Distributions from Terminated Small DB Plan

[Guest pension222]

Consider a typical Professional Service DB plan not subject to PBGC. The plan is terminated with $800,000 in the trust. Lump sums will be paid and total NHCE lump sums equal $600,000 and the lump sum to the only HCE is $400,000.

Most plan documents say something like: "In the event of termination of this Plan the rights of all affected Participants to benefits then accrued, to the extent funded, shall thereupon become 100% vested."

For the above situation I have always seen it done where the NHCE's get all of their benefit, in this case a total of $600,000 and the HCE gets the remainder of the trust, or $200,000 which in this case represents only half of his benefit.

The above language could lead one to believe that everyone gets 80% of their benefit otherwise payable, i.e. $480,000 to the NHCE's and $320,000 to the HCE.

I seem to remember a private letter ruling from a few years back that said the HCE cannont short himself to make the trust sufficient but I also know that the PBGC will allow certain HCE's to do just this.

Keeping in mind that my example plan is not subject to the PBGC, what is the correct approach in paying benefits from this terminated plan? NHCE's get all their benefit and what remains in the trust goes to the HCE or NHCE's and HCE's all get their benefit to the extent funded?

Also, what if the plan was subject to PBGC (prior to the provision of EGTRRA allowing for funding upon termination). Would we always pay the NHCE's 100% of their benefit and then short the HCE?

[Guest merlin]

The IRS will permit a waiver by the HCE on plan termination. They don't call it a waiver,though. They call it a reallocation of assets to the extent available.The ruling you're referring to- It is a Revenue Ruling not a PLR- says that a participant may not waive a benefit for the purpose of avoiding a deficiency in the plan's funding standard account.There's also one-maybe the same one -that says that the assumption that a participant will take a benefit less than he would be entitled to under the plan will automatically be considered unreasonable.

As far as reducing everyone's benefit goes, I've only done it once at the direction of the plan's attorney.The plan was covered by PBGC,and the attorney wanted to pay only the vested benefits (NOT 100%) . Since I disagreed with this I had to attach a statement to the PBGC Form 500 to the effect that I had calc'd the plan liabilities based on the atty's interpretation of the plan,with a copy to the PBGC office of the General Counsel.Nothing ever came of it.

WRT to your last question it,may be possible to fund all or part of the termination liability on a deductible basis,regardless of whether the plan is covered by PBGC,although PBGC coverage allows for more options. A lot of it depends on timing.What is your plan year? What is the date of plan termination?

[Guest pension222]

The PLR I referred to is PLR 9146005 and while it specifically addresses the question of whether an accumulated funding deficiency can be corrected if the owner waives his benefit, it does say that the 'reduction or "waiving" , of a benefit by a key employee such as *** upon plan termination reduces the accrued benefit of the employee, and directly violates sections 411(d)(6), 411(a), and 401(a)(13) of the Code'.

Does anyone have a reference where the IRS address the "reallocation of assets to the extent available" that allows a terminating underfunded DB plan to short the owner on his or her benefit and not be in violation of sections 411(d)(6), 411(a), and 401(a)(13)?

[Guest merlin]

You're right - it was two separate rulings on the same topic. As far as written authority goes, see Q&A 69 from the 1998 ASPA Conference. It's as close as I can come.

[Guest pension222]

I've checked with my sources and have not been able to get a copy of Q&A 69 from the 1998 ASPA Conference.

Does anyone out there have this?

[KJohnson]

I have a follow up question in this regard. I have a small defined benefit plan not covered by PBGC that is terminating. One HCE is 100% vested, one HCE is 60% vested and the two nhce's are 20% and 40% vested. The Plan is underfunded even for vested benefits--Can the plan be funded only for vested liability and not accrued liability and then participants only be paid their vested benefit? My reaction was probably not. However, I had a question on 411(d)(3) which only requires for vesting upon termination "to the extent funded".

