Key Points

• Overfunded defined benefit pension plans can trigger significant tax liabilities, including a 50% excise tax on surplus assets that revert to the employer upon plan termination.
• Closely held business owners face overfunding risk when deductible contributions and strong investment performance exceed the plan’s ability to pay legally permitted benefits.
• Alternative strategies may preserve more value than a taxable reversion, including transactions that transfer overfunded pension plans to sponsors with underfunded plans.

For many owners of closely held businesses, a defined benefit pension plan begins as a powerful retirement and tax-planning tool. The employer funds the plan, receives deductions and relies on an actuary to determine how much must — or may — be contributed each year. But when investment performance, contribution strategy and statutory benefit limits collide, the result can be a plan with far more money than it can legally pay out in benefits.

That surplus may look like success, but it can become a costly trap. If excess assets revert to the employer after plan termination, the reversion is taxable income and generally subject to a steep (50%) excise tax. For many business owners, the realization that “their” pension assets are not simply theirs to reclaim can be jarring.

We asked Harvey M. Katz, Partner and Co-Chair of Fox Rothschild’s Employee Benefits & Compensation Practice, to explain how overfunded pension plans arise, why traditional fixes often fall short and what sophisticated alternatives may be available when the usual answers do not work.

Q: Let’s start with the basics. What does it mean for a pension plan to be overfunded?

A: An overfunded defined benefit plan is one that has more assets than it needs to pay all promised benefits, measured on a termination basis. That sounds like a good problem to have, but in the defined benefit world, there are legal limits on what the plan can pay out. Participant benefits aredetermined by formula, not by whatever amount happens to be sitting in the trust.

A defined contribution plan, like an IRA or 401(k), works differently because the contribution is defined and the participant generally receives the account balance, subject to the applicable rules. In a defined benefit plan, the plan promises a benefit — often based on compensation, years of service and retirement age (subject to legal maximums) — and the actuary determines the funding needed to support that benefit. If the trust ends up with more than is needed to pay the maximum permissible benefits, the excess does not automatically belong to the owner.

Q: Why does this issue come up so often with closely held businesses?

A: Many closely held business owners use defined benefit plans because they can make much larger deductible contributions than with a defined contribution arrangement. That can be attractive for the owner of a profitable business who is trying to build retirement assets and reduce current tax exposure. In practice, the plan may be designed so the owner and family members receive the overwhelming share of the projected benefit, while still complying with applicable pension rules.

The problem is that the funding rules allow room for a cushion. That cushion makes sense in the broader pension system because investment losses, demographic changes and economic downturns can leave a plan underfunded. But the same rules can create a mismatch for smaller plans when the employer consistently contributes at the high end of the permissible range and the plan’s investments outperform actuarial assumptions.

Q: So an employer can be following the rules and still end up with a serious problem?

A: Exactly. The actuary may be certifying the plan annually, and the employer may be making contributions within the permitted range. But if the actuary assumes a relatively conservative return and the investments perform better, the plan can accumulate assets beyond what it can ultimately pay out.

That is often when the owner has a “come to Jesus” moment. The owner may be nearing retirement or selling the business, and the actuary explains that the plan has millions of dollars more than it can use to satisfy benefit liabilities which cannot be withdrawn without penalties. The business owner’s first reaction is often emotional: “I put the money in; why can’t I get it back?” The legal answer is that the money is in a qualified trust for the benefit of participants, not simply in the owner’s pocket.

Q: What happens if the employer terminates the plan and takes the excess assets back?

A: A reversion of excess assets to the employer can be extremely tax inefficient. The reversion is taxable income to the plan sponsor and is subject to a 50% excise tax under Internal Revenue Code Section 4980. The IRC states that the excise tax is generally 50% unless the employer satisfies specific exceptions, such as establishing or maintaining a qualified replacement plan or providing certain benefit increases.

In practical terms, that can leave the employer with a surprisingly small portion of the surplus after federal income tax, state income tax and excise tax are taken into account. Plan sponsors typically may realize only 10% to 15% of the overfunded amount after income and excise taxes. That is why these cases can feel so unfair to owners who spent years funding the plan aggressively.

Q: How did the law get to that point?

A: The harsh tax regime has roots in abuses that occurred in the 1980s. Large companies with overfunded defined benefit plans could terminate a plan, take back the surplus and then establish a new plan, effectively stripping out the cushion that had protected participants. Congress viewed that as an abuse because the surplus was being removed from the pension system and used for corporate purposes, including acquisitions.

The initial 15% excise tax did not deter employers sufficiently, so Congress made the tax far more punitive. Today, the tax rules are designed to make a straight reversion unattractive unless the employer fits within a statutory exception or is willing to absorb the penalties.

