WASHINGTON - Companies with surplus pension fund assets considering using that money to pay for other employee retirement benefits can kiss that thought goodbye, thanks to a recent IRS ruling.
In a ruling denying the request by an unidentified company, the Internal Revenue Service said employers contemplating using excess assets from a traditional defined benefit plan to pay their matching employee contributions to a defined contribution plan might not only have to give back the tax deduction previously claimed on their contribution to the defined benefit plan, but also be levied a hefty "reversion" surcharge on the money siphoned out. That reversion excise tax can amount to as much as 50%.
Worse still, employers could risk losing the tax-favored status of both retirement plans in the process, the IRS pointed out.
"It definitely kills the technique, unless a company goes in knowing that they are going to take on the IRS," said Louis T. Mazawey, partner in the Washington law firm of Groom and Nordberg.
"Most companies are not willing to do a transaction that might in any way jeopardize the qualified status of their plan," said Paul V. Strella, principal in the Washington office of William M. Mercer Inc., whose client received the unfavorable IRS ruling. Mr. Strella declined to identify the client.
The ruling, however, would affect no more than a dozen or so companies - those offering defined contribution plans and whose defined benefit plans are so overfunded they might not need to make any contributions for five or 10 years. In addition, companies considering tapping their surpluses in this manner would be those with a strong stomach, willing to take their chances with the IRS.
In the private letter ruling, 9723033, issued March 10 but made public only earlier this month, the IRS noted siphoning out assets from a defined benefit pension plan to pay for the employer match to a defined contribution plan "is fundamentally inconsistent" with the premise that permits companies to claim tax deductions for pension plan contributions in the first place.
The unidentified company had sought permission to stop making matching contributions to a profit-sharing plan and instead set up individual employee accounts within the overfunded pension plan and channel excess assets to those separate accounts in proportion to the money workers put in for their own retirement. The company already had received a favorable letter from the IRS granting tax-favored status to the new wrinkle in the pension plan, also known in the parlance as a 414(k) arrangement.
But the more recent IRS ruling made it clear that a company drawing down excess pension assets to pay for its share of defined contribution plans also would violate the exclusive benefit rule of federal pension law, which stipulates companies must use pension assets solely for the benefit of participants.
The question that diversion raises is that not all employees - just those putting in their own money into the profit-sharing plan - would be eligible for matching contributions by the employer.
But companies undergoing downsizings often tend to use excess pension assets to pay for generous early retirement packages available only to some employees, and courts have upheld that use of pension assets, experts say.
"There's nothing that says you can't use different assets for different people," said Mr. Strella.
Mr. Strella also observed the IRS made a technical point in noting the 414(k) arrangement fails to meet the definition of an "employer match" because the company was not actually reaching into its pocket for the contribution, just shifting money out of the pension plan into the defined contribution profit-sharing plan.
What's more, the IRS ruling notes that unless specifically permitted by exceptions to the law, the assumption is that such transfers amount to reversions that are taxable to the employer.
Michael A. Thrasher, of counsel to Groom and Nordberg and previously assistant chief counsel in the IRS' division of employee benefits and exempt organizations, said the recent IRS ruling draws from a July 1988 memorandum issued by the general counsel's office on a similar situation.
In that memo, the IRS had spelled out why such a transfer of assets from a defined benefit pension plan to a defined contribution plan violates the Employee Retirement Income Security Act.
Defined benefit plans, the memo points out, "generate a specific benefit guaranteed by the employer and in most instances by a governmental entity." In contrast, defined contribution plans are "a non-guaranteed benefit that is subject to the vagaries of investment fluctuation."
Moreover, while ERISA focuses on the eventual use of money put away in traditional defined benefit pension plans, the focus on defined contribution plans is on current contributions to the accounts of covered workers.
The ruling also confirms the worst fears of many Washington employee benefits lawyers who had sought inclusion of a provision in the 1995 federal budget package that would expressly expand the ability of companies to use excess pension assets to pay for other employee benefits. That provision ultimately got axed in the negotiations between lawmakers over the House and Senate versions of the tax bill, in large part due to fierce opposition from the Clinton administration.
The ruling also confirms what the IRS had hinted at broadly when it announced in early 1995 that it would no longer approve 414(k) arrangements premised on the companies tapping surplus pension assets to pay for defined contribution plan costs.