[120] employees. The Treasury Department, in the so-called Kintner regulations, held that professional corporations were not taxable as corporations. A number of court cases, however, have overturned the regulations and the Service has now acquiesced and generally recognizes these professional corporations as corporations for income tax purposes.

General reasons for change

Many self-employed people, especially professionals, feel that they are discriminated against as compared with corporate executives and proprietary employees of corporations in regard to the tax treatment of retirement savings. This is because, at present, there is no comprehensive limit on the amounts the corporate employer can contribute on behalf of its executives and proprietary employees. Self-employed persons, on the other hand, are subject to the contribution limits described above.

In addition, many of the self-employed argue that, as a result of these contribution limits, it is difficult for them to provide adequately for their retirement, particularly as many professionals have a limited number of years of peak earnings, in which it is comparatively easy to set something aside. It is also argued that the $2,500 limit is no longer appropriate, since in the approximately 10 years since H.R. 10 was first enacted, there has been a substantial inflation factor in the economy. Furthermore, it is contended that the present law in the retirement plan area creates an artificial incentive for the incorporation of businesses which more traditionally, and perhaps more appropriately, have been conducted in unincorporated form. For all of these reasons, the committee believes that a substantial increase in deductible contributions for self-employed individuals is justified at the present time. Under the committee bill, the present limits would generally be increased to 15 percent of earned income, up to a maximum deduction of $7.500 per annum.

At the same time, it is clear to the committee that the formation of professional corporations, a practice which has proliferated enormously in recent years, has had the effect of circumventing the limitations which Congress intended to impose on deductible contributions by persons who are essentially, in most respects, self-employed. In many corporate plans a much larger percentage of the contributions and benefits go to "rank and file" employees than is the case with regard to most H.R. 10 plans. In such corporate plans, if large contributions are made for executives, then the antidiscrimination provisions of present law (sec. 401 (a) (4)) require that proportionate contributions be made on behalf of rank and file employees. Not only does this "financial drag" effect tend to impose practical restrictions on the size of contributions made for the highest level employees, but it also means that, if large contributions are made for this group, then lower level employees will also benefit. Thus, it appears that many corporate plans are subject to practical limitations which do not apply in the case of self-employed plans. The absence of such practical limitations is the reason that it has been thought necessary to impose legal limitations upon self-employed plans.

However, it appears to the committee that the current method of limitations does not apply equally to all situations where "financial

[121] drag” is very small or nonexistent. Also, the committee feels that the present system discriminates in favor of those who choose to incorporate, and against those who do business in the more traditional partnership form. Similarly, other small businesses in corporate form are treated differently for pension plan purposes depending whether or not they are under subchapter S, and without regard to whether most of the benefits under the retirement plan go to rank and file employees.

The committee bill would correct this situation by putting the regulation of retirement benefits on a realistic basis, applying limitations where they are appropriate, whereas the current system depends too greatly on the form of business operation. Thus, under the committee bill, limitations on contributions would be imposed not only on selfemployed plans, as under present law, but also on proprietary employees holding a two percent or greater interest in an incorporated business, but only where all such persons, in the aggregate, have more than a 25-percent interest in benefits under the plan.

Explanation of provisions

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The committee bill increases the maximum deductible tribution on behalf of self-employed persons to the lesser of $7,500, or 15 percent of earned income. (A similar, although not identical, rule is applied in the case of defined benefit pension plans.) However, no more than the first $100,000 of earned income may be taken into account in applying the percentage limits. The $100,000 ceiling on the earned income rate base means that a self-employed person with more than $100,000 income will have to contribute at a rate of a least 712 percent on behalf of his employees if he wishes to take the full $7,500 deduction on his own behalf (in order to comply with the antidiscrimination requirements). A self-employed person earning more than $100,000 who wishes to contribute $5,000 for himself will have to contribute at least 5 percent on behalf of his employees.

