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mwyatt

Substantial Owner Waivers in Plan Termination

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We are currently terminating an underfunded DB plan; as part of the termination, the Owners have signed Substantial Owner Waivers so that all other participants will be paid in full and the two owners will split remaining assets.

Plan is terminating as part of sale of company. Lawyers for new owners are a little concerned about Substantial Owner Waivers. I recall back in time (late 80's-90's maybe) that IRS looked askance at the waivers, although PBGC had no problems with waivers. IRS subsequently went along with PBGC and haven't had any problems or discussions with IRS in quite some time on this issue. Does anyone recall anything specifically issued by the IRS on the waiver issue that would satisfy the concerns of the law firm?

I did go through the Super Grey Book and found #21 from the 1994 Book, which posed the question of which benefit to use for 415(e) purposes (and IRS raised no beef as to validity of waiver), but would like if possible some formal cite for validity.

Thanks for any help in advance.

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Unfortunately do not (only have 2000 and 2001 - victims of ill-timed purge of materials by boss in midst of office move in 2000). Any chance of seeing that?

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Ther is an IRS PLR which holds that owner of business cannot waive vested benefit to avoid underfunding of plan upon termination because vested benefits cannot be waived by a participant. Cite should be under IRC 411(a). Of course you could submit the waiver and see if you can get it by the IRS.

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I've run into that issue before; I think that the semantics that the IRS accepted was that you aren't actually reducing the vested benefit (a 411 cutback) but that the owner is being "paid" the lump sum value of his vested benefit at less than "fair value". (An angels dancing on the head of a pin argument, of course, but it reconciles IRS with PBGC's position). My recollection from a termination long ago is that this issue was settled. If you look, here is #21 from the 1994 EA Meeting Grey Book:

QUESTION 21

415(e) DB Fraction if Substantial Owner Waives Accrued Benefits -- 415

If a defined benefit plan subject to PBGC coverage terminates with less than sufficient assets to pay out all benefits as a lump sum, the PBGC expressly permits majority owners to waive a portion of their accrued benefits so that all non-majority owners are paid in full.

For purposes of calculating the majority owner's defined benefit fraction under Section 415(e) of the Code, is the numerator equal to the actual benefit that had been accrued, or is it the actual (reduced) benefit that was paid out? Would the answer be different if the Plan were not subject to PBGC coverage?

RESPONSE:

The numerator should be equal to the actual benefit that is paid out. It makes no difference whether the plan is subject to PBGC coverage.

Since Holland and Weller were part of the panel, I would have thought that they would have objected to the validity of the waiver in their response. As an aside, I think that they have since reversed this answer (as in for 415 you now use the whole benefit, not the amount effectively received), although in the post-415(e) world the effect is less relevant. Only would be an issue if another DB plan was established in the future.

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Please forgive the typing, I only have this in hard copy so I could not cut and paste.

69. At ALI-ABA last fall, Jim Holland stated that the IRS position on wavers of db plan benefits by a >50% owner in order to termnate an underfudned plan, is that it creates taxable income to the owner under the assignment of income doctrine (at best) and should disqualify the plan because it violates 401(a)(13).

I have never been questioned by IRS when we've used this device in the past, nor has anyone else that we're aware of. Nor have administrators issued 1099's for the full, unreduced benefit.

To the best of our knowledge, he has never taken this position before. He has said (in the ASPA Q&A, maybe in 1996 or 1995) that the IRS does not consider the waiver a reduction in the accrued beneftit, just a change in the allociation of assets of the plan. The impact of that was primarily that you still had to count the full accrued benefit for future 415 issues (including 415(e). But they never said anything about taxation.

I'm not sure how income could be taxed since there is no contstructive receipt doctrine anymore for retirement plans, and without constructive receipt, how could be be taxed for giving it up.

Jim apparently bases this on a 1986 Tax Court case, preceded by a TAM. Can we get a current reading from the Service on this?