As I see it there are the following provisions:

1) 411(d)(3) which required vesting "to the extent funded"

2) 1.401(a)(4)-5(B)(2) which requires that benefits distributed to any HCE or former HCE must be non-discriminatory under 401(a)(4) upon termination.

3) ERISA 4044(a) distribution provisions with regard to a terminated plan.

Is paying benefits only to the extent vested prior to termination non-discriminatory under 1.401(a)(4)-5(B)(2)?

[mbozek]

While vested benefits cannot be waived, there is a provision in the the IRS termination guidelines that permits the controlling owner to waive/defer part of the benefit due if the plan assets are not sufficient to pay all benefits. It is in the section on vesting of benefits upon termination.

KJ_ I though that ERISA prevents an employer from terminating a plan if assets are insufficient to pay vested benefits. I though the only exception is if the controlling owner agrees to waive (PBGC) or defer (IRS) part of his accrued benefit. Otherwise an employer could walk away from the obligation to fund DB plan benefit accruals whenever the plan assets were less than its laibilities without any consequence (why bother to ask for a waiver of funding standards). For PBGC covered plans termination of an underfunded plan is only permitted as a distress terminaton.

[KJohnson]

Mbozek, thanks for the comment--I have always dealt with standard terminations in plans covered by the PBGC where you have to cover all accrued benefits and the standard practice was to get a waiver from the owner if assets were insufficient.

However, this is a non PBGC covered plan and I am now wondering whether a waiver is the way to go in this context. I guess where I am having problems is that if you are dealing with situations where participants are only partially vested and if 411 only requires full vesting upon termination "to the extent funded" then could you simpy just fund based on the vested status immediately prior to termination. Arguably participants would be paid their full "vested" benefit even if they were only paid out at their vested status (20%, 40% etc) immediately prior to termination --because the termination did not result in 100% vesting under 411. Thus, you would not be walking away from a plan without paying vested benefits. The problem that I have with this, is that to the extent that an HCE was already 100% vested pror to termination he would be getting 100% of his accrued benefit while other participants would only be getting a portion of their accrued benefit (although their full vested benefit). Does this raise 1.401(a)(4)-5 or other problems?

[Blinky the 3-eyed Fish]

See Rev. Rul. 80-229.

[KJohnson]

Thanks, Blinky--I have posted the Rev-Rul below for anyone else who looks at this thread in the future. The applicable language with regard to 401(a)(4) is the assets shall be allocated, to the extent possible, so that the rank and file employees receive from the plan at least the same proportion of the present value of their accrued benefits (whether or not nonforfeitable) as employees who are officers, shareholders, or highly compensated.

Rev. Rul. 80-229

1980-2 C.B. 133, 1980-34 I.R.B. 8.

Internal Revenue Service

Revenue Ruling

TERMINATION; ASSET ALLOCATION; DISCRIMINATION; DEFINED BENEFIT PLAN

Published: August 25, 1980

26 CFR 1.401-4: Discrimination as to contributions or benefits

(Also Section 411; 1.411(d)-2.)

Termination; asset allocation; discrimination; defined benefit plan. Guidelines and examples are provided for determining if an asset allocation is discriminatory under section 401(a)(4) of the Code upon the termination of a defined benefit plan; Rev. Ruls. 55-60, 59-241, and 65-294 superseded.

SECTION 1. PURPOSE

The revenue ruling provides guidelines for determining whether an asset allocation is discriminatory within the meaning of section 401(a)(4) of the Internal Revenue Code upon the termination of a defined benefit plan. The ruling supersedes Rev. Rul. 55-60, 1955-1 C.B. 37, Rev. Rul. 59-241, 1959-2 C.B. 118, and Rev. Rul. 65-294, 1965-2 C.B. 136.

SEC. 2. BACKGROUND INFORMATION

Section 401(a)(4) of the Code provides that contributions or benefits under the plan shall not discriminate in favor of employees who are officers, shareholders or highly compensated.

