Defined Benefit Plan Termination with Funding Deficiency
We all know (or should know) that defined benefit plans that are qualified (or were ever qualified) are subject to the minimum funding standards of the Internal Revenue Code (IRC). Also, title I of the Employee Retirement Income Security Act of 1974 (ERISA), as amended, contains minimum funding standards. In this article, we will be concerned only with the impact of the IRC. The reason is that failure to meet § 412 brings about the application of excise taxes under IRC § 4971, while failure to meet ERISA would require an action by a participant or the Department of Labor (DOL) to compel compliance. For the scenarios discussed below, a lawsuit by participants, or action by the DOL, is highly unlikely.
Under Rev. Rul. 79-237, the minimum funding standards apply through and including the plan year of plan termination, but not for later years. The regulations under IRC § 430 now define a plan termination. Section 1.430(a)-1(d)(5)(i) defines the termination date for a plan subject to title IV of ERISA (PBGC covered plan) as the termination date under § 4048 of ERISA. Section 1.430(a)-1(d)(5)(ii) defines the termination date for a plan that is not a PBGC covered plan as the date set by the plan administrator provided certain requirements are met. The issue of concern is what happens (and how to resolve it) if there is an unpaid minimum contribution in the plan year of plan termination.
Benefit Waivers as a Solution?
For a small plan covering an owner (who is a majority owner) and one or more employees, there are three possible situations:
1. Plan is covered by the PBGC and ERISA.
2. Plan is not covered by the PBGC but is subject to title I of ERISA.
3. Plan is not covered by the PBGC and is not subject to title I of ERISA.
Under title IV of ERISA, PBGC requires that a plan terminating in a standard termination must generally provide all participants their accrued benefit. A PBGC-covered plan terminating in a distress termination that cannot provide all benefits will be trusteed by the PBGC. For this article, we assume that the plan sponsor wants a standard termination. PBGC will allow a majority owner to forego (some would use the word “waive”) receiving his or her benefit (with spousal consent) so as to allow the rest of the benefits to be paid in standard termination.
Because PBGC will allow the majority owner (the owner) to forego receiving a benefit to facilitate a standard termination, some practitioners have suggested that one way to cure the underfunding issue is to have the owner waive the benefit. The waiver of benefit would be taken into account and reduce the liabilities thereby eliminating (or reducing) the underfunding.
A waiver of benefits will not be accepted by the IRS for funding purposes. In Private Letter Ruling (PLR) 9146005 (which is a technical advice memorandum to the field office), the IRS stated that an accumulated funding deficiency (the years involved were in the mid-1980s) could not be corrected by waiving the benefit. The PLR stated that waiving a benefit upon plan termination “directly violates sections 411(d)(6), 411(a), and 401(a)(13) of the Code.” The next three paragraphs state why the IRS believed the waiver violated each of those sections.
In essence, the PLR says you cannot make a waiver of your own benefit under the IRC. Accordingly, there is no reduction to take into account. (Yes, the PLR could have been written a little better, but the point is made.) The question naturally arises as to whether the PLR position has been tested. The answer is that the waiver of benefit idea has been tested and the IRS won on the anti-alienation issue.
The case was Gallade v. Commissioner, 106 TC 355, May 28, 1996. The defined benefit plan was overfunded. Arthur Gallade was the sole shareholder of Gallade Chemical, Inc. (CGI). Mr. Gallade waived his benefit upon plan termination with a termination date of Sept. 16, 1985. This was just before the change in law to require spousal consent for a lump sum distribution became effective. The waiver had the effect of creating a reversion to the company. Mr. Gallade did not report any distribution as being included in income.
The IRS agent reviewing the plan termination requested technical advice from the IRS National Office, and the determination letter request was withdrawn upon issuance of the technical advice memorandum. An examination ensued and the parties ended up in the Tax Court litigating the validity of the waiver. In short, the court held that the waiver was an impermissible assignment of benefits under ERISA and the IRC. Accordingly, the present value of the benefit was includible in income.
The key point of the PLR and the Gallade case is that a waiver of benefits does not work. Accordingly, attention turns to how to deal with the looming excise tax consequences.
Waiver of the 100% Excise Tax
IRC Section 4971(a) imposes a 10% excise tax on an unpaid minimum contribution (accumulated funding deficiency prior to the Pension Protection Act), and § 4971(b) imposes a 100% excise tax if there is no correction. Section 3002(b) of ERISA provides that the Secretary of the Treasury may waive the imposition of the tax imposed under IRC § 4971(b) in appropriate cases. The law does not define what constitute “appropriate cases.” There is no similar provision with respect to the 10% excise tax. Accordingly, outside of a bankruptcy filing, the IRS will typically ask that any 10% excise tax be paid. The real question is whether the IRS will attempt to collect the 100% excise tax.
In Revenue Procedure (Rev. Proc.) 2000-17, the IRS provided a waiver of the 100% excise tax provided four conditions were met:
1. The plan is subject to title IV of ERISA and is terminated in a standard termination under ERISA § 4041.
2. Plan participants are not entitled to any portion of residual assets remaining after all liabilities of the plan to participants and beneficiaries have been satisfied.