The case referenced is Arthur Gallade vs. Commissioner. The Service does not recognize waiver of benefits. If it is an allocation for sufficiency, the Service will not object because it is just an asset allocation procedure. Any such "waiver" is not recognized for minimum funding purposes. If this is not being done for sufficiency purposes, the Service will not recognize it and it will be taxable to the participant as in the referenced case.

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Under the assignment of income doctrine, retirement income will be taxed to the person who earns it regardless of a transfer/assigment to another person or entity. See Duran v. CIR, 123 F2d 324 (1941). Therefore it is not necessary that income be constructively received- it is the transfer to another person that creates income tax to the employee. I don't think the IRS position has changed on taxation because this tax doctrine goes back many years.

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Focusing on the last sentence of KJOhnson's paragraph is key: if not being done for sufficiency purposes.... Why else would you do the waiver at termination? At first my heart stopped reading the question, then settled down to normal beats. So if you are terminating with a waiver and an underfunded plan, no taxation would occur.

Consider the following situation (which I would guess is what Holland was thinking about): A small DB plan of a wholly family DB plan with adequate funding. Substantial Owner waives benefit (although not needed) so as to create additional excess assets which are then reallocated to other family members (and hence escaping estate/gift taxes). In this case I could see his point as to taxation issue, although I haven't seen this in theory or real life (just trying to imagine what he had in his head).

Thanks KJohnson and MBozek for your help!

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I remember that 1998 Q&A discussion pretty clearly. I took from that the clear impression that the IRS considers such waivers to be bogus, but that they recognized the problem and intended to continue to look the other way. I know of nothing that has changed that attitude.

The rationalization as I recall it was to consider it a reallocation of assets rather than a waiver.

P.S. Myatt, why not call Jim Holland. An actuary in my office has called him several times and has always received a prompt reply (and a direct answer to the question posed). I don't have his number with me but I can get it tomorrow if you are interested.

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I have some familiarity with Gallade. ;-)

The issue was very much as stated. The plan was sufficient and the waiver was intended to divert assets from a participant that would have received them under the terms of the plan had the waiver not been signed.

mwyatt, you really have nothing to be concerned with in this case, unless your plan document doesn't have the standard language that I think all plans are supposed to have with respect to the allocation of funds upon plan termination.

Essentially, you have two issues to deal with. One is concern for the rules as promulgated by the IRS, the other for the rules of the PBGC. The plan goes about its normal business upon plan termination and allocates the funds, usually "to the extent funded." This satisfies the IRS. That is, there is no waiver or document that is signed that gives rise to the reduced benefits paid to the substantial owners. It just automatically happens according to the rules of the plan. What's the expresson? Oh, yeah: RTFD. (Read the fantastic document.)

But then we run smack dab into the PBGC's rules on terminations. More specifically, standard terminations. Here, every participant has to be paid their full accrued benefit under the plan, whether funded or not. That is, the plan sponsor is supposed to make the plan whole in order to satisfy the PBGC's rules under a standard termination. The one exception is the ability of a majority owner to execute what is commonly referred to as a waiver. Well, it isn't really a waiver. It is a document that agrees to "forego receipt of all or part of his or her benefit until the benefit liabilities of all other plan participants have been satisfed." See Reg. 4041.7(B).

This is not a waiver in the IRS sense. It is an acknowledgement that they are last in line to receive benefits. It lets the PBGC off the hook, really. I don't call mine "waiver of benefits". I title them "Waiver of PBGC Liability".

And, once executed, it allows the plan's provisions to control who gets the money. So, we come full circle. If the plan provides that benefits are paid only to the extent funded, the two concerns are dealt with.

In cases like these, there are sometimes 2 or more majority owners (such things as options and marriages can cause there to be quite a few, actually). When this happens, and all the participants other than the majority owners have been paid, the IRS will allow the benefits remaining to be paid in any amount and any manner that the clients want, since they are of course HCE's. Getting the majority owners to agree is sometimes a challenge, though, once they realize what their options are. I think, if memory serves, the relevant cite on this is RR 80-229. While it primarily deals with the non-discriminatory allocation of excess assets, it is also used by some as justification for the allocation amongst the owners at the end.