Section 411(d)(2) and (d)(3) of the Code provides certain vesting standards regarding prohibited discrimination, which are also qualification standards, in the event of plan termination.

Section 1.401-4© of the Income Tax Regulations provides restrictions on the distribution of assets for certain employees in the event of early termination of the plan. Section 1.401-4©(1) of the regulations provides that the Commissioner may determine that such restrictions are not necessary to prevent prohibited discrimination in the event of an early plan termination.

Section 4044(a) of Title IV of the Employee Retirement Income Security Act of 1974 (ERISA), Pub. L. 93-406, 1974-3 C.B. 1, sets forth the rules applicable to the allocation of assets to participants and beneficiaries by priority categories in the event of the termination of a defined benefit plan.

Under section 4044(B)(4) of ERISA and section 1.411(d)-2(a)(2)(ii) of the regulations, assets that would otherwise be allocated pursuant to paragraphs (4)(B), (5) and (6) of section 4044(a) of ERISA may be required to be reallocated to the extent necessary to avoid discrimination within the meaning of section 401(a)(4) of the Code. Further, section 1.411(d)-2(e) of the regulations provides that assets in excess of the early termination limits may be reallocated to avoid discrimination.

SEC. 3. ASSETS NOT LESS THAN PRESENT VALUE OF ACCRUED BENEFIT

In the case of a terminating plan in which the value of plan assets as of the date of termination is not less than the present value of all accrued benefits (whether or not nonforfeitable) as of such date, a distribution of assets to each participant equal to the present value of that participant's accrued benefit will not be discriminatory within the meaning of section 401(a)(4) of the Code if the formula for computing benefits as of the date of termination would not be discriminatory had the plan not terminated. All present values and the value of plan assets are computed using assumptions that are acceptable to satisfy section 4044 of ERISA.

If the assets as of the date of termination exceed the present value of the accrued benefits (whether or not nonforfeitable) as of such date, the plan will not be considered discriminatory if such excess reverts to the employer or is applied to increase benefits in a nondiscriminatory manner. One method of applying the assets to increase benefits in a non-discriminatory manner is to amend the plan to provide a new benefit structure such that (1) the benefit structure would not be discriminatory if the plan were not terminated and (2) the present value of the revised accrued benefits (whether or not nonforfeitable) as of the date of termination equals the value of plan assets, and to distribute assets equal to the present value of the revised accrued benefits. The new benefit structure must satisfy other requirements of the law such as sections 411(d)(6) and 415 of the Code.

The guidelines provided by this section may be applied whether or not the termination would otherwise invoke the early termination restrictions described in section 1.401-4© of the regulations.

The guidelines described in this section may be illustrated by the following examples:

EXAMPLE 1. A plan provides a benefit of 10% of the first $5,000 of compensation plus 47 1/2% of compensation in excess of $5,000. Such plan satisfies the requirements of Rev. Rul. 71-446, 1971-2 C.B. 187, and is fully integrated. As of the date of termination the assets equal $100,000 and the present value of the accrued benefits (whether or not nonforfeitable) equals $80,000.

The plan distributes the $100,000 by providing each participant with assets equal to 125% of the present value of such participant's accrued benefit (whether or not nonforfeitable).

Distributing assets equal to 125% of the present value of the accrued benefits is tantamount to amending the plan by multiplying each of the terms of the benefit formula by 125% and distributing the present value of the accrued benefits. The revised formula would be 12.5% of the first $5,000 of compensation plus 59.375% of compensation in excess of $5,000. The revised formula is discriminatory in an ongoing plan because the formula fails to integrate properly. (See Rev. Rul. 71-446.) Accordingly, such distribution is discriminatory.

