .

A11: In the case of a plan year that begins in 1986 and ends in 1987, will actions attributable to the 1986 part of the plan year that would normally make an individual an active participant for a year, make an individual an active participant for the 1987 taxable year?

A: No. For purposes of determining whether an individual is an active participant for 1987, a plan year beginning in 1986 and ending in 1987 (an "overlap plan year") is to be treated as two short plan years, the first ending on December 31, 1986 and th e second beginning on January 1, 1987. In addition, any employee contributions or employer contributions or forfeitures allocated during the 1987 portion of the overlap plan year shall be treated as allocated on December 31, 1986 to the extent such contri butions are attributable (i) to compensation that would have been paid (but for a deferral election) or was actually paid before January 1, 1987 or (ii) to services performed before January 1, 1987.

For example, if a participant in a cash or deferred arrangement that is part of a plan with an overlap plan year elects to have no elective deferrals made out of compensation that would have been paid (but for the deferral election) in the 1987 portion of the overlap plan year, such participant will not be treated as an active participant for the 1987 taxable year merely because of the elective deferrals made out of compensation that would have been paid (but for the deferral election) before January 1 , 1987. Similarly, if a participant in a defined contribution plan with an overlap plan year separates from service from the employer on December 31, 1986, such participant will not be treated as an active participant for the 1987 taxable year merely beca use an employer contribution that is based on the participants's compensation and service before January 1, 1987 is allocated to such participant's account as of the last day of the overlap plan year.

A12: Is an individual considered an active participant merely because such individual participates in a plan as an Armed Forces reservist if the individual has less than 90 days of active duty during the year, or participates in a plan described in sec tion 219(g)(5)(A)(iii) of the Code, based on activities as a volunteer firefighter?

A: No. Such individual is not an active participant pursuant to section 219(g)(6) of the Code.

A13: If only a single dollar is allocated to an individual's account for a plan year (in a defined contribution plan), or an individual accrues a benefit of only one dollar for a plan year (in a defined benefit plan), is such an individual an active pa rticipant in such plan?

A: Yes.

A14: If an amount is allocated to an individual's plan account for a plan year in a defined contribution plan, or an individual accrues a benefit for a plan year in a defined benefit plan, but such individual has no vested interest in such account or a ccrual, is such an individual an active participant in such plan?

A: Yes. Active participant status is determined without regard to vesting.

DEFINED BENEFIT PLAN ACTIVE PARTICIPATION QUESTIONS

A15: In many defined benefit plans a participant's right to benefit accruals is conditioned upon the performance of a prescribed number of hours of service. If an individual does not complete the requisite hours of service needed in order to accrue a b enefit in a plan year, is the individual an active participant for such year?

A: Yes. If the individual is not excluded under the eligibility provisions of the plan for the plan year ending with or within the individual's taxable year, the individual is an active participant.

A16: If an individual participates in a defined benefit plan in which benefit accruals are frozen for the entire plan year ending with or within the individual's taxable year, is such individual an active participant in such plan for the taxable year?

A: No. When a plan is frozen, i.e., when benefit accruals under a plan have ceased for all participants, an individual in such a plan is not an active participant. However, where a benefit may vary with future compensation, all accruals will not be con sidered to have ceased. For example, a "High 3" plan, in which future accruals have ceased but the actual benefit will depend upon future compensation, will not be considered as a plan in which accruals have ceased for all participants.

A17: If a calendar year defined benefit plan terminates on January 2, 1988, is an individual who is covered under the plan an active participant for such individual's 1988 taxable year?

A: Yes. If an individual is not excluded under the eligibility provisions of the plan for any portion of the plan year ending with or within the taxable year, the individual is an active participant. Accordingly, an individual covered by the plan shall be an active participant for the taxable year in which the plan year ends, whether or not the plan terminated.

A18: If a calendar year defined benefit plan terminates on November 30, 1987, but does not commence distributions until January 31, 1988, is an individual covered under the plan an active participant in either plan year?