As long as the IRS is approving the termination, you can make an amendment that allocates the remainder any way the client wants, thereby modifying, in effect, the "to the extent funded" language of the plan.

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About a year ago I submitted an underfunded plan to the IRS for a favorable determination letter upon plan termination. I included a Waiver of Benefits signed by the owner. The IRS reviewing agent simply asked me to reword/retitle the Waiver to say the owner was waiving his "portion of the allocation of distributable assets". The words in quotes came directly from the agent. He said that this would avoid conflicts with 411(d). That is my experience. The plan was not covered by the PBGC.

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Mike: How do you deal with the income tax question? Under Rev rul 81-140 Vested benefits can be forfeited only for statutorily permitted reasons and under the Assignment of Income Doctrine/duran case retirement benefits must be taxed to the person who earns it. there is no exception for a transfer to another entity such as the Plan. Also isnt a transfer of accrued benefits to the plan by an owner a prohibited transaction under IRC 4975©(1)(A), (D)or (E), e.g., an act by a fiduciary who deals with plan assets in his own interest or for his own account?

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David, the IRS agent was simply wrong. Pension plans have always had the language in them that states they pay benefits on plan termination only to the extent funded. It is not a violation of 411(d)(6) to follow the terms of the plan.

In your position, though, where the IRS requests a meaningless amendment in order to carry out the process as you want it to be carried out, the prudent course is to just go along with their suggestion.

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mbozek, the issue is what makes up a vested benefit and a forfeiture and an assignment. While we are all indoctrinated by the various 411d6 mantras (thou shalt not reduce a participant's benefit, thou shalt not reduce the future rate of accrual of a participant's benefit without advance notice, thou shalt not take away a protected form of benefit unless there are specific regs that allow it) there are a number of exceptions in the code. Probably the one that is most clear revolves around ongoing underfunded plans. One can amend a plan to eliminate benefit options (like lump sums) and/or reduce benefits if one amends the plan, submits the amendment to the DOL and the DOL makes no comments for 90 days. Union plans in declining industries that were significantly underfunded quite a few years back took advantage of this provision somewhat frequently to eliminate some benefit accruals retroactively. There are others. The language in a plan on plan termination serves as one such reduction.

Any of these "cutbacks" serve to formally reduce, IMO, the accrued benefit for the purposes you are referencing such as the assignment of income doctrine. You aren't taxed on something you don't yet have under the constructive receipt doctrine as implemented in ERISA plans. So, if the benefit is formally eliminated, outside the direct control of the participant, and with the IRS's blessing, there are no income tax issues.

The only reason the IRS was successful in Gallade was that the waiver was effectively under the unfettered control of the plan participant and was not implemented through already existing plan language (benefits on termination are paid only to the extent funded) or through negotiation with the IRS (an amendment during the plan terminatnion process negotiated with the IRS in the process of getting a letter of determination on termination). In fact, the waiver in Gallade was submitted as part of a plan termination to the IRS. The IRS refused to go along with it and that is what led to the IRS taking the issue to court.

There are some people who will point back to various IRS representative's "from the podium" statements that benefits which are reduced in this fashion were still "earned" in the 415(e) sense. I firmly believe that position to be wrong and have made my opinions known to those from the IRS who have stated this in the past. Happily, 415(e) is a thing of the past so the issue no longer matters much.

In short, the answer to the issues you raise is that the shuffling of monies under the terms of the plan, which result in modified benefits being payable and hence paid from a plan, are not forfeitures or assignments. They are merely a mechanism to determine the correct benefit under the terms of the plan. The correct benefit is what is taxed, not some theoretical amount that might have been paid from the plan if certain things had been different.