EXAMPLE 2. The facts are the same as in Example 7 except that the distribution is revised as follows: By a separate actuarial computation it is determined that a nonintegrated increase in the benefit formula of 1% of all compensation would increase the present value of the accrued benefits by $4,000. The plan has surplus assets of $20,000 ($100,000 of assets as of the date of termination less $80,000, the present value of accrued benefits as of such date). Therefore, an increase of each of the terms of the benefit formula by 5%

($20,000 surplus)/($4,000 present value of accrued benefit for each 1% increase in benefit formula)

will produce a benefit formula that would be nondiscriminatory in an ongoing plan and whose present value of the accrued benefits (whether or not nonforfeitable) equals the value of plan assets. The benefit formula is therefore revised to provide 15% of the first $5,000 and 52 1/2% of compensation in excess of $5,000, and assets equal to the revised present value of the accrued benefits may be distributed without causing discrimination.

SEC. 4. ASSETS LESS THAN PRESENT VALUE OF ACCRUED BENEFITS

.01 Applicability--This section applies to the termination of a defined benefit plan in which the value of plan assets as of the date of termination is less than the present value of all accrued benefits (whether or not nonforfeitable) as of such date whether or not the restrictions of section 1.401-4© of the regulations apply.

.02 General Rules--The following guidelines apply in testing for discrimination in the case of a plan described in subsection .01 with respect to which the benefit structure, if the plan were not terminated, would not be discriminatory under section 401(a)(4) of the Code.

(1) Except as provided in paragraph (4), the assets of a plan are allocated in accordance with sections 4044(a)(1), (2), (3), and (4)(A) of ERISA.

(2) Subject to the requirements of paragraph (1), the assets shall be allocated, to the extent possible, so that the rank and file employees receive from the plan at least the same proportion of the present value of their accrued benefits (whether or not nonforfeitable) as employees who are officers, shareholders, or highly compensated.

(3) Notwithstanding any other paragraph, in the case of assets restricted by section 1.401-4© of the regulations, assets may be reallocated to the extent necessary to help satisfy paragraph (2).

(4) In the case of a plan establishing subclasses within the meaning of section 4044(B)(6) of ERISA, the assets within any paragraph of section 4044(a) of ERISA may be reallocated within such paragraph to the extent that such reallocation helps to satisfy paragraph (2).

(5) Subject to paragraphs (1), (2), (3), and (4), the assets shall be allocated in accordance with section 4044(a)(4)(B), (5), and (6) of ERISA.

.03 Examples--The guidelines described in subsection .02 are illustrated by the following examples:

Example 1. A plan described in subsection .01 which provided benefits on an ongoing basis as of the date of termination that were not discriminatory within the meaning of section 401(a)(4) of the Code, terminates. The plan has two employees: A, an officer of the company, and B, a rank and file employee. The value of plan assets as of the date of termination is $130,000 which would, without regard to this section, be allocated to the employees under section 4044(a) of ERISA as follows:

Paragraph of

section 4044(a) Allocation to Allocation to

of ERISA Employee A Employee B

--------------- ------------- -------------

(3) $120,000 0

(4)(A) 0 0

(5) 10,000 0

(6) 0 0

-------------

$130,000

The present value of A's and B's accrued benefit on the date of termination, whether or not nonforfeitable, is $240,000 and $60,000, respectively. The limits described in section 1.401-4© of the regulations do not apply.

The proposed distribution described in section 4044(a) of ERISA would not satisfy section 4.02(2) of this revenue ruling because (1) employees who are officers, shareholders or highly compensated would receive 54% ($130,000)/ ($240,000) of the present value of their accrued benefit whether or not nonforfeitable and the rank and file employees would receive 0% and (2) there are assets in paragraphs (4)(B), (4) or (6) of section 4044(a) of ERISA to be reallocated to minimize the discrimination. The $10,000 allocated in paragraph (5) to A should be reallocated to B. a would then receive $120,000 (50% of the present value of his accrued benefits whether or not nonforfeitable) and B would receive $10,000 (16 2/3% of the present value of his accrued benefits whether or not nonforfeitable). This distribution would be deemed nondiscriminatory because the assets have, in accordance with section 4.02(2) of this revenue ruling, been allocated to the extent possible to preclude discrimination.

