Demutualization Proceeds on Terminated Plans

[MGB]

When Prudential sent out letters last year to terminated defined beneift plans, I didn't expect them to actually give stock to nonparticipating nonmutual contracts such as group annuities upon a plan termination. Well, now they did. There have been many threads on these boards dancing around the issues involved without clear guidance.

Has anyone received official guidance from the IRS on the various tax issues?

Has anyone received official guidance from anyone on various trust/employer/reporting issues?

I can list more than 40 specific (semi)unanswered questions, but first need to find out if the IRS has given any insight on this (I am not talking about extrapolating general principles from other similar situations - I am looking for concrete info directly on these demutualizations; and the information from Prudential is worthless).

[Guest 91smithie]

This question has recently come up regarding a terminated plan I have been working on. Did you get any answers to these questions?

[mbozek]

The only rulings I am aware of from the IRS are a plr that held that the stock issued by a demutualized ins. co is not considered an annual addition under 415 and a ruling that allowed stock to issued to 403(B) annuity contracts to be converted to a mutual fund. There are many questions involving terminated plans -including questions on dispositions of stock to plans which terminated pre ERISA. ERISA does not apply to plans which terminated before Sept 2, 1974. There are no definitaive guidelines and each case is a facts and circumstances decision as to how the stock will be treated. Policy holders need to retain counsel and make business decision of whether to take the stock into general account, deposit stock into another DB plan, or revive a terminated plan and increase benefits for surviving participants. Its is not clear whether the stock is reversion or a dividend. By the way Pru was required to give stock to all holders of its ins contracts (including policies issued to terminated plans) under the terms of the demutalization. The terms of the stock distribition were announced in advance and policy holders had the option of receiving cash. Pru cannot act as legal advisor to the employers who must retain their own advisors. Most clients who recieve the stock are pleased to receive the extra cash-- its found money. Under the tax benefit rule the stock will be taxable income to the policy holder with a basis of 0.

[Guest CCHP]

I would like to know if anyone has any information on this as well, particularly if there have been any claims based on state law theories arising from an employer/contract-holder's decision to retain the demutualization proceeds, resulting in litigation from the former plan participants/beneficiaries.

[mbozek]

State laws are preempted by ERISA so any claims by participants for demutualization proceeds under state law will be rejected. Also, Under the Hughes case, participants in a Defined benefit plan cannot make a claim for the surplus amounts under the plan since they are only entitled to the benefit that accrues under the plan formula. Demutualization shares paid to a DC plan will have to be allocated to partaicipant accounts under some basis devised by the plan fiduciaraies...I dont see how an employer subject to ERISA could retain the shares in a plan that has not terminated because this would be a prohibited transaction.

[Guest CCHP]

I should have made my facts clearer:

If the plan has been terminated, and the demutualization proceeds arise under an insurance annuity contract that was purchased subject to the termination, the former plan sponsor can argue that ERISA does not apply because there is no plan. Therefore, the former plan participants, now beneficiaries under the contract would have to argue under state law theories (e.g., a constructive trust theory)

I may be wrong on this interpretation of the Hughes case, but I believe it stands for the proposition that particinants are not entitled to plan surplus if the plan document itself contemplates that such a surplus belongs to the employer and not the plan. If the plan is silent on this, the surplus must be used for the "exclusive purpose" of the plan.

[Guest CCHP]

I might also add that there are several cryptic statements in Prudential's demutualization guide and several articles that raise this possibility. My real question is whether this sort of situation has actually played itself out yet (or is in the process of playing itself out).

[mbozek]

If the plan was subject to ERISA and terminated under rules of ERISA I think the claims would have to arise under ERISA since the distribution of plan assets are subject to ERISA 403(d)(3) or 4044. State law would apply if the plan was terminated prior to the effective date of ERISA ( 9/2/74) although I think the claims would have been extinguished by the S/l. I am aware that terminated vested participants of Prudential who received annuity benefits under a contract issued by Prudential in 1992 sued the company in Fla fed court a few years ago for demutualization benefits before the hughes case was decided. Dont know what happened to the case. Also my recollection of the hughes case is that participants in plan A who made after tax contributions to a DB plan claimed that they were entitled to a portion of A's $1B surplus when plan A was merged with Plan B, an noncontributory plan which covered other participants because of the exclusive benefit rule. The Sup ct held that participants were only entitled to recieve the benefits that they had accrued under plan A. I dont remember any other facts.

[Guest CCHP]

mbozek,

I think that is an argument that can be made. The problem, I believe, is that how can there be plan assets when there is no plan?

Plan, pursuant to a termination, purchases an annuity contract for the benefit of the participants, using plan assets. The contract holder is the plan-sponsor. At the time of the termination, surplus plan assets are distributed to the participants (or used to purchase the annuity contract).

15 years pass. Former plan sponsor receives notice that it is going to receive this windfall from the demutualization proceeds. I will concede that the former plan participants/current contract beneficiaries have an argument that since these funds were derived from the former plan assets that ERISA's fiduciary duties still apply as to them. But this argument is far from clear, and from what I can tell there is very little authority on this principle. And there are several problems with this argument. First, the annuity contract does not contemplate such a distribution (or any dividends or other distributions that are not explicitly contemplated by the terms of he agreement). How can it be a plan asset when it was never contemplated that the participants would receive it? THe former plan sponsor can simply state that this is an ancillary benefit to sponsoring the annuity contract. Second, the DOL has issued regulations that seem to go against this argument See 63 Fed. Reg. 69317n.7.

Thank you for your thoughts and dialogue on this. I will see if I can find that Florida case.

[mbozek]

I think state laws are preempted for any plan termination or demutualization dividend received after 9/2/74 See--Ruocco v. Bateman, Eichler etc, 903 2d 1232-- Cal Ins. is preempted by ERISA regarding an employer's right to the surplus because ERISA regulates employee benefit plans funded by insurance and the state only regulates the terms of the insurance contract. Also in a pension plan funded solely by the employer, the demutualizaton surplus will be paid to the employer even if the plan is silent on the distribution of assets, because to rule otherswise would result in an unintended windfall for employees. Wright v. Nimmons 641 FSupp 1391 (1986). This decision is consistent with Hughes which held that employees have no right to a plan surplus after a merger of their contributory plan with a non contributory plan because the employer takes investment risk in a DB plan.

[Guest CCHP]

Thank you for the guidance. I have seen the Ruocco case. the distinction there is that the plan was still active and in existence. And of course any state law construing the disposition of assets is going to be preempted when the plan at issue is still governed by ERISA. But here, there is no plan.

The dicta in Wright is very helpful, however, in determining how a court may look at such a state law argument. Like I said, I still think it is possible that a court might find that ERISA applies, but there is no guarantee on that point. And I have seen many cases that focus on application of ERISA while the plan is active or during the termination process. When that process ends is the unanswered question. :confused:

Thak you again for your guidance.