Here are a couple more examples: floor-offset plans and plans integrated with social security. In both cases the accrued benefit under the plan can be reduced without violation of 411d6. I think there are specific reg cites that allow both of these, just like there is something out there (probably, at a minimum, the LRM's) which support the "to the extent funded" language.

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Mike: U seem to ignore that ERISA was enacted to protect employees from themselves as well as the employer and that is why the nonforfeitablility provisions were drafted with narrow exceptions. An employee once asked to forfeit retirement benefits to make the employee eligible for medicaid. The rules dont permit such a waiver. There are plenty of ct cases which have held that benefits can only be forfeited for the enumerated exceptions in 411(a). The exceptions u note are permitted under ERISA, e.g, benefits can be reduced after the close of the plan year if the DOL approves under IRC 412©(8). The IRS has disqualifed plans if the offset prevents "meaningful benefit" accrual. Offsets are permitted if they are allowed under the plan formula at the inception of the plan-- They are a cutback if the offset is added by an amendment after benefits have accrued. I dont know of any exception that permits a participant in an underfunded plan (DB or DC) to waive accrued vested benefits because this would be a bad precedent that would be adopted by employers to avoid the funding requirements of ERISA when it became financially desireable to do so ( Enron?). Even if the IRS approves the elimination of the benefits it does not affect the participants right to sue an responsbile party under ERISA to recover the benerfit -plan trustee anyone. Under your logic an employee could assign their retirement benefits to a separate employer plan to provide retiree health insurance without having to pay income tax on the transfer.

The problem is that the rules cannot be enforced only when it is in the employer's interest to do so and not when it is inconvenient, e.g., if the plan is underfunded at termination. If the IRS approves plan terminations as you describe then the result is an arbitrary and capricious adiministration of the tax law.

Finally the transfer you say should be permitted is a violation of the PT rules because it benefits an owner/fiduciary's personal account, e.g, the owner does not have to make the additional contributions by waiving the plan benefits as well as a transfer of plan assets for the benefit of the owner.

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I don't disagree with your premises, just the conclusion.

I guess it all boils down to what the interpretation of "to the extent funded" is. If the language in the plan, since inception, has provided for the payment of benefits only to the extent funded, then the benefit is never really earned in the income tax sense, or even the 411d6 sense, until it is paid. Of course, in order for the reduction to be excluded from being labeled a 411d6 cutback the reduction (if you want to call it that) must be based on the fact that the plan, on termination, is not sufficiently funded. I think this is a very narrow exception to the 411d6 rules.

It is also not a violation of the non-forfeitability provisions of ERISA, I would presume, although I don't have the cite handy, because it is in every db plan I've ever seen. Also, if the requirement would be to fund all accrued benefits, there would be no need for the substantial regulations issued by the PBGC in support of standard terminations. All terminations would be standard terminations by default.

I agree that we are talking exceptions to the general rules you appropriately reference. The question is how are those exceptions implemented? I disagree with your conclusion that the implementation is arbitrary and capricious because I see the elimination of those protections only in narrowly defined circumstances, each of which serves a powerful, IMO, policy purpose. The alternative I infer from your comments would be a defined benefit system that is too heavily weighted against orderly termination such that it would provide a big disincentive to the establishment of plans. While I agree that ERISA was established to protect the participants, majority owners are a class that the PBGC has seen its way clear to un-protect a bit, and so has the IRS. That is a long way from arbitrary and capricious, IMO.

I think the transfer issue you raise is overridden by the carefully constructed rules of 412. If 412 requires a payment, then a payment must be made. If it doesn't, then it doesn't. I agree that any of the documents that have been mentioned, whether they are called waivers or not, have no bearing on the 412 contributions. That is an entirely separate issue. If I've implied that the "waivers" (I *hate* calling them that, because I don't believe that a participant can waive a benefit) serve to reduce minimum funding requirements I want to set the record straight that I meant no such thing.

