Refund From Annuity Provider

[Guest merlin]

We have a client who terminated their defined benfit plan in 2003. The plan was underfunded by about $1M, which the client contributed and presumably deducted on their tax return under 404a1D (they were covered by PBGC). Distributions were made through an annuity purchased from a carrier for $16M. All plan assets were distributed by 2004. Some time later, the Attorney General of the state of CT brought a complaint against the carrier for inadequate disclosure of the commission structure, as a result of which the carrier agreed to make refunds to its affected customers. Our client is due a refund of $44K under this agreement. The question is how to treat it? Is it an excess plan asset, to be returned to the trust (that no longer exists) to be reallocated to the participants as per the plan? Is it a refund that should go to the sponsor to be taxed as ordinary income? Could the refund be considered a reversion subject the 4980A excise tax?

[Guest mjb]

Q1 who is the payee of the check, the employer or the plan.

Q2 how is the check to be reported to the IRS? as a taxable or non taxable distribution or dividend?

If the employer is the payee (because the annuity contract was issued to the employer) the check may be considered a refund of an excess premium since the premium would have been reduced if all of the facts had been disclosed. (If the plan was fully funded at temination there could be no further contributions at a future date). There were similar questions raised when insurance co demutualized in the last decade and plan sponsors received dividend checks from insurers on plans that had been terminated many years previously. There are some DOL opinion letters on demutualization proceeds around 99-2001 but none answer this Q.

Where the plan has terminated the employer usually has four options:

1. treat proceeds as a reversion of plan assets and pay the penalty tax and income tax which means that the IRS will collect most of the $,

2. deposit the refund in another DB plan as a contribution and take a corresponding deduction,

3. treat the premium as a dividend subject to income taxation since there is no qualified plan at this time.

4. re establish the terminated plan and use the proceeds to provide additonal benefits ( I have never heard of this occurring.)

You need to discuss the issues with the accountants since they will be familiar with how these transactions are booked.

[Guest ak]

We have a client who terminated their defined benfit plan in 2003. The plan was underfunded by about $1M, which the client contributed and presumably deducted on their tax return under 404a1D (they were covered by PBGC). Distributions were made through an annuity purchased from a carrier for $16M. All plan assets were distributed by 2004. Some time later, the Attorney General of the state of CT brought a complaint against the carrier for inadequate disclosure of the commission structure, as a result of which the carrier agreed to make refunds to its affected customers. Our client is due a refund of $44K under this agreement. The question is how to treat it? Is it an excess plan asset, to be returned to the trust (that no longer exists) to be reallocated to the participants as per the plan? Is it a refund that should go to the sponsor to be taxed as ordinary income? Could the refund be considered a reversion subject the 4980A excise tax?

It seems to me the amount returned would be a reversion of plan assets. Technically, the plan paid for the annuity contract and thus it is the plan's property. The receipt of "settlement" funds relating to the contract by the employer would appear to involve a transfer of plan assets to the employer, i.e., a reversion. You may want to look at DOL AO 2001-02A for some related guidance on the DOL's opinion of "plan assets. In pertinent part, footnote 2, "....where the policy is paid for out of trust assets, it is the view of the department that all of the proceeds received by the policyholder in connection with a demutualization would constitute plan assets". Seems the same opinion would apply here regarding a "settlement". Also, see DOL AO 2003-05A. While it seems to imply there is no ERISA plan asset issue, "ordinary notions of property rights" would lead to the conclusion that these funds resulted from property that came from plan assets, i.e., from premiums paid by the plan at the time of purchase. Nothing in the interim would seem to allow it to go to the employer and if it did it would appear to result from a reversion. Furthermore, see DOL AO 2005-08A, "If an employer takes steps that cause the plan to gain a beneficial interest in particular assets, under ordinary notions of property rights (e.g., causing the plan to be the named policyholder or using trust assets to pay the entire premium) such assets would become plan assets. See, Advisory Opinion 99-08A (May 20, 1999), Advisory Opinion 94-31A (September 9, 1994), and Advisory Opinion 2001-02A (February 15, 2001)".

The IRS also considered the treatment of funds after a termination from a demutualization and took the position that the funds were plan assets for tax purposes. Admittedly these were PLRs, see 200214031 and 200317049.

Also, look at DOL FAB 2006-1, which discusses fiduciary issues regarding recent similar mutual fund settlements. The DOL again took a "plan asset"position and pointed out that various ERISA fiduciary issues arise with regard to the receipt and handling of plan assets.

Thus, the available guidance, for similar or analogous situations appears to favor the reversion position. Note, that if so, this also raises fiduciary issues.

[jpod]

Did the plan say that excess assets would revert to the employer? If not, it's not at all clear what you do at this point other than give the money to the participants who were in the plan at the time of termination, in which case the 44k would not be taxable to the employer.

If the plan allowed for the reversion of excess assets, then it's a reversion, and without question the 44k is ordinary income to the employer. However, I must admit that there is something fundamentally unfair here about the 50% excise tax, because the employer made a final contribution to enable the plan to be terminated in a standard termination.

[Guest mjb]

1. Under Supt ct decisions participants are not entitled to any distribution of surplus from a q plan which exceeds the value of their accrued benefits.

2. How are you going to distribute the 44k to participants other than by reestablishing the terminated plan which would require that the employer revoke the termination and then terminate the plan again after making the distributions which will cost more than 44k. Creating a sucessor plan will not work because it would not have any permanence.

[WDIK]

. . .which will cost more than 44k.

I wish I could get away with charging mjb's fees!

[jpod]

mjb: What S. Ct. decisions say that surplus assets in a Title IV plan that has not had the requisite reversion language for at least 5 years need not (or cannot) go to the participants?

Anyway, I was thinking about the Title I implications and the expansive definition of "plan assets" that the DOL is likely to try to enforce. I would advise my client that it may be a fiduciary breach and/or a pt to put the 44k in its pocket if the plan did not allow for reversions. Assuming the client did not wish to take a risk, I think the 44k would be divided up among the participants in accordance with the present values of their accrued benefits, minus the cost of paying an actuary to figure this all out, without going through the step of reestablihing the plan.

As to the 401 implications of this whole deal, frankly, who gives a darn at this point? Certainly not IRS.

[Guest mjb]

What is the fiduciary breach if the participiants were made whole under the plan as of the date of termination and have no right to any additional amounts under the plan formula as of the date of termination? Under the Hughes case participants have no right under ERISA to any surplus amounts above their accrued benefits. There is no requirement that the employer accept the reversion. A charitable contribution can be made to United way or some other organization.

Wdik: I wish I could charge that much but I was thinking of the actuary's fees for reestablishing the plan under the IRC/PBGC and then terminating the plan again.

[Kirk Maldonado]

mjb:

I think that a more appropriate case would be Ruocco v. Bateman, Eichler, Hill, Richards, Inc., 12 EBC 1563 (9th Cir. 1990). My notes on that case (made many years ago) indicate that the court held that the employer acted improperly in retaining all of the demutualization proceeds even though most of the contributions to the plan had been made by participants.

Merlin:

I think that one way to avoid this entire issue would be for the fiduciaries to obtain a legal opinion on this issue, assuming that the legal fees would equal (or exceed) the amount in question. However, for some reason that I can't fully comprehend, most employers would rather give the money to their employees than to spend it on legal fees.

[Guest mjb]

ERISA is a law of equity and participants are only entitled to accrued benefits under the plan. When a plan terminates and pays all of the benefits accrued under the plan as of termination the participants have no right to any surplus or other benefits. In the Hughes case the sup ct rejected a claim by a group of employees that that they were entitled to a portion of the surplus in a contributory DB plan that was merged with non contributory DB plan in proportion to their contributions in addition to the benefits accrued under the plan. The sup ct decided the Hughes case long after the case you cite. I dont see anything in the facts that indicates this is a contributory plan.

Not all employers can spend the money on their employees as you suggest. I once had a client that received a demut payment on a DB group annuity that had been terminated 20 yrs previously. The client had no records of who were participants in the plan (and had no records that the plan existed). Many employers cannot do the right thing because the employees have been spun off or otherwise sliced and diced or lack records for long ago terminated plans. PS most of the fees in these cases are generated by the accountants and actuaries.

[GBurns]

While there might not be ".. anything in the facts that indicates this is a contributory plan." by that same token, there is nothing that indicates that it is not, is there?. So there is no reason why taking any side is better or more correct than any other side. But is that even relevant?

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merlin

Will you clear up some issues?

It seems that the Plan itself is not the issue, so it should not matter whether there is anything that says that it was a contributary plan or not. The issue is the distributions, is it not?

These distributions were done through the purchase of this annuity. I read this to mean that only the distributions are related to this annuity. Is that correct?

Is this a group annuity contract or not?

Who is the annuity contract issued to and what did the participants get, cash or coverage certificate? In other words, what is the nature of the distributions?

Who is entitled to the settlement according to the settlement agreement? The contract owner or the covered insureds?

It might be held that the certificate holders were the parties affected by the payment of undisclosed commissions since payment of commissions would have reduced their distributions. As such, any refund might really belong to those certificate holders.

[Guest merlin]

Thank you all for the replies. With respect to some of your other questions:

1. The plan is non-contributory.

2. The plan requires that excess assets be reallocated to the plan participants.

3. The annuity carrier was selected through the services of an annuity search firm. I'm trying to get the details of the contract.

4. I haven't seen the settlement agreement from the AG's office.

5. I advised the client to retain counsel, which they have now done.

[GBurns]

I hope that you will let us know the final outcome. Aside from my curiousity, The issue might come up again for someone else.

[Guest MeToo]

But aren't the facts of this case a bit different. Isn't the AG saying that if the commissions were disclosed, the amounts charged would have been arguably reduced as excessive and therefore the amounts initially paid for the contract were inflated? The refund in that case should be a refund of monies paid before they were plan assets, inure to the company, and not be subject to a reversion of any sort.

I know that fairness has little to do with it, though, but that is how it SHOULD work, IMO.