Overfunded pension plans can present many challenging issues. The most important is the 50% penalty and reversion of excess assets. This imposes penalties and interest or around 90%!
One solution is using a Qualified Replacement Plan (“QRP”). But there is some complexity involved in how to administer the QRP accounting to IRS guidelines.
In this post, we will examine some recent IRS guidance surrounding QRPs and take a look at a few options. Let’s jump in.
IRS Private Letter Ruling
The IRS has issued a ruling, known as PLR 202230006, which provides clarity on how to handle the transfer of excess assets from a defined benefit plan that is terminating to three defined contribution plans under Section 4980, also known as the “receiving plans.”
Section 4980(a) imposes a 20% excise tax on any specific reversion from a qualified retirement plan. An employer reversion is the amount of cash and fair value of any other property received by an employer from a qualified retirement plan. The excise tax would be increased to 50% of the amount unless the company establishes (or even maintains) a qualified replacement plan (QRP) or the terminating pension provides for specific benefit increases.
A QRP must meet certain conditions, including:
- Keeping at least 95% of the active participants in the terminating plan who still remain as employees of the company after the plan termination as active participants in the QRP; and
- Transferring 25% or more of the total excess asset amount from the terminating plan to the QRP
If the excess assets are transferred to a QRP, including assets over the 25% minimum amount, the excess assets:
- Are not deductible by the company;
- Are not included in the taxable business income of the company; and
- Are not treated as “reversion” subject to either the 20% or 50% excise tax penalty under Code Section 4980.
The 20% Penalty
However, if the employer receives any excess assets not transferred to the QRP, they will be subject to the 20% excise tax and included in the employer’s taxable income.
The IRS ruling clarifies that the three receiving plans collectively meet the conditions to be treated as a QRP, even though they do not meet the conditions separately. In this example, each receiving retirement plan had less than 95% of the company’s active participants in the terminating plan. But collectively, they had over 95% of the active participants in the terminating plan. In addition, the total amount transferred to all the three receiving plans exceeded 25% of the total amount of the terminating plan’s excess assets.
The IRS has provided clear and comprehensive guidance on how to allocate the excess assets among the three receiving retirement plans. The IRS’s guidance underscores that the excess asset amount is allocated to the receiving plans based on the projected (or anticipated) future obligations for nonelective employer contributions under each of the three plans, providing a clear roadmap for the administrators.
If the QRPs are defined contribution plans, any excess assets transferred are required to be either fully allocated to the employee participants in the year of transfer or must be credited to a suspense account and then allocated from the account to the participant accounts in the QRPs.
This allocation should occur no less rapidly than ratably over the seven years beginning with the transfer year. The IRS also ruled that allocating any excess plan assets to each receiving retirement plan was reasonable and consistent with the IRS’ treatment of the receiving retirement plans as one single QRP.
IRS Guidance
IRS Section 4980(a) provides for a 20% excise tax on any amount of qualified plan reversion. Section 4980(d)(1) states that the excise tax under § 4980(a) would be increased to 50% unless the company maintains or establishes a qualified replacement plan (QRP) or the plan allows for pro rata benefit increases described in § 4980(d)(3).
Section 4980(c)(2) defines “employer reversion” as the amount of cash and any fair value of property received by a company from the qualified plan. Under IRS § 4980(d)(2), a plan is deemed a QRP if it is maintained by the employer or established in connection with a qualified plan termination (replacement plan) and specific other requirements are met.
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Under IRS § 4980(d)(2)(A), to qualify as a qualified replacement plan, at least 95 percent of any active participants in the terminated plan who still remain as employees of the company after the termination remain as active participants in the replacement retirement plan. IRS Section 4980(d)(2)(C) contains rules for allocations of the amount transferred.
Under IRS § 4980(d)(2)(B) states that a qualified replacement plan must receive a direct transfer from the terminated plan prior to any employer reversion. In addition, the transfer is required to be an amount equal to the excess (if any) of:
- 25% of the maximum amount the company could receive as an employer reversion (determined without regard to § 4980(d) over
- the present value of any aggregate increases in the accrued benefits under the terminated plan of any participants (or even beneficiaries) under a plan amendment that must be adopted within 60 days prior to the plan termination and that takes effect immediately upon termination of the plan.
Section 4980(d)(2)(B)(iii) states that in the case of any specific amount that is transferred under § 4980(d)(2)(B)(i) from a terminated plan to a QRP, such amount:
- will not be included in the income of the company,
- no deduction shall be allowable concerning such transfer, and
- such funds transfer will not be treated as reversion under § 4980.
Final Thoughts
In an ideal world, closing out an overfunded defined benefit plan would allow the excess assets to flow back to the company cleanly. In practice, without the proper structure, that excess is slapped with a 50% excise tax (plus income tax), often wiping out much of the benefit. That’s why the concept of a Qualified Replacement Plan (QRP) has become so powerful — when the rules are met, you can reduce that excise tax burden down to 20% instead of 50%.
Of course, the QRP route isn’t automatic or simple. It demands strict compliance: the plan must move surplus assets into a QRP (or horizontal set of plans that collectively qualify), meet participation thresholds (e.g. 95% of active participants), and allocate the transferred funds correctly (often via immediate allocation or over a suspense schedule of up to seven years). If even one condition falters, the full 50 % penalty may reapply — or worse, the IRS might disqualify the strategy altogether.