Example 2. The facts are the same as in Example 1 except the early termination restrictions described in section 1.401-(4)©

would limit the assets to be allocated to A to $100,000. It is proposed to distribute $120,000 to A and $10,000 to B.

The proposed distribution does not satisfy section 4.02(3) of this revenue ruling because (1) the assets allocated to officers, shareholders, and highly compensated are 50% of the present value of their accrued benefits and the assets allocated to the rank and file employees are 16 2/3% of the present value of their accrued benefits and (2) there are assets that are restricted by section 1.401-4© of the regulations that may be allocated to preclude discrimination. If an additional $16,000 were allocated to B so that A would receive $104,000 (43 1/3% of the present value of his accrued benefit) and B would receive $26,000 (43 1/3% of the present value of his accrued benefit) the distribution would be nondiscriminatory even though A is receiving $104,000 and the limits described in section 1.401-4© would otherwise limit his benefits to $100,000.

Example 3. A plan described in subsection .01, which provides benefits on an ongoing basis that are not discriminatory within the meaning of section 401(a)(4) of the Code, is terminated. The plan has two employees: A, a shareholder employer whose benefits are not nonforfeitable, and B, a rank and file employee whose entire benefits are nonforfeitable. When the assets are allocated in accordance with section 4044(a) of ERISA only B receives an asset allocation. It is proposed to reallocate the assets to provide both A and B with the same proportion of the present value of their accrued benefits whether or not nonforfeitable.

The proposed reallocation is not permitted. Because the rank and file employees are receiving at least the same percentage of the present value of their accrued benefits as the employees who are officers, shareholders, or highly compensated, there is no discrimination within the meaning of section 401(a)(4) of the Code and no reallocation under section 4.02(2), (3), or (4) of this revenue ruling and section 4044(B)(4) of ERISA is permissible. The assets, in accordance with section 4.02(1) and (5) should be allocated in accordance with section 4044(a) of ERISA.

SEC. 5. EFFECT ON OTHER RULINGS

Rev. Ruls. 55-60, 59-241 and 65-294 are superseded.

Rev. Rul. 80-229, 1980-2 C.B. 133, 1980-34 I.R.B. 8.

[RTK]

K Johnson, note that the portion of the Rev. Rul. you highlighted is still subject to the allocation required by ERISA 4044(a)(1), (2), (3) and 4(A).

Thus, I believe that you could terminate a non-pbgc db plan and not allocate any funds to nonvested participants, even if all hces were 100% vested so long as the hce allocation was in the above allocation categories (and with the correct plan language).

pension222, I believe the typical language you cite addresses vesting upon termination, and not the allocation of assets upon termination.

Regarding the allocation of assets, ERISA 403(d)(1) provides that upon termination of a pension plan to which 4021 does not apply, the assets are allocated in accordance with 4044, except as otherwise provided in regs.

[KJohnson]

Thanks, RTK I did notice that and I went through the steps and a good portion of the 100% vested HCE's benefit was actually in 4044(a)(4)(B) and therefore was subject to reallocation for discrimination purposes.

I do have a question, however. In my copy of ERISA 4044(a)(4) states that:

"For purposes of this paragraph, Section 4021 shall be applied without regard to Susection © thereof."

4021© is the definitional section of the coverage provision. What does this mean?

[RTK]

My copy of ERISA 4044(a)(4) states the same phrase. It appears to exclude the (otherwise covered) fixed benefit plan from a guaranteed benefit calculation. I would really like to say that I know what it means in the context of a 4044 allocation, but unfortunately, I have never seen a concrete application.

[david rigby]

In case readers would like a link to the Revenue Ruling: http://www.taxlinks.com/rulings/1980/revrul80-229.htm