We know that overfunded defined benefit plans present many problems. The most of which is the 50% excise tax. But did you know that you can lower that penalty to 20% if assets are transferred to a Qualified Replacement Plan (QRP)?
In this guide, we discuss what qualifies as a QRP and review the pros and cons of using an overfunded defined benefit plan to fund a QRP. In the right situation, this can be the best option. Let’s dive in!
Table of contents
Overfunded defined benefit plan
Overfunded defined benefit plans have become a big problem in recent years. We know because companies often come to us for assistance with overfunding issues.
What is the problem? When an overfunded plan is terminated, it is subject to something called reversion.
Reversion is basically an IRS rule that states that the overfunded portion is subject to an excise penalty of 50% and also income tax at the federal and state level. The combined amount can often be as high as 90%!
But reversion can often be avoided or at least mitigated. There are many ways to deal with an overfunded defined benefit plan. Some of them include the following:
- Keep the plan open for an extended time
- Increase compensation for current employees
- Pay plan expenses from assets
- Increase existing retirement benefits
- Hire additional employees
- Consider life insurance
- Plan merger or strategic sale
All the above options are available. But some work better than others, depending on the overfunded amount.
But there is another option. The company can roll the plan into a qualified replacement plan (QRP). This may not completely avoid the 50% penalty, but it can lower it in some situations to 20%.
What is a Qualified Replacement Plan (QRP)?
A plan is deemed a “qualified replacement plan” if it is set up or maintained by the company in association with a qualified plan termination (replacement plan) and specific rules are met.
Suppose an employer establishes or maintains a qualified plan in connection with a defined benefit plan termination. In that case, the excise tax is reduced to 20% (rather than 50%) of the amount of employer reversion, provided the plan satisfies the following requirements to be a QRP.
What are the QRP Requirements?
In order to meet the QRP requirements, the new plan must be set up in connection with the terminated plan and must satisfy certain requirements. These requirements are:
- asset transfer, and
For determining if there is a QRP, two or more plans can be treated as one plan. Also, a plan of a successor employer may be taken into account.
A minimum of 95% of the active participants in the terminated plan who remain as employees of the company after the plan termination date must be active participants in the QRP.
For purposes of this participation requirement, there are a few important items to consider:
- Employer means all employers that are treated as a single employer.
- An existing plan can be a QRP. That plan can have participants other than those who participated in the terminating plan. However, a minimum of 95% of the active participants in the terminated plan who remain as employees after plan termination are active participants in that plan.
Asset Transfer Requirement
Before any reversion, a direct transfer must be made from the terminated plan to the QRP in an amount that is at least 25% of the maximum amount the employer could receive as a reversion. This can be reduced by increased benefits in the terminating plan (more about this shortly).
The amount transferred to the QRP is not:
- Included in the gross income of the employer;
- Allowed as a deduction by the employer; or
- Treated as a reversion to the employer.
If the employer amends the terminating plan to increase the accrued benefit of the participants, which is adopted during the 60 days ending on the plan termination date and taking effect immediately upon the plan termination date, the minimum transfer to the QRP of 25% of the maximum amount the employer could receive as a reversion (referenced above) is reduced by an amount equal to the present value of the aggregate increases in the accrued benefits so provided to participants or beneficiaries under the terminating plan.
Any such increase in benefits is treated as an annual benefit. Still, the reduction for participation or service of fewer than ten years shall not apply to such increase to the extent that its nonapplication does not discriminate to the benefit of highly compensated employees.
In most situations, the qualified retirement plan is a defined contribution plan. In that case, the amount transferred to the QRP must be allocated to the participant accounts in the year the transfer occurs.
Alternatively, the employee allocation can be credited to a suspense account and then distributed to participant accounts no less rapidly than ratably over the seven plan-year periods beginning with the year of the transfer.
The IRS Code does not specify a method for allocating amounts from the suspense account to individual participant accounts. Still, the plan should determine how the transferred amounts will be used such that the allocation provisions of the plan satisfy the definitely determinable requirements for profit-sharing plans.
The amounts could be allocated to individual participant accounts using:
- an age or service weighted formula;
- pro-rata based on participant compensation; or
- any other determinable method provided such method otherwise satisfies plan qualification requirements.
An amount may not be allocated to a participant if such allocation would fail to fulfill any provision of the IRS Code.
Restrictions designed to prevent discrimination in contributions in favor of highly compensated employees that are applied to participants of a QRP who are highly compensated employees would not cause such participants to cease being active participants in the QRP for purposes of the 95% participation requirement (described above).
Because the transferred amounts must be allocated to participant accounts, it would seem the amounts transferred could not be used to pay the expenses of the QRP.
In that case, such an amount shall be allocated to the accounts of other participants. Suppose any portion of such amount cannot be allocated to other participants due to any limitation under Code Section 415. In that case, such a portion shall be allocated to the participant.
7 Year Rule
Any income credited to a suspense account must be allocated (after the coordination with Code Section 415 limits described in the prior sentence) to accounts of participants no less rapidly than ratably over the remainder of the period set for allocating the suspense account (the original period set being no longer than the 7-plan-year period beginning with the year of the transfer).
Suppose any portion of such amount cannot be allocated to other participants because of any limitation under Code Section 415. In that case, such portion shall be treated as an employer reversion to which the excise tax may apply.
Subsequent private letter rulings have cited this regulation to the effect that an allocation of excess assets from a defined benefit plan termination to a defined contribution QRP generally cannot be allocated as matching contributions.
The pro-rata benefit increases provided under a terminating defined benefit plan needed for the 20 percent excise tax rate to apply to a reversion, rather than the 50 percent tax rate, must satisfy several requirements with respect to qualified participants.
Plan technical rules
|Who is a qualified participant?||A qualified participant is an individual who is:|
(a) An active participant;
(b) A participant or beneficiary in pay status as of the plan termination date;
(c) A participant not described in (a) or (b) who has a right to a benefit under the retirement plan as of the termination date and whose employment service terminated during the period beginning three years before the plan termination date and ending when the final distribution of assets occurs; or
(d) A beneficiary who has a right to an accrued benefit under the terminated plan as of the termination and is a beneficiary of a participant described in (c).
|Pro-rate Increase rules||The pro-rata increase must be an increase in the present value of the accrued benefit of each qualified participant in an amount that is in the same ratio to the aggregate present value determined under the prior sentence as the ratio of the present value of such participant’s accrued benefit (determined without considering an amendment to provide the pro-rata increases or the transfer of assets to the QRP) is to the aggregate present value of accrued benefits of the terminated plan.|
|Plan amendment||An amendment to the terminating plan to provide pro-rata benefit increases must be adopted in connection with the plan termination and take effect immediately on the plan termination date.|
The amendment must provide pro-rata increases in the accrued benefits of all qualified participants with an aggregate present value of more than 20% of the maximum amount the employer could receive as an employer reversion without regard to such amendment or a transfer of excess assets to a qualified retirement plan.
The parent company of a subsidiary sponsor of both a terminated defined benefit plan and the QRP to which the transferred excess assets of the terminated plan could retain the QRP upon the sale of the subsidiary sponsor provided the plan continued to meet the requirements of a qualified replacement plan.
Considering the prior paragraph, the increases in the present value of the accrued benefits of qualified individuals who are not active participants must not exceed 40% of the aggregate present value equivalent to 20% of the maximum amount the employer could receive as a reversion.
Any increase in benefits described in this paragraph is treated as an annual benefit for purposes of Code Section 415. Still, the reduction for participation or service of fewer than ten years will not apply to such an increase to the extent that its nonapplication does not discriminate in favor of highly compensated employees. A benefit may not be increased if such an increase would fail to satisfy any requirements.
As you can see, a qualified replacement plan is a viable option for companies with overfunded pensions.
How to set up a Qualified Replacement Plan
Now let’s discuss how you would set up and maintain a QRP.
The following are 5 steps to establishing a qualified replacement plan:
- Finalize the overfunding amount
Make sure the plan actuary has determined the final overfunded balance that would ordinarily be subject to reversion.
- Draft plan amendment
When terminating the defined benefit plan, make sure to process an amendment to allow the allocation to the participant account according to IRS rules. The amendment is completed to provide the pro-rata benefit increases must take effect immediately upon the date the plan is terminated.
- Allocate to participant accounts
Suppose the qualified retirement plan is terminated and any amount credited to a suspense account is not allocated as of the termination date of the QRP. In that case, such amount shall be allocated to participants’ accounts as of the QRP termination date, except that any amount that cannot be allocated because of any limitation shall be allocated to the other participant accounts.
- File final Schedule SB and Form 5500
Once completed, the actuary and plan administrator should file the Schedule SB and final form 5500 to close out the defined benefit plan.
- Remit 20% excise tax penalty
The 20% excise tax penalty should then be remitted to the IRS. This should be coordinated with the administrator and your CPA.
|Significant tax deductions||Complex structure requirements|
|Range for min/max contributions||Permanent plan design|
|Asset protection||Mandatory funding|
|Investment gains tax-deferred||High cost structure|