The committee bill also extends the application of these provisions to plans for the benefit of "proprietary employees." In general, a "proprietary employee" would be any individual owning either directly, or through attribution rules (those prescribed in sec. 1563 (e)), at least 2 percent of the total combined voting stock of the corporation, or 2 percent of the total value of all shares of stock in the corporation. However, the provision does not apply unless all proprietary employees who are active participants, as a class, have more than 25 percent of the total account balances for active participants under a defined contribution plan (such as a money purchase plan), or in other cases have more than 25 percent of the present value of all accrued benefits under the plan (whether or not vested) for active plan participants. The committee believes that this approach will place the treatinent of corporate plans on a more realistic and equitable basis— where most of the benefits under the plan are for individuals who are not proprietary employees, the contribution ceiling will not apply, but

The limitations on nondeductible contributions on behalf of owner-employees in a self-employed plan is not increased, however.

In a case where a corporation has two or more plans, an individual will be a proprietary employee for purposes of all the plans, if the more than 25 percent test is met with respect to any of the plans.

[122] where a substantial portion of the plan benefits are for proprietary employees, the ceiling will apply.

The new rules are also to apply in the case of subchapter S corporations. Under the committee bill, section 1379 is repealed. However, subchapter S corporations would remain subject to limitations under the same rules applicable to other corporations. Thus, if more than 25 percent of the benefits under the plan were for individuals who each held at least 2 percent of the stock in the corporation, these stockholders would be considered to be proprietary employees, and would be subject to the 15 percent-$7,500 limitation. But if less than 25 percent of the benefits were for these individuals, these limitations would not apply.

As is the case under present law with respect to an owner-employee, a proprietary employee (or a group of two or more proprietary employees) who controls more than one business would be required under the bill to group together all controlled business activities for the purpose of determining whether all employees of the proprietary employee are covered by a retirement plan on a nondiscriminatory basis, and also for the purpose of assuring that the limitations on contributions are not exceeded. As a result of this requirement, a proprietary employee could not make contributions under two or more retirement plans, which, when totaled together exceeded $7.500. This provision ensures that a proprietary employee may not exceed the limitations on deductible contributions by splitting his activities among two or more businesses and establishing retirement plans in each, nor could he divide his business and set up a retirement plan in one business where, for example, he is the only employee.

The bill also provides that-like an H.R. 10 owner-employee under present law an individual who is a proprietary employee in a business (whether or not he controls the business), and is also a proprietary employee in another business which he controls, may not be covered under the plan of the first business unless he has established a plan for the employees of the business which he controls. The plan for the business which he controls must provide contributions and benefits for employees which are at least as favorable as the contributions and benefits provided for him under the plan of the first business.

The rules outlined above also apply in cases where an individual is an owner-employee in one firm and a proprietary employee in a second business.

Defined benefit plans-limitation on benefits.-The committee bill also contains a provision, which applies in the case of all defined benefit plans (including corporate plans without proprietary employees). generally limiting the annual benefits which can be paid out under these plans (as of age 65) to 100 percent of the participant's average compensation from the employer during his highest 3 consecutive years of earnings. A pension is essentially a substitute for earning power during the retirement vears and the committee believes that no qualified pension plan should pay defined benefits which are higher than an employee's average earnings during his highest 3 years. It is the understanding of the committee that this provision is consistent with present law (Rev. Rul. 72-3, 1972-1 C.B. 105) and by this provision the committee only intends to clarify and make more explicit present law.

[123] The plan could, however, provide for a cost of living adjustment over and above the 100 percent limit. However, benefits paid in the event of early retirement would have to be scaled down from the 100 percent of salary level on an actuarial basis. In general, in the case of any defined benefit pension plan which does not pay benefits in the form of a straight life annuity, commencing at age 65, or which provides ancillary benefits, the 100 percent limitation would have to be adjusted in accordance with regulations. In the case of a contributory plan, upward adjustments in the benefit schedule would be permitted in accordance with regulations, to reflect the fact that part of the annuity had been purchased with the employee's own aftertax dollars.

