Distributions From Worthless Account - How To Document

[namealreadyinuse]

Assuming the horrible situation where a participant has invested her assets in investments that become totally worthless, how do you document the distribution when they terminate employment?

The plan does not provide for in-kind distributions, but we are conisdering it if that is the answer.

We need to document that the account is closed out somehow, but don't think a $0 value distribution notice and distribuiton request form works at all. We know that there could (will?) be litigation and am only focused on procedural prudence at this point.

We know that there is no rollover right for distributions below $200, so is that our "out" for not documenting a distribution?

[jpod]

Interesting question, although not one that tends to come up every day.

Obviously, this plan permits investments in anything legal, such as individiual securities and heaven knows what else. I would serioudly consider amending the plan to provide that all assets which cannot be readily converted to cash shall be distributed in kind.

[Peter Gulia]

As always, the choice of solutions often turns on how much of the plan's assets the plan fiduciares find it prudent to spend, or how much of their own assets they're willing to spend. But some steps don't require significant expense.

Without seeing the plan or the full set of facts, a few questions to lead your analysis:

(These assume that the plan provided, and still provides, participant-directed investment.)

Is the property temporarily worthless (later, someone might buy it), or is it permanently worthless (for example, because it was destroyed)?

Did the participant request the distribution? Or is it that the participant severed from employment, the plan's involuntary-distribution provision applies, and the plan administrator has decided that the participant's accrued benefit is less than the plan's cash-out limit?

If a distribution will become payable, does the plan give the distributee a choice between delivery of some (or all) of the property allocated to her account (or her account's proportionate share of property held generally under the plan trust) -or- an instruction to the plan trustee to sell property, getting payment of an amount that reflects the proceeds of the property sold? When a plan trust invests only in shares of SEC-registered open-end funds, it's customary not to provide this choice, because (unless the fund is closed to new purchases) all shares are fungible and the distribution, whether taken or rolled over, can't have different tax or other economic consequences based on a difference between money and property. But with many other kinds of property, it's sometimes smart to provide the choice.

Don't be too quick to assume that the plan doesn't allow a distribution of property. The plan administrator might thoroughly read the document and find that the plan administrator or the plan trustee has some discretion that's useful. Moreover, amending the plan (if that's necessary or would be clearer) shouldn't be an anti-cutback problem if the amendment expands (rather than limits) the manner of distribution. (Depending on the kind of property, one might worry about whether it's wise to extend the choice to other participants.)

If the plan's usual claim form doesn't describe a choice between a distribution in money or property, a plan administrator might revise the form (even if only for the one participant) to be super-clear about all of the consequences of the property-or-money choice. Or if it's really impossible to sell the property, the form should say so, explain why, and explain the distribution of property.

If the distribution is a delivery of property and it's not feasible to deliver the ordinary document of title for that kind of property, the plan fiduciaries should prudently consider doing something to make sure that they complete the best possible delivery of the property. For example, the plan trustee might sign and deliver a deed that coveys the trustee's rights to the distributee (to the extent of the individual account's portion of the plan trust's property). In one situation I handled, the plan trust's property had been destroyed, and I drafted the trustee's deed to covey property to each distributee, including rights to claim remedies against any persons that one might allege had destroyed the property.

If the distribution is a delivery of property, the plan administrator or other "payor" must make an honest effort to estimate the fair market value of the property. If the distributions to a distributee for a year total a value less than $10, a Form 1099-R is not required. See IRC 6047(d). But it is not prohibited. As you suggest, filing a tax-information return or report might be a way to leave behind more records showing that a transaction happened. The Form 1099-R Instructions expressly states: "If you are distributing worthless property only, you are not required to file Form 1099-R. However, you may file[,] and enter 0 (zero) in boxes 1 and 2a[.]"

If the distribution is a delivery of property rather than money, a plan administrator might be reluctant to omit the usual 402(f) notice about rollover opportunities. Why? A distributee might assert that the true value of the property was more than $200 and that the absence of the notice harmed her. How? "If the plan administrator had done its duty and informed me that the distribution was rollover-eligible, I could have found an IRA or other eligible retirement plan trustee that would have accepted the property, and I could have kept it accumulating under a tax-deferred plan." The regulations recognize that although a plan administrator might, in good faith, tax-report a distribution on estimated values, an eligible distributee retains her right to a rollover based on the actual values. See by analogy 26 C.F.R. 1.402©-2/Q&A-15.

If the plan fiduciaries fear litigation (and worry about a less-than-secure defense against participant-directed investment), communicating fully now might be a way to shift some remaining responsibility to the former participant, and so weaken or in time bar her claims.

I've been to this movie before, so please call me if I can help you.

Peter Gulia

Fiduciary Guidance Counsel

215-732-1552