A: As noted in question Al7, the individual will be an active participant for the taxable year within which the plan terminates (1987) because such individual was not excluded under the eligibility provisions of the plan in the plan year which ended wi th or within the taxable year. In the 1988 plan year, a participant is excluded under the eligibility provisions for the plan year which ends with or within the participant's taxable year because the plan has terminated.

DEFINED CONTRIBUTION PLAN ACTIVE PARTICIPATION QUESTIONS

A19: Is an individual an active participant merely because earnings are allocated to such individual's account?

A: No. An individual is not an active participant merely because earnings have been allocated to such individual's account.

A20: Certain defined contribution plans condition the right to an allocation on the performance of a specified number of hours (e.g., 1,000) or on the employment of the participant on a certain day. In such a plan, if an individual does not meet the co ndition for a particular plan year, is the individual an active participant with respect to the taxable year within which such plan year ends?

A: No. An individual is not an active participant in a defined contribution plan if, under the terms of the plan, the individual is not entitled to an allocation of contributions or forfeitures to the individual's account with respect to the plan year ending with or within the individual's taxable year.

A21: If an employer sponsoring a defined contribution plan is required to make a contribution to an individual's account but fails to do so (whether or not in violation of section 412(d) of the Code), is an individual for whom an allocation is required an active participant in the plan for the plan year ending in the individual's taxable year?

A: Yes. In the case of such a plan, if an allocation must be made to an individual's account with respect to a particular plan year, such individual shall be an active participant in the taxable year in which such plan year ends, regardless of whether the contribution is made.

A22: If a plan is required to make a top heavy minimum allocation for the plan year, and must make an allocation to the account of an individual who would not otherwise be entitled to an allocation for the plan year, is the individual an active partici pant merely because a top heavy minimum allocation is made to such individual's account?

A: Yes. If a top heavy minimum is required to be allocated to an individual's account, the individual is an active participant for the taxable year in which ends the plan year with or within which the allocation is required to be made.

A23: If an individual elects to defer compensation under a section 401(k) cash or deferred arrangement (CODA), is such individual an active participant?

A: Yes. An individual who elects to defend compensation pursuant to a plan described in section 401(k) shall be an active participant. The same rule applies to elective deferrals and salary reductions under sections 408(k), 501(c)(18), and 403(b).

A24: If an individual who is eligible to make elective deferrals under a CODA declines to make elective deferrals for a year, and no other contributions or forfeitures are allocated to such individual's account for the plan year ending with or within t he individual's taxable year, is such individual an active participant for that year?

A: No. An individual shall not be an active participant merely due to eligibility to participate in a CODA.

A25: If an individual makes an elective deferral during a plan year, but later has the deferral distributed from the plan as an excess deferral, pursuant to section 402(g)(2) of the Code, is such individual an active participant for the taxable year wi th or within which ends the plan year?

A: Yes. For purposes of determining active participant status, if an individual chooses to make an elective deferral to a plan, the individual is an active participant for the plan year as of which the deferral contribution is allocated, regardless of whether the contribution remains in the individual's account.

A26: A profit sharing plan has a July 1 to June 30 plan year. Under the terms of the plan, employer contributions, if any, are made at the sole discretion of the Board of Directors. As of June 30, 1987, no employee or employer contributions have been m ade and no amounts have been forfeited for the plan year ending June 30, 1987. Moreover, it is impossible to determine whether a contribution will be made for the plan year ending on June 30, 1987. On January 15, 1988, the employer makes a contribution fo r the plan year ending on June 30, 1987. On November 30, 1988, the employer makes a contribution for the plan year ending June 30, 1988.

On June 30, 1989 it is again impossible to determine whether a contribution will be made for the plan year ending on that date, and no contribution is made by December 31, 1989. Will a participant in the plan described above be an active participant on ly for the 1988 taxable year?

A: No. In such a situation, when contributions to a discretionary defined contribution plan for two plan years are made in one calendar year, solely for the purposes of determining active participant status, the contributions for the later plan year ar e deemed to be made in the next taxable year. In the fact pattern described above, the contribution made on November 30, 1988 is deemed to be made in taxable year 1989. Thus, the individual is an active participant in both the 1988 and 1989 taxable years.