Termination of an Underfunded DB Plan

[Guest Gary A. Luing]

 Termination of an Underfunded DB Plan

Here is the fact pattern: Sole practitioner, the only employee, retired two years ago so little or no income is generated on Schedule C. The DB plan is underfunded just before termination this year, so $50,000 is required to be funded but is not deductible under 404(a)(8) because of the income limitation on sole proprietorships. The $50,000 represents the final contribution under the minimum funding standards of 412 for the year of termination. The Code and the Regs specify what cannot be deducted, but not what happens to the amounts that are required, but not deductible.

The benefits attorney has suggested two options:

Alternative One: Do not make the minimum funding contribution for the 2002 plan year. Proceed with the plan termination. As sole participant in the plan, and as a "substantial owner", agree to waive enough of the accrued benefit so that the plan assets equal the reduced benefit liabilities. The actuary will calculate how much will need to be waived. At the same time, request a waiver of the minimum funding requirement for 2002. When the plan is submitted to the IRS for a favorable determination letter on plan termination, disclose what is proposed. The attorney feels the IRS would be agreeable. Any reaction?

Alternative Two: Deposit the 2002 contribution requirement of $50,000 by the funding deadline of 9/15/03. Proceed with a standard termination of the plan and submit it to the IRS for review. Once a favorable determination letter is received, distribute the plan assets and treat the non-deductible contribution as "tax basis" and report this amount as a non-taxable distribution on the 1099-R. Can the non-deductible amount become a basis in the assets in the DB trust, or is it lost forever?

[david rigby]

Need some more facts. The $50K is the 2002 PY contribution, but when is it being deducted?

[pmacduff]

pax - the original post said it isn't deductible under 404(a)(8) because of the income limitation on sole proprietorships; little or no Sch C income

[MGB]

It is my understanding that it still must be deducted (in whichever year is appropriate), regardless of whether or not there is a zero or negative Schedule C income. You cannot carry over the deduction to a different year. However, the Schedule C loss may be carried over in certain circumstances.

[WDIK]

Just to clarify, contributions to a pension for a self-employed individual are deducted on Line 31 of Form 1040 rather than on Line 19 of the Schedule C.

[david rigby]

Just to clarify, my Q about timing of the proposed deduction still stands; enough ambiguity in the orginal post.

I would recommend that the plan sponsor forget about a waiver. Since a waiver is for temporary business hardship, it is highly unlikey the IRS would consider this either temporary or hardship.

[Guest RSNOW]

Don't you also have the option of spreading the final deduction over the subsequent 10 year period even after trust ceases to exist ? (IRC 404(a)(1)(A)(iii), though that may be small consolation). However, maybe he won't even have enough Schedule C to make that a viable option if he's pretty much retired.

[mbozek]

Option 1: Under IRS termination guidelines a substantial owner can forego the part of the benefits until the liabilities of other plan partaicipants have been satisfied to facilitate the termination of the plan if plan is subject to Title IV and does not affect the minimum funding requirements in the year of termination.

Option 2: The only basis in the plan not subject to taxation are employee contributions. Employer contributions are made on a pre tax basis even if no tax deduction is taken by the sponsor, e.g., if employer has a net loss for a the year.