In the case of an employee who is a participant in both a defined benefit pension plan and a money purchase pension plan, the maximum 100 percent of salary benefit under the defined benefit pension plan would be reduced under the committee bill by multiplying 100 percent of the participant's average compensation by a fraction, the numerator of which is the percentage of compensation contributed under the money purchase plan, and the denominator of which is 20. (Under another provision of the committee bill, 20 percent would be the maximum tax-excludable contribution under a money purchase plan.)

For example, if an employee had an average high-three-year salary of $20,000, and a 10 percent of salary contribution had been made on his behalf to a money purchase plan, his maximum yearly benefit under the defined benefit pension plan could not exceed $10,000 (10/20ths of $20,000). This would prevent the situation where an employee might seek to circumvent the limitations on benefits under a defined benefit plan, or on tax-excludable contributions under a money-purchase plan, by setting up two different types of plans for himself. (In cases where the rate of contributions to a money purchase plan fluctuated over the career of the employee, or were made for certain years when he was a participant under the defined benefit plan, but not for others, appropriate adjustments to this formula will be made in accordance with regulations.)

As a further adjustment, in the case of an employee who participates in a defined benefit plan for less than 10 years, the defined benefit otherwise allowable in accordance with the rules described above is to be reduced by multiplying the otherwise allowable benefit by a fraction, the numerator of which is the proprietary employee's years of active participation in the plan, and the denominator of which is 10. For example, if an individual who was an active participant for 3 years under the plan had an average high-three years salary of $50,000 (and no other adjustments were required) his maximum benefit could not exceed 3/10ths of $50,000, or $15,000 per annum.

This would prevent a situation where an individual might receive an extremely high pension, even though he had only a few years of active service under a plan.

Defined benefit plans for proprietary employee corporations.-At present, many small corporate plans are defined benefit plans, although

5 The committee expects that the adjustment for ancillary benefits will be substantially equivalent to the adjustment now provided under present law for a plan which is integrated with social security.

[124] most self-employed plans are defined contribution plans because of the limitations on contributions imposed on self-employed persons under present law. The committee was concerned that in extending the contribution limits to certain proprietory employee corporate plans, the committee bill might inadvertently take away, as a practical matter, the option of having defined benefit plans from these corporations. As a result, the committee bill contains a formula (which under the bill may also be used by self-employed individuals) which would allow proprietary employees, in effect, to translate the 15 percent$7,500 limitations on contributions, to which they would otherwise be subject, into limitations on benefits which they could receive under a defined benefit plan. (Of course, all employees of all corporations, and all self-employed individuals, remain subject to the 100 percent of salary limitation, discussed above.)

Under the formula, the basic benefit for the employee (that is, a straight life annuity commencing at the later of age 65 or 5 years from the time the participant's current period of participation began, with no ancillary benefits) is not to exceed the amount of the employee's compensation which is covered under the plan (up to a maximum of $50,000) times the percentage shown on the following table.

The percentages in early years are higher to reflect the fact that contributions made during these time periods earn interest for a longer period prior to retirement than contributions made in later years. The Secretary or his delegate is to have authority to prescribe regulations in cases of plans which provide something other than the "basic benefit." Also, the regulations are to specify percentages for individuals who become participants at ages other than those shown on the table. In addition, the Secretary or his delegate is given authority to prescribe new percentages, to be used in years beginning after December 31, 1977, based on changes in money rates and mortality tables occurring after 1973.

To illustrate how this formula would work, assume that a selfemployed person enters a defined benefit plan at age 30, and participates in the plan for 5 years, with income covered under the plan of $20,000 per annum. At age 35, he leaves the plan, but at age 50, he again becomes a participant. For the first 5 years his covered income. is $30,000 per year, then $40,000 for the next 5 years, and finally $50,000 for the last five years prior to his retirement. The calculation would work as follows: