Pretermination Restrictions

[nancy]

What are the consequences of making a lump sum payment to an owner when the current liability is not 110% funded? We took over a plan that we are now terminating and have discovered that this occurred in 2002.

[Effen]

I have been wrestling with this problem for a while and have spoken to the IRS numerous times and really haven't come up with any solutions.

If the plan is now terminating and assets are sufficient to cover all liabilities, the IRS may view it as a "no harm, no foul issue". That said, it is a potentially disqualifying event if they get caught.

Or if the person who was paid has died, it’s probably a "no harm no foul" issue as well.

We looked into VCP filings, but the only solution the IRS will accept is a return of the money, or set up escrow account to cover any potential shortfall if the plan terminates. Therefore, if the plan is now terminating and assets are sufficient, your client may choose not to say anything and just hope it doesn't come up, however if the assets are short, your client could be in deep do do.

I highly recommend you contact an attorney who should look into some form of law suit against the prior service provider who permitted the distribution in order to protect the plan from future potential IRS penalties.

[rcline46]

As a service provider, I would disagree with Effen on it being my problem. It is the Plan Administrator's problem and a Trustee problem to make such distributions.

Now I would agree the service provider should have said something, but they cannot prevent such a distribution from taking place.

And yes if you are short funded, get an ERISA attorney involved now.

[Effen]

rcline - If the PA did the bc themselves, then you are right, this is strictly the PA's problem, but I was assuming the service provider was an actuary who calculated the lump sum, who knew the funded status of the plan (or should have known), who sent the forms to the PA, who paid the benefit.

I don't think this is something PA's should be expected to know. The actuary is really the only person in a position to know if and when this applies, therefore I would lay it strictly at their (my) feet.

Now, if the actuary isn't involved in the bc, then they may be exempt, but the liability would then be passed to the person who actually did the calcs. If you are doing the calcs, you have an obligation to your client to keep them out of trouble.

If you tell the client they don't need to make a contribution and they end up with a deficiency because if it, is that their problem too? They might pay the fine on paper, but the cash will come out of the actuaries pocket.

[rcline46]

Now I love argueing without letting facts get in the way. Nancy needs to get the correspondence and bene option forms used for the distribution and maybe question the prior service provider on the distribution. We may find they did not disclose the issue, or maybe they did. The approach to the problem would be different as to the service provider (the client still needs to post bond/escrow if they are short!).

An actuary can get their ticket lifted for messing up a Schedule B cost calculation.

Maybe you can get the service provider on malpractice if they did not disclose the benefit limitation. Maybe not. Maybe they were asked for an illustration and the owner paid himself on an illustration. So there is much to learn, then we can bash to prior service provider, IF we are sure they failed the 110% test in 2002!

[SoCalActuary]

Do any of you deal with plan sponsors who don't wait when they want to distribute their own account?

Unfortunately, I do. The TPA and the actuary often have not even advised the max distribution and discover it only after the next plan anniversary.

In other words, let's play the blame game only when we know the facts.

[nancy]

We do know that they were not advised about making the distribution. I've seen the forms and the correspondence. The plan is terminating and the plan is short on assets. However, the plan sponsor has agreed to contribute the shortfall to make the plan whole. Ironically, he would have gotten a much larger distribution had he waited until plan termination due to a decrease in GATT interest rates. THis is also a PBGC covered plan. I'm trying to decide whether or not to file with the IRS at this point.

[Guest Texas_Acty]

A client of mine had this problem: Lump sums had been distributed to high-25 HCEs under a former service provider, and the three recipients could not repay.

When we took over the case, the client had just concluded an agreement with the IRS to pay the otherwise restricted lump sums into the plan. The client did so, the payment was treated as a regular contribution, and deductible (though the deductible limit was already high enough to accomodate the extra payment).

[Effen]

Texas - if the client put the otherwise restricted amount back into the plan, do they still owe the HCEs a distribution? Was the original distrubtion disqualified as if the plan never paid it? I have heard this solution suggested before, but I never really understand how it would work in practice.

I guess if the "payback" was deductible and it resulted in the plan being > 110% funded it would be treated like they complied with the rule, but if the fund is still < 110% funded and they "paid back" the restricted amounts, what have they accomplished? Aren't they still in violation of the rule? If they are acting like the distribution was never paid, don't they still owe it? How can simply making a contribution equal to the restricted amount make the issue go away?

[Guest Texas_Acty]

Texas - if the client put the otherwise restricted amount back into the plan, do they still owe the HCEs a distribution? Was the original distrubtion disqualified as if the plan never paid it? I have heard this solution suggested before, but I never really understand how it would work in practice.

The payment back to the plan was the restricted amount that the plan had mistakenly paid out. The deal was for the sponsor to pay those restricted amounts back to the plan, to put the plan back to where it would have been had the distributions not been made. The HCEs are not owed a distribution, they were paid their distributions the payment of which is what created the problem in the first place.

I guess if the "payback" was deductible and it resulted in the plan being > 110% funded it would be treated like they complied with the rule, but if the fund is still < 110% funded and they "paid back" the restricted amounts, what have they accomplished? Aren't they still in violation of the rule? If they are acting like the distribution was never paid, don't they still owe it? How can simply making a contribution equal to the restricted amount make the issue go away?

The sponsor approached the IRS about having made this error. The parties worked out the deal I described, namely, to pay the otherwise restricted amounts back. That action made the problem go away because the IRS had agreed that it would. Now, had the problem been discovered by the IRS first, I imagine the consequences would have been more severe...

[Effen]

So, based on that fact pattern, all the ER had to do was make a contribution equal to the restricted amounts and the problem goes away? (and submit a VCP filing) Seems a little strange, the HCE's end up with their money and the other participants are still at risk because the plan is still underfunded. Not a bad deal for the HCEs. I thought that is what this rule was supposed to stop.

Thanks for the info.

[SoCalActuary]

I would not cite that particular case as a global solution. I think the IRS made a special deal once.

If we jump on it as the "solution" to the 110% funding rules, we are taking risks that the IRS will agree next time. And I worry that they will not.

[Guest Steve C]

Sorry for jumping into this one late, but I've just been handed a case where the pretermination restriction was violated. HCE took a lump sum and rolled it to an IRA. HCE was age 54 at the time.

IRS reviewer says that HCE must return the distribution (Texas clients must just have better luck).

As it stands now, the lump sum should not have been paid so rollover is taxable. Also, seems to me that the participant is subject to 10% early withdrawal penalty since under 55.

We need to encourage the participant to return the distribution, but IRS hasn't yet answered questions about the individual tax impact. Will returning the distribution erase income tax liability for the HCE? Will it also erase the early withdrawal penalty?

Inquiring minds want to know.

[Guest mjb]

How is the plan going to induce the employee to return the money since it will be deemed a taxable distribution. The employee has nothing to lose by keeping the money since it will be taxed. (What year will the distribution be taxed in?) The only way this could work is if the employee could be allowed to roll the money back to the plan tax free but why would he give up the funds if he will ultimately get a lower amount?

What basis would the plan have for suing the participant if the amount paid was the amount of the accrued benefit due the participant? ERISA is a law of equity and the plan could only have a claim for an overpayment of a benefit that the participant had not earned. I dont see anything in Title I that would provide for recovery of a payment that violates the IRS reg regarding the high 25 if the amount paid was an accrued benefit earned by the participant under the plan. The plan could be liable for the taxes owed by the employee because of the negligent payment.

[Guest Steve C]

Thanks, mjb, for the quick response. You've hit on what prompted my question - will the participant's situation be improved by returning the distribution? If so, I want to be able to accurately communicate the situation and ramifications so that the participant can make an informed decision (in the process I'll recommend that he speak to his own tax counsel).

You're right - the participant has no inducement, IF his tax position is unaffected by his action. However, a tax-free reversal of the distribution might provide some incentive. He won't be happy, but on balance he may be better off returning the distribution IF that means he can escape taxation.

There are still more issues to consider.

If the funds are returned, the hope is to make a new lump sum distribution as soon as possible. To do so will require an escrow account per 92-76. Can another party (plan sponsor? service provider?) establish the escrow account, with funds released to that party as they become non-restricted?

Once an escrow account is established, what's the proper amount for the new lump sum? Seems like it should be the new 417(e) value. Given that the 417(e) interest rate is lower (for now), that should mean that the new lump sum will exceed the amount returned.

More questions will arise, but my energy is starting to drain. Looking forward to more feedback.

[jpod]

I'm afraid I don't have a firm opinion on the participant's tax issue. However, concerning the Plan's right, and the Plan fiduciaries' legal duty under ERISA, to try to get the money back, doesn't the plan document contain the IRS-required pre-termination restrictions? If so, the participant was not entitled to the distribution under the terms of the Plan. It is on that basis that the participant can be sued by the Plan for recovery.