Key Points

• Plan sponsor risk — defined benefit pension plan overfunding: Higher deductible contributions and strong investment returns can create excess plan assets, often not identified until retirement or immediately prior to plan termination.
• Plan termination excise tax exposure: Employer reversion of excess pension assets is taxed as ordinary income and also triggers a 50% Internal Revenue Code (IRC) excise tax — potentially consuming 85%-90% of the overfunding.
• Plan sponsor mitigation/pension de-risking: Increase benefits, add eligible participants, move assets to a replacement plan, or use other financial transactions to reduce overfunding and minimize excise-tax costs.

As an employee benefits attorney, I have encountered this conundrum on too many occasions, and it often leads to an unbelievably bad financial result, which can be easily avoided. First, here is some background.

Many small, closely held businesses, (including a large number of medical practices and law firms) sponsor traditional defined benefit pension plans. As permitted by the Internal Revenue Code and Treasury regulations, these plans heavily favor owners and key employees and are primarily established for tax deferral purposes. Defined benefit plans are the preferred plan design because they enable the plan sponsor to take much larger deductions than would be permitted under a typical 401(k) or profit-sharing plan.

However, the unintended pitfall associated with defined benefit plans is that they can become overfunded. How this occurs is counterintuitive, and it is the reason the problem comes as a surprise to most plan sponsors. Most simply do not appreciate that the Code imposes hard limits on the pension that can to be paid to participants in defined benefit plans. Unlike 401(k) plans (which can legally pay any earnings and appreciation to the participant) a defined benefit plan can only pay the value of the pension due to participants under the plan terms, subject to the maximum limits permitted by law. The plan sponsor is responsible for ensuring that there are enough funds in the plan to pay the Plan’s benefits and is entitled to keep any excess funds after the plan is terminated.

Overfunding takes place because the “liberal” deduction rules allow employers to make much larger deductible contributions to the plan than necessary to fund the benefits payable. In many cases, the plan assets’ investment performance far exceeds the projected returns assumed by the actuary. This combination frequently results in a severely overfunded plan on a termination basis. Despite cautionary notes contained in most actuarial reports, most employers do not focus on the problem until they approach retirement. The shock occurs when they receive the news that the plan is overfunded by millions of dollars, which is taxable ordinary income to the employer, and subject to a 50% excise tax on the excess, resulting in payment of 85% to 90% of the overfunding in taxes, if returned to the employer.

While there are several strategies to reduce the overfunding or minimize the financial consequences, this article focuses on the business owner’s state of mind, which is similar to the four stages of grief. Invariably business owners’ express denial, as their belief that virtually all of the plan’s asset belongs to them is dispelled. This is generally coupled with anger seeking to blame someone else (usually their actuaries) for providing inadequate advance warning.

The period of anger is typically followed by a period of “bargaining,” in which they seek a way to keep all of the overfunding for themselves, while avoiding most of the taxes imposed. There are legitimate ways to minimize the adverse result, (by raising benefits, adding additional benefits or family members, moving funds to a replacement plan or a financial transaction with the sponsor of an underfunded plan). However, none of these alternatives live up to their expectations that the entire pension fund belonged to them.

While most business owners move past the bargaining period (to acceptance), and choose one of the available alternatives, others simply cannot get past the bargaining stage — hoping that a more favorable alternative will magically appear. In most cases, (i.e., those that cannot be solved by simply raising Plan benefits or adding family members as Plan participants), 40 years of experience has taught me that an overfunding situation cannot be solved by kicking the can down the road. Invariably, the problem only gets worse, even if no additional contributions are made to the Plan. Aside from falling victim to scammers who advise rolling the excess into an IRA or backdating Plan documents (both of which are tax fraud), waiting and hoping is the absolute worst strategy. It will only increase the size of the overfunding and expose the plan to continued IRS scrutiny.

Plan sponsors are well advised to look at the situation objectively and take decisive action.

Harvey Katz is a seasoned employee benefits attorney with more than 40 years of experience counseling plan sponsors. He can be reached at hkatz@foxrothschild.com.

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