Overfunded Plan

[Lori Foresz]

Any insight is greatly appreciated.

DB plan is very overfunded. Sole participant is no longer accruing additional benefits.

A suggestion has been made to purposefully disqualify the plan by adding plan language to raise/remove the 415 limit and then pay out all plan assets as taxalbe income to the sole participant to avoid the reversion/tax issue.

Thoughts?

[Blinky the 3-eyed Fish]

Wouldn't this suggestion put in jeopardy the past deductions taken for contributions? Who made this suggestion and did he/she give a detailed reason why this approach is best? Personally, I have never heard of this recommendation.

Give more details as to why this plan is so overfunded. Is the person at the dollar or compensation limit? What is the amount of the overfunding? Is the employer still an active company or a shell?

[AndyH]

Actuarial error of course. Isn't that always true?

On a serious note, is this plan subject to ERISA's fiduciary rules? I though if a plan got disqualified (at least for certain reasons), the accrued benefits would be taxed to HCEs. Excess assets are not accrued benefits. So, it seems like giving the excess to himself is not much different than giving the excess to somebody else.

Maybe go to the track and find a 10 percenter who the client can give the money to temporarily, pay him 10%, have him return 90% and put the rest under his pillow and pay no taxes. Sounds more efficient to me.

[Lori Foresz]

AndyH,

That concept has kind of tripped me up as well. He is limited by the 100% of comp 415. I think the ERISA attorney is thinking that by removing that limit and disqualifying the plan, the participant's accrued benefit now includes the excess assets and thus the disqualification taxes the participant on the total trust value. This avoids the reversion to the company.

Thoughts?

[AndyH]

My thought is that the participant's accrued benefit does not include the excess. In a DC plan, a 415 excess it must be forfeited or refunded. How is that different in a DB plan?

[SoCalActuary]

Three strategies:

1. Start benefit payments, including up to one year of back payments, and just keep the plan forever.

2. Sell the plan sponsor and use the over-funding as a business asset. There are companies that buy overfunded plans at about 70% of value.

3. Look to the plan sponsor's relatives to take over the plan for their own business enterprise, and keep the overfunding as part of their eventually earned estate.

None of these require the obscene reversion penalty, but all of them limit the owner to their 100% of pay benefit. Only the second choice also puts money in the owner's pocket.

[David MacLennan]

When did the plan become overfunded?

If he is at the 100% limit, the participant should have commenced annual payments in the amount of the 415 limit as soon as the plan became overfunded, as this does not impact the 100% of pay limt. How much percentage-wise is the overfunding? The annual payments may still substantially help the overfunding, but it may take time. Interesting question is whether such annual payments can be rolled over to an IRA - seems like they could be if they were made pursuant to a partial lump-sum distribution election each year.

The lump sum of th 415 100% limit goes down by approx 3%/year, so things are getting worse.

Another option: invest in non-publicly traded assets and heavily discount them per Rev Rul 59-60 (submit the form 5310 for a blessing).

Don't disqualify the plan - there's always a better way to go, in my opinion. May want to consider getting a new attorney.

[David MacLennan]

So Cal - I posted before I saw your #1. We had the same thought. Like your suggestions.

Re #3, is there a spouse? Even if the spouse never got any W-2, some feel that unpaid service counts for 415 Years of Service (put it in the document and submit it for approval). This could use up approx $4 of assets for every $1 of W-2 paid to the spouse now, depending on age, etc.

[david rigby]

Are we assuming the plan has been amended for 415 as far as possible? COLA?

(Yes, this probably only helps with annual payments, but, as suggested earlier, it might be a great intermediate step.)

[Guest dsyrett]

Another option, might not be choice #1 but could use up a lot of plan assets:

Consider payment of benefits in the form of a joint and 100% annuity eg., with spouse as beneficiary. Have trustee buy a commercial immediate annuity to do this. See for example immediateannuity.com for current annuity costs.

You get the added kicker of basing it on 100% of high 3 pay without having to make a downwards actuarial adjustment for a non-life annuity form. May require a plan amendment.

Editorial comment: although most clients want to move their money as a rollover to an IRA, a J&100 annuity can be a good part of a person's retirement program. Might split the purchase between several highly rated insurers to spread the risk of an individual insurer insolvency.

[AndyH]

The J&100 annuity might be a good idea, especially if the spouse is young .

[mbozek]

One thing that is overlooked is that the fmv of the surplus assets is part of the value of the business interest included in the gross estate of the owner which is taxed at a estate tax rate of 45% if the taxable estate exceeds 1.5m (2.0m in 06). If the spouse inherits the business interest the tax is postponed until the spouse dies. It is better to sell the surplus assets as part of the sale of the business at discount (if the business is incorporated) because the net profit will be taxed as capital gains and the taxes will reduce the value of the estate. If the surplus is not sold it will be included in the estate of the owner or spouse at its fmv and will be taxed at a rate of up to 113% for income, estate and reversion tax. The 100% survivor annuity will be be excluded from estate tax as a marital deduction.

[MGB]

I don't think this discussion has addressed the original question.

Has anyone actually gone through a plan disqualification? I realize there are a number of things the IRS may do, but what do they actually do? If they end up just taxing the benefits, as described in the original posts, it sounds like a viable alternative.

If they go back and disallow deductions from prior open years, there is a problem with interest and penalties. However, in this situation, the prior deductions should not come into play...the plan was qualified at that time. The suggestion was to do something NOW that disqualifies the plan.

I am still mulling over the idea that the original suggestion may be reasonable.

What exactly happens when a plan is disqualified (assuming the disqualification is prospective only)?

[mbozek]

The answer is really an accounting question to determine what would be the minimum tax ultimately paid-disqualfication would result in a tax to the employer on all plan assets if it is a C corp and then a separate tax to the owner when paid by the corp. If the business is not taxed as a corp then the 35% max income tax & state tax will apply. If the plan purchases benefits for the owner and then sells the surplus assets the tax due may be only a capital gains tax on the sale price. The financial disadvantage of disqualifying the plan is the loss of investment income on the amount of plan assets that will be needed to pay fed and state tax.

[Lori Foresz]

The belief of the attorney is that the plan is essentially now a nonqualified deferred compensation plan and thus all assets are paid out to the sole owner as W-2.

The participant has taken distributions in the past so remaining PVAB to assets is about 5% and surplus assets are around half a million.

I appreciate all the ideas and comments.

[Lori Foresz]

MZOBEK, not sure why the disqualification would be a tax to the corp and also the the participant. Suggestion is to treat it as only taxable to the participant as a nonqualified deferred comp benefit and not the corp as well.

Just thought I would add this :-)

[David MacLennan]

lgolden - if the participant has taken multiple distributions to the point where the PVAB is only $25,000, then the computation of the 415 100% limit might not be straightforward. I would have someone review it.

[AndyH]

Are there no consequences to persons who intentionally violate 415? Is the consequence merely taxes? And what would happen if the excess were sent to a third party in an owner-employee only plan?

[mbozek]

Under IRC 402(b) employee is taxed on amount of vested benefit in disqualified plan. Surplus amount is not included as part of the vested benefit but would revert to employer under the terms of the trust (although not subject to 50% excise tax of IRC 4980). Under IRC 111 amount of reversion will be subject to income tax in year received to extent employer received a tax benefit (e.g., tax deduction in a prior year) from the reversion. Dont know if waiver of reversion by employer will generate income tax which is why this needs to be reviewed by tax accountant.