3. Excise taxes that have been or could be imposed under § 4971(a) have been paid for all taxable years, including the taxable year related to the year of plan termination.
4. All applicable forms in the 5500 series, including Schedules B (Actuarial Information), have been filed for the plan for all plan years including the year of plan termination.
Note that by only requiring a standard termination, the IRS is waiving the 100% tax in situations where the majority owner has elected to forego benefits. This waiver makes good policy sense as there is no IRC requirement that a plan be fully funded upon plan termination. Rev. Proc. 2000-17 takes care of the PBGC covered plans that have an unpaid minimum contribution upon plan termination. The second and third scenarios outlined above are more challenging.
ERISA § 403(d) requires that a plan that is not covered by the PBGC allocate assets on plan termination in accordance with § 4044, except as otherwise provided in regulations of the Secretary of Labor. No such regulations have been issued. Thus, a plan that is not covered by the PBGC but is subject to title I of ERISA would seemingly need to allocate assets to a majority owner if that was called for under the § 4044 rules (for example, the benefits of a majority owner are in a higher priority category than the benefits for a non-owner employee). However, IRC § 411(d)(2) and (d)(3), §1.411(d)-2(a)(2)(ii), and Rev. Rul. 80-229 provide for the reallocation of assets to prevent prohibited discrimination in the event of plan termination.
Clearly, the IRS is more concerned with a nondiscriminatory distribution of plan assets than with whether a majority owner receives the maximum possible benefits. If a majority owner elects to forego benefits to the extent needed to provide all other participants their benefits, then the distribution is clearly not discriminatory. While there may be a technical violation of title I, the majority owner is not going to sue himself or herself (and I assume spousal consent is obtained). Therefore, the IRS typically accepts such an allocation. However, the issue of the 100% excise tax remains.
Rev. Proc. 81-44 sets forth the procedure for requesting a waiver of the 100% excise tax. However, the revenue procedure is more than 30 years old and is obviously out of date. A request sent to the address will be returned. The IRS organization has changed and user fees are now applied to almost any ruling request. Furthermore, the letter rulings that once were directed to the Director, Employee Plans are now sent (with some exceptions) to the Associate Chief Counsel (Tax Exempt and Government Entities).
I undertook to determine where a request for a waiver of the 100% tax should be directed. Looking at Rev. Proc. 2018-1, I found § 4971(b) listed in the sections under the Associate Chief Counsel (Tax Exempt and Government Entities). I even found Rev. Proc. 81-44 listed in an appendix that listed revenue procedures that provided additional instructions for certain requests. It appeared therefore that a waiver could be requested from the Associate Chief Counsel’s office for a user fee of a mere $28,200 (I think I read it correctly). This is not cheap, but it may be a savings where the 100% tax is concerned. This was an answer, though — or so I thought, but there was more to find!
Further investigation found a July 2017 internal IRS delegation order on the IRS website. It delegates to the Director, Employee Plans the authority to waive the 100% excise tax. This was a surprise to me and to my contacts in the IRS. So, where does that leave us? The answer, to put it nicely, is that we are left with much uncertainty.
For the plan sponsor of a small plan, the 100% excise tax can loom large as a possibility. The IRS does not have a strong policy interest in making the majority owner put more money into the defined benefit plan upon plan termination just to distribute it to himself and defer taxes (assuming the money was rolled into an IRA). Anecdotally, situations have occurred where the IRS obtained the 10% tax, ascertained that all other participants received their benefits, and then simply dropped the matter.
Of course, anecdotes are not much comfort for the business owner. However, the choices (assuming that there is no desire to declare bankruptcy) are basically to either: (a) spend the money to get the 100% tax waived; or (b) wait until an agent raises the issue, and then either negotiate a settlement of some sort or put the money into the plan at that time.
In part, because of the peculiarities of the statutory structure with respect to the excise taxes under IRC § 4971, waiting is not a bad strategy. It will take another article to describe the statutory structure, which is quite complicated until you understand it. In the meantime, I regard the situation as an unfolding story. Perhaps the best long-term solution is an update to Rev. Proc. 2000-17 that gives recognition to situations 2 and 3. Stay tuned!
 IRC § 412(a) provides that the minimum funding standards apply to a plan if, for any plan year beginning on or after the effective date of § 412, such plan (1) included a trust which qualified (or was determined by the Secretary to have qualified) under § 401(a), or (2) satisfied (or was determined by the Secretary to have satisfied) the requirements of § 403(a).
 The DOL would have to be asked by the Secretary of the Treasury or participants to take such action. See ERISA § 502(b)(1). Note that just because participants request an action the DOL will not necessarily take action. The DOL will act only if the violation affects benefits, or is needed to protect benefits.
 See the two-part series of ACOPA Monthly articles published in November 2015 (Part 1) and December 2015 (Part 2) for more details.
 The substance of the technical advice memorandum is not stated, but we can presume it was not favorable to the taxpayer.
 Which is now Schedule SB for a single-employer plan.
 The statutory wording is “to which section 4021 does not apply at the time termination and to which this part applies …”
 I would be interested in knowing of any situations where the IRS objected to such an allocation of plan assets.