By: Carolyn M. Cumbee, Esq.

At a recent cocktail party, Dr. McDreamy discussed his upcoming retirement from his very busy job as the Head of Emergency at Grey Sloan Memorial Hospital. He told Dr. McSteamy that he had a supremely overfunded defined benefit plan from his private practice that is going to terminate at the end of the year, using the extra funds as a down payment on a swanky new property on the beach.  He wants to continue his private practice but get away from the drama of the hospital scene. Dr. McDreamy is just so happy that his financial advisor really came through by getting returns of over 20% in the last two years. (If you are thinking outside the box, you might wonder if there is an affiliated service group problem with Dr. McDreamy’s defined benefit plan.  If so, check out this discussion of ASG rules.)

Dr. Grey overhears the conversation and recalls a conversation she had with her ERISA counsel at Ferenczy Benefits Law Center.  She remembers that an overfunded plan isn’t actually good news.  In fact, it can be problematic if the Plan Sponsor is hoping to avoid excise taxes.  She tells Dr. McDreamy to reach out to the team at Ferenczy to see if they can help deal with the overfunding that may end up costing him a bundle.

Why Can an Overfunded Defined Benefit Plan be Problematic?

Dr. McDreamy calls the team at Ferenczy to understand why this could possibly be bad news. His financial advisor can’t help that he’s just too good at his job! The team explains how a defined benefit plan works, and why dramatic returns in those plans are often more of a curse than a blessing. Creating the additional unexpected earnings doesn’t fall in line with the purpose of a defined benefit plan, which uses assumptions for returns in order to have a target amount of money accumulated for retirement. When you have an overfunded defined benefit plan, the plan must generally deal with the excess assets by either reallocating additional benefits to participants or reverting assets back to the Plan Sponsor.  The reallocation must not be discriminatory in favor of the owners or other highly compensated employees and, probably most importantly, cannot cause the benefit for any participant to exceed the legal limit on benefits found in Internal Revenue Code (the “Code”) Section 415.

A reversion of excess assets comes with a hefty price tag. Under Code Section 4980(d), a Plan Sponsor must pay a 50% excise tax on excess assets that are reverted to the Plan Sponsor at a defined benefit plan’s termination. This excise tax is in addition to income tax – the assets were deductible when contributed, so refunds back to the company are taxable income.

Never fear, however!  Nothing is irreparable, Dr. McDreamy is told.  There is a method to get the excise tax reduced to 20% – or perhaps eliminated entirely – using a Qualified Replacement Plan or QRP.

What is a Qualified Replacement Plan?

To lower the excise tax, the Ferenczy team advises Dr. McDreamy that he can use a QRP, which is a plan also to be sponsored by Dr. McDreamy’s practice to which excess assets can be transferred from a terminating defined benefit plan. There is no excise tax on the transferred assets and the excise tax on any remaining assets that revert to the company is reduced from 50% to 20%. Under Code Section 4980(d)(1), the recipient plan must meet certain requirements to constitute a QRP:

1. The replacement plan must cover at least 95% of the participants of the terminating plan;
2. At least 25% of the excess assets must be transferred to the replacement plan; and
3. The transferred excess assets must be allocated as contributions over a period not longer than seven years in the replacement plan.

Because there is no excise tax on transferred assets, if the entire excess amount is transferred to the QRP, the Code does not impose an excise tax on the excess assets at all.

Some of the Finer Details

Dr. McDreamy initially thinks that this will equate to even further tax deductions. However, Plan Sponsors do not get to take additional tax deductions when the amount is transferred or allocated in the QRP.

Upon transfer, the excess assets are placed in a suspense account in the QRP prior to allocation in that plan. The allocation of these excess assets within the QRP may be used in place of and allocated as employer contributions, such as Safe Harbor Non-Elective Contributions or discretionary non-elective contributions, or even to pay reasonable plan expenses. However, the IRS has stated in private letter rulings that amounts transferred to a QRP cannot be used to fund matching contributions, unless the matching contribution was earned prior to the transfer of the excess assets.  Additionally, the transferred funds cannot be used to fund salary deferrals for any participant.

Dr. McDreamy reasonably assumes that he can just keep making contributions only for himself in the QRP, but all other coverage and nondiscrimination requirements, as well as the Section 415 limits on contributions, must be met for these allocations. Likewise, if any of the transferred assets remain in the QRP after the seven-year period, those assets will revert to the Plan Sponsor, triggering an excise tax of 20% of that reversion.

Application to Dr. McDreamy’s Excess Assets

Dr. McDreamy’s defined benefit plan is currently about $1 million overfunded beyond the plan’s liabilities, and the benefit for the doctor is at its Section 415 maximum. If Dr. McDreamy were to take the full reversion of assets back to his entity, he would owe income taxes on the $1 million and $500,000 in excise taxes under Code Section 4980(d). (And, note, the excise tax is not deductible on the income tax return, so the income tax is calculated on the full reversion.)

To meet the requirements of a QRP, Dr. McDreamy must transfer at least $250,000 to a defined contribution plan. If he does this, a 20% excise tax will be imposed on the remaining reversion of $750,000 – or a tax amount of $150,000 (in addition to income taxes on the $750,000).

Dr. McDreamy decides he wants to avoid all excise taxes, so he will transfer the full $1 million to the QRP. Because this plan covers all the same employees as the defined benefit plan, it will meet the requirements.

Alternatives to the QRP

The QRP is one option to deal with excess assets. The Plan Sponsor may choose to increase the benefit formula in the Plan to use up the excess assets or to reallocate the assets in a nondiscriminatory manner at termination. In both cases, the Plan will provide additional benefits to participants, which may be contrary to the Plan Sponsor’s objectives. These options also may not be feasible if participants (particularly the business owner) have already reached their lifetime maximum benefits under Code Section 415. However, in light of the fact that income and excise taxes on the reversion will likely add up to more than 75% of the excess, a Plan Sponsor may decide that it would rather have all or a part of those monies go to employees than the government, even if the owner cannot share in the excess allocation themself.

Here are some other strategic options to use excess assets in a defined benefit plan:

1. Include an owner’s spouse or child in the Plan as a means to transfer wealth from the parent’s business to the child within a qualified plan. Please note that the spouse or child must be a bona fide employee of the entity with reasonable compensation.
2. Increase compensation for participants in the Plan to permit additional benefits. This is particularly useful for owners who are intentionally keeping their compensation low for tax purposes.
3. Include otherwise excluded employees in the plan, if any.
4. Add a related entity as a participating employer in the Plan.
5. Transfer some or all of the excess assets to a program used to pay for retiree health and retiree life benefits, as permitted under Code section 420, as amended by SECURE 2.0. Special rules apply to these structures, so additional professional advice is required before this is done.

Conclusion

Without Dr. Grey’s referral to the Ferenczy team and their sage advice, Dr. McDreamy would have been stuck with a large excise tax bill. Instead, he and his employees will be able to benefit from those dramatic returns in the form of contribution allocations in the QRP over the next seven years.

If you have an overfunded defined benefit or cash balance plan, or if you have any questions about your retirement program, give us a call… After all, we are your ERISA solution!