PLAN TERMINATION

To be qualified, the regulations require that a plan be "permanent." By this it is meant only that the employer must not have an initial intention of operating the plan for a few years to obtain tax benefits and then terminating it. Thus, despite the permanence requirement, qualified plans can be terminated and often are.

A plan can be terminated unilaterally by the employer, unless a collective bargaining agreement or other employment contract prohibits it. If an employer does not formally terminate a plan, but merely discontinues contributions to it, the IRS may find that the plan has been terminated, with the same consequences as if a formal termination had been made by the employer. It is also possible to have a partial termination of a plan, which usually means that the plan is terminated for an identifiable group of employees, such as employees at a given geographic location, while it is continued for other employees.

When Should a Plan Be Terminated?

If a qualified plan ceases to be an effective method of compensating employees, or becomes too expensive for the employer, it should be terminated. However, under the rules discussed in this chapter, a proposed termination may have such undesirable consequences that the employer will decide to continue the plan, possibly in amended form. As discussed below, the substitution of a different plan or plans may avoid some of the undesirable consequences of simply terminating the old plan.

Asset-Reversion Terminations

Defined-benefit plans are sometimes terminated not because they are too costly or ineffective but because the employer wants to take out some of the plan's assets. If the plan is fully funded, excess plan assets will revert to the employer, if the plan so provides. The assets that revert are taxable income to the employer.

For some time, commentators have expressed concern that the applicable law in this area favors stripping of assets from qualified plans, with a possible detriment to the retirement security of employees. Congress initially responded to this concern by imposing a 10 percent tax on asset reversions, in addition to the income tax payable on the reversion amount. This tax was criticized as merely penalizing employers slightly without any direct benefit to employees. Consequently, the law was changed; the penalty is now set at 50 percent of the reversion amount unless (1) the employer adopts a replacement plan, (2) the employer provides pro rata increases in the benefits of participants in the terminated plan totaling at least 20 percent of the reversion, or (3) the employer is in bankruptcy. If any of these three conditions is met, the excise tax is 20 percent rather than 50 percent (Code Section 4980).

Consequences of Termination

If an employer terminates a plan within a few years after its inception, the employer must usually show that the termination resulted from business necessity or the IRS will infer that the permanence requirement for qualification never existed. The plan will thus be treated as a nonqualified deferred compensation arrangement, resulting in a loss of tax benefits for both employer and employees. If the plan is terminated after many years of operation, the IRS will not raise a presumption of impermanence so long as the plan is properly funded and termination does not result in prohibited discrimination.

Plan termination results in immediate 100 percent vesting for some or all employees. With a defined-benefit plan, 100 percent vesting means that the accrued benefits of affected participants become 100 percent vested at the time of termination, to the extent the plan is funded. Most defined-benefit plans are insured by the PBGC, and the further complications involved are discussed below. At termination, with a defined-contribution plan, participants become 100 percent vested in their account balances derived from employer contributions, regardless of where they stand otherwise on the vesting schedule. This precludes the possibility of any future forfeitures (and therefore, in a profit-sharing plan, any future reallocation of forfeitures). Obviously, the purpose of the vesting remedy is to limit the possibility of any discrimination resulting from termination of the plan.