I suppose it would be an interesting case should a majority owner regret a decision to amend the plan to allocate the remainder in a given manner and bring suit under ERISA for recovery of benefits not paid. I see some support for both sides of that one, so as an expert witness that would be a fun case to be involved in.

Interesting discussion.

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I think this issue can resolved as follows: Although the IRS termination guidelines in the Internal Revenue Manual prohibit a waiver of benefits by participants to eliminate a funding deficiency because it violates 411d6, 411a and 401a13, an owner of >50% interest may "agree to forego receipt of all or part of his or her benefits until the benefit liabilities of all other participants have been satisfied to faciliate the termination of a plan subject to Title IV." While a plan may use standard termination only if plan assets are "sufficient for benefit liabilities", PBGC regulations 29 CFR 4041.7(a)(1) allow an insufficiently funded plan to proceed with a standard termination if the plan sponsor executes a " commitment to contribute the additional sums necessary to make the plan sufficient for all benefit liabilities". The commitment is considered to be a plan asset for the purposes of a plan termination. So maybe what happens is the 50% owner agrees to forego reciept of accrued benefits in an insufficiently funded plan which has sufficient assets for the other participants and then executes a commitment letter to the pbgc to pay the additional sums at a future time. The plan is then terminated with this outstanding liability which is never paid and nobody cares about because the owner only has the obligation to pay the money to himself. There is no assignment of income, no PT because nothing is transferred. Capisci?

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Sorry, but I couldn't resist a comment.

The accountants ought to love such an unresolved debt on the financial statements, let along the lendors.

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In the case of a PBGC covered plan, I think that resolves it just fine, but at the risk of making a long thread longer, here are a couple of additional thoughts.

First, the PBGC regs go on to say that the the alternative to 4041.7(a) is 4041.7(B), which just calls for the elimination of the benefit. No liability being left on the books. It is a pure choice, you can make the plan whole, which you can do in stages, reserving the last monies to be funded until the day of the last check being written or you can execute a 4041.7(B) agreement to forego.

So I don't think that it necessarily follows that there must be a 4041.7(a) committment.

But if we change the tune slightly to non-PBGC plans, we still have the issue of the underfinded plan on plan termination paying monies out that are less than the promised benefits under the terms of the plan. In a non-PBGC environment, the IRS allows any allocation of the assets in a manner that is non-discrimiantory. Many practitioners argued for similarity in treatment between PBGC and non-PBGC plans. That is, one would pay out the non-owners and then allocate the balance to the owners. But some, such as I, advocate across the board haircuts. The IRS routinely agrees to this, but sometimes plan provisions get in the way. :-( The practitioners that advocate consistency between PBGC and non-PBGC plans frequently cite the potential cost of litigation if a participant were to object to the methodology. Since these have to be non-PBGC plans, by definition they don't usually have a lot of participants and typically there is no critical mass that would give rise to a legal challenge. So I've never seen such a challenge. This would also be an interesting case. But the point I'm trying to make is that there is no assigment of income issue that has ever been raised on these types of cases, either. Just gotta make sure you aren't the one training the IRS auditors who run into this, so there never will be!

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Maybe the correct IRS term for the underfunded plan is forgiveness of debt not assignment of income if the accrued benefit liability is never paid?

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I know I should just agree, but I really feel that the benefit never gets to the point where it reaches the assignment of income potentiality. Just because it is acrrued under the plan doesn't necessarily mean that if it is eliminated there is an assignment. You have to actually have something before one can get stuck with income by assigning it.

And there is no forgiveness at the plan level, either, because 412 doesn't provide for that.

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Guest andy rochman

Would not advise asking IRS for written opinion as they can only reply that accrued benefits may not be waived. However, on numerous plan terminations, have waived benefits and disclosed in COVER LETTER to 5310 that owner-employee has elected alternate allocation under ERISA Section 4044. We also obtain the spouse's consent to the benefit waiver which acknowledges that the spouse may be forfeiting valuable benefits.

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