3979 / What is the tax treatment of trust assets that revert to a plan sponsor?

The fair market value of any property reverting to an employer from a qualified plan is includable in the employer’s gross income and generally is subject to a nondeductible excise tax.¹ The basic rule is that the excise tax is equal to 50 percent and is imposed on the amount of reversion that is subject to income taxes. The 50 percent tax rate can be reduced to 20 percent if the employer establishes or maintains a qualified replacement plan, provides for pro rata benefit increases for generally all participants and certain beneficiaries, or is in Chapter 7 bankruptcy liquidation as of the termination date of the qualified plan. Where the entire reversion is paid to a qualified replacement plan, there is no reversion to the employer, the employer pays no income taxes on the amount of the reversion, and as a result there is no excise tax.

A qualified replacement plan is any qualified plan established or maintained by the employer in connection with a qualified plan termination in which:

(1)  at least 95 percent of the active participants in the terminated plan who remain employed by the employer are active participants;

(2)  a direct transfer of assets is made from the terminated plan to the replacement plan equal to 25 percent of the maximum reversion that could have been received under prior law, reduced, dollar-for-dollar, by the present value of certain increases in participants’ accrued benefits, if any, made pursuant to a plan amendment adopted during the 60 day period ending on the date of termination and taking effect on that date, before any reversion occurs; and

(3)  the portion of the reversion transferred to a defined contribution replacement plan is allocated to participants’ plan accounts in the plan year in which the transfer occurs or is credited to a suspense account and allocated to participants’ accounts no less rapidly than ratably over the seven year period beginning with the year of the transfer.

If any amount credited to a suspense account cannot be allocated to a participant’s account within the seven year period, such amount generally must be allocated to the accounts of other participants.²

The IRS has determined that where the above requirements were met, amounts transferred to a replacement plan could be used to make employer matching contributions.³ If the entire surplus is transferred to a 401(k) plan that meets the requirements of a qualified replacement plan, the employer’s excise tax on the reversion will be eliminated.⁴ A profit sharing plan with a 401(k) feature also has been approved as a qualified replacement plan.⁵ None of the reversion, however, may be treated as employee salary deferrals.

Any amount transferred to a qualified replacement plan is not includable in the employer’s gross income and is not treated as a reversion. No deduction is allowed with respect to the transferred amount.⁶

An employer is considered to provide for pro rata benefit increases for generally all plan participants and certain beneficiaries under the terminated plan if (1) a plan amendment is adopted in connection with the termination of the plan, (2) the pro rata benefit increases have an aggregate present value of not less than 20 percent of the maximum amount that the employer would otherwise have received as a reversion, and (3) the pro rata benefit increases take effect immediately on termination of the plan.⁷

Where a plan is amended to increase benefits in an effort to reduce the reversion, the benefits may not be increased, and amounts may not be allocated in contravention of the qualification requirements of IRC Section 401(a) or the IRC Section 415 limits ( Q 3719, Q 3728, and Q 3868). Any such increases or allocations must be treated as annual benefits or annual additions under IRC Section 415.⁸ The employer is determined on a controlled group basis and the Secretary of the Treasury may provide that two or more plans may be treated as one plan or that a plan of a successor may be considered.⁹

The tax applies to both direct and indirect reversions. An indirect reversion occurs where plan assets are used to satisfy an obligation of the employer.¹⁰

An employer maintaining a plan must pay the tax, which is due on the last day of the month following the month in which the reversion occurs.¹¹ Where money or property reverts to a sole proprietorship or partnership, the employer is the sole proprietor or the partners.

A distribution to any employer by reason of a contribution made in error may be permitted if one of three criteria is met: a mistake of fact has occurred, the funds are being returned because of a failure of the plan to qualify initially, or the error arose from a failure of employer contributions to be deductible and the repayment is permitted by the terms of the plan document.

A reversion from a multiemployer plan also will not be subject to the tax if made because of a mistake of law or the return of any withdrawal liability payment.¹² ERISA exempts from the prohibited transaction rules the return of contributions or withdrawal liability payments if certain requirements are met.¹³

A transfer of excess assets from a defined benefit plan to a defined contribution plan constitutes a reversion of assets to an employer if the assets were first transferred to the employer followed by a contribution to the defined contribution plan. Thus, excess assets are included in the employer’s income and subject to the penalty tax.¹⁴

Although a qualified transfer of excess pension assets ( Q 3836) from a defined benefit plan to an IRC Section 401(h) account of the plan is not treated as a reversion to the employer, any amount transferred and not used to pay for qualified current retiree health benefits must be returned to the transferor plan and generally is treated as a reversion subject to the 20 percent excise tax.¹⁵