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Plan Terminations for small Defined Benefit plans


Guest AK1321

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When small DB plans (1 person plans, or a person and spouse) are preparing to go through the termination process, is it necessary to file all of the standard termination forms (5310, 6088, etc.), or is it acceptable just to file the 5500 and mark that it is the final filing for the plan?

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Form 5310 is not a required filing.

What are all of the required filings for these types of plans when terminating?

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In practice, it's usually been a matter of how much assets the Plan has accumulated that guides the Plan sponsor as to whether or not he/she goes for a d-letter. If it's a relatively small amount (e.g., $150,000), the Plan sponsor may usually opt to forego the d-letter. At one time the word on the street was that if you terminated a plan without obtaining a d-letter that you were asking to be audited. My experience with plans with small fund accumulations that failed to ask for a d-letter was that this wasn't the case.

The material provided and the opinions expressed in this post are for general informational purposes only and should not be used or relied upon as the basis for any action or inaction. You should obtain appropriate tax, legal, or other professional advice.

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That was too short an answer for me. So here goes:

Terminating a plan is an important decision to make. During the life of a qualified plan, the plan has enjoyed the benefits of tax-free earnings and tax-deductible contributions. These have been allowed by complying with the qualification requirements imposed by the Internal Revenue Code. Thus, in order to keep the IRS happy, the plan has been required to maintain compliance both in operation and in form. That means two things:

  1. the plan must operate in accordance with the terms of its written plan document and under any requirements under the law and guidance, and
  2. the plan must have a written document which is qualified (meaning its language meets IRS approval).

Of course, the above two items are only at risk if the plan is examined by the IRS. Item number 2 can have its risk eliminated by having the IRS approve the plan’s language. If the plan gets such approval and has also operated by that plan language, then the whole plan’s risk is virtually eliminated. That approval would be in the form of a favorable IRS Determination letter.

So, how do plan documents get that favorable letter? Under a prototype, the IRS provides a determination letter (or a letter of reliance for a volume submitter) which approves the document's language. The last time the IRS provided prototype document approval was generally in 2002 for the GUST prototype documents. Plan language changes have been required by law since that time, such as amendments for:

  • EGTRRA (generaly due in 2002)
  • Minimum Distributions, or Post-EGTRRA (generally due in 2003)
  • Mandatory Distributions (generally due with the company 2005 tax return deadline)
  • Final 401(k)/401(m) Regulations (generally due with the company 2006 tax return deadline)
  • PPA 2006 (generally due in 2009)
  • Final 415 Regulations (generally due in 2007 / 2008)
  • Final Roth Regulations (generally due in 2007 / 2008)
  • And so on…

Most of the above amendments are not IRS-approved model amendments (meaning the IRS did not issue model language). Therefore, the only sure method to guarantee that it meets the IRS's qualification requirements upon plan termination is to submit a favorable determination letter request using IRS Form 5310. If you elect not to request an IRS review of the plan’s language, you may need to agree to hold your document provider harmless from any errors or deficiencies that could have been corrected if the plan were to request and obtain a determination letter when the plan terminated.

When the IRS reviews the Form 5310, the normal result is a favorable determination letter (an IRS stamp of approval for the plan’s language). Sometimes during the review they indicate where language changes are necessary, and this can vary by plan type and by IRS region. These required changes are allowed after the plan termination date only because the plan submitted under Form 5310.

Plans terminating right now should have already have done the amendments for the first 4 amendments listed above (EGTRRA through the Final 401(k)/401(m) Regulations). That language is under good faith compliance for now and will all be wrapped into the next prototype (or volume submitter) plan document, thereby giving full approval by the IRS at that time. However, if the plan terminates now, before the EGTRRA document restatement, then that language has no IRS approval. The only way to get approval is to file a Form 5310.

Also, virtually no plans have been amended yet for PPA 2006. What’s even worse, a lot of guidance for this law will not be issued until later in 2008 or 2009, so writing a perfectly compliant amendment now is fairly improbable. But a plan that terminates now MUST be amended to add that language as well (depending on the plan year and the actual plan termination date). Again, the only way to get an approval stamp on any of that language is to file a Form 5310.

Any plan that terminates without filing a Form 5310 will be considered open game if they get audited. When the guidance gets issued in 2008 and 2009, will the IRS auditors look for language that complied with that guidance (even though the plan terminated in 2007 or 2008)? If the plan obtained a favorable determination letter via form 5310, then the IRS cannot audit such language at all.

So, a client that does not submit a form 5310 to the IRS upon termination risks plan disqualification, meaning that none of the money would be rollover eligible and would be taxable immediately upon the distribution when the plan terminated (well, it could be worse, they could disallow some of the deductions taken too).

With the knowledge from the above explanation, why would a terminating plan not submit a Form 5310?

  1. Okay, suppose the client refused to sign amendments timely or had some other clear violations that they refuse to fix. These things would stick out like red flags in the Form 5310 application. If that is the case, then it’s advisable to steer clear of the Form 5310 filing, assuming the client has first been advised of the risk they are taking by not fixing their plan problems and the risk they are taking by not filing a Form 5310.
  2. Another reason may be cost, but really, that cost is a small price to pay for protection against the mafia IRS.

I hope you find this helpful. If you read the whole thing, my apologies for the verbosity! If you have any questions or need further information, please let us know.

Edited to say that I agree with Andy the Actuary.

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Couldn't agree more with Mr. J4KFBC. Lay it out for the client. In the end, it is the client's money and if he wants to take the risk, that is his business decision.

By the way, since we need some humor to end the week, my favorite IRS request regarding the termination of a one-participant DB Plan (that has repeatedly indicated no other employees on the 5500EZ) is for the 401(a)(26) demonstration!

The material provided and the opinions expressed in this post are for general informational purposes only and should not be used or relied upon as the basis for any action or inaction. You should obtain appropriate tax, legal, or other professional advice.

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Let say one person plan is underfunded and the owner wants to terminate it since his income is substantially decreased. Is there an easy way for him to get money out of the plan before the IRS blesses the plan termination, since the IRS is sitting on the d-letter for over 6-9 months?

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The Plan can be amended to provide for an inservice retirement, provided the owner meets the age requirements. However, if the owner is simply going to roll the benefit to an IRA, why not wait? If the owner intends to take all in cash, then he could "retire" and take cash since the tax-qualified status of an IRA would not be at issue. However the owner proceeds, however, should be under the guidance of legal and tax counsel.

The material provided and the opinions expressed in this post are for general informational purposes only and should not be used or relied upon as the basis for any action or inaction. You should obtain appropriate tax, legal, or other professional advice.

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Once the plan is terminated, there is no legal requirement to delay distribution until the letter of determination is received. Most consultants urge the plan sponsor to delay the distributions, though, as it just makes business sense to do so. Hence, if the plan's provisions allow for partial distributions, a plan participant can elect to receive a portion of their benefit after any distributable event of which plan termination is one.

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