Q: What are the conventional ways to address overfunding?

A: There are several conventional strategies. A sponsor may consider increasing benefits, adding ancillary benefits, increasing participant compensation, adding family members to payroll, using a qualified replacement plan or pursuing a financial transaction involving excess assets.

Each option has limitations. Increasing benefits or compensation often does not consume a meaningful amount of overfunding. Adding family members to payroll requires real employment, meaningful compensation and years of lead time for new participants to accrue a significant benefit. Ancillary benefits such as life insurance were once more useful, but IRS scrutiny has curtailed strategies that relied on large differences between premiums paid and early cash value.

A qualified replacement plan can reduce the excise tax under some circumstances, but it is not a universal solution. To qualify, the replacement plan generally must cover at least 95% of active participants who remain employed and must receive a direct transfer of at least 25% of the overfunding. . The transferred amount must also be allocated under specific rules, including rules that can require allocation over a period of up to seven years.

Q: Why do qualified replacement plans often fall short for retiring owners?

A: Qualified replacement plans can work when the sponsor expects to continue the business and has a workforce that can benefit from the transferred assets. But many owners facing overfunding are already preparing to retire or sell the business. If the owner has to keep operating the business and paying salaries for years to use the excess through a replacement plan, the solution will likely not match the owner’s real-world objective.

That is why timing matters so much. If the issue is identified five to 10 years in advance, there may be planning opportunities. If the owner is retiring tomorrow, the menu of practical options narrows quickly.

Q: What is the alternative strategy you focus on?

A: In many cases, the preferred alternative is a transaction that keeps the surplus inside the pension system while allowing the original sponsor to realize substantially more value than a taxable reversion would provide. The basic idea is to transfer sponsorship of the overfunded plan to a buyer that has an underfunded defined benefit plan and can use the surplus to support its own pension obligations.

The best buyer is often not a taxable employer because a taxable employer receives a deduction for contributing to its own underfunded plan. The more logical buyer may be a tax-exempt organization — such as a hospital — that does not receive the same tax benefit from making deductible contributions because it is not paying income tax in the first place. For that buyer, acquiring pension assets at a discount can be economically meaningful because funding its own plan otherwise costs a full dollar for every dollar contributed.

Q: How does the transaction work in general terms?

A: The structure involves creating an entity that becomes a co-sponsor of the overfunded plan. After benefits are paid to the existing participants and the original employer withdraws as sponsor, the newly created entity becomes the remaining plan sponsor and is sold to the buyer. Once the buyer owns the entity, the overfunded plan can be merged into the buyer’s underfunded plan.

Think of the economics this way: the sale price is typically 60% to 80% of the overfunded amount, and the sale price is subject to long-term capital gains tax. Buyers may pay roughly 60 to 85 cents on the dollar depending on the transaction. Compared with a reversion that may leave the sponsor with only 10 to 15 cents on the dollar after taxes, the difference can be significant.

Q: Is the IRS comfortable with this approach?

A: Let’s be careful not to overstate the point. The IRS has not formally blessed the transaction structure in a published ruling, but the IRS is notoriously parsimonious in issuing advance rulings on any subject.

The key distinction is that the surplus is not being pulled out of the pension system and somehow finds its way back to the employer as a disguised reversion. Instead, the money remains in a qualified pension environment and is used to fund other pension benefits. That is also why the transaction is aligned with the broader policy goal of preserving pension assets for participants, and improving the health of the federally mandated pension insurance system.

We take a different view regarding transactions involving underfunded plans, where regulators have materially different concerns because the buyer may be assuming funding obligations it cannot satisfy.

Q: Who should be paying attention to this issue before it becomes a crisis?

A: Actuaries and third party administrators are often the first line of defense. They see the funding reports, understand the benefit limits and are often the first advisors to know when a plan is accumulating a surplus. Accountants, financial advisors and transaction counsel should also recognize the issue because overfunding can affect retirement planning, business sales and the owner’s expectations about enterprise value.

My point is not that every overfunded plan should be sold. Some clients and their advisors will view the strategy as too aggressive for their level of risk tolerance clients, and some fact patterns will not fit. But advisors should know that the option exists so they can raise it before a client assumes that a heavily taxed reversion is the only path.

Q: What is the most important takeaway for plan sponsors and advisors?

A: Overfunding is not just an actuarial footnote. It is a legal, tax, fiduciary and transaction-planning issue that can materially affect what an owner receives at retirement or sale. The earlier the issue is identified, the more options the sponsor is likely to have.

For me, the work is part technical and part practical. The technical rules matter because a mistake can have serious tax and qualification consequences. But the practical work is helping owners and advisors understand that a plan surplus is not simply trapped money — and that, with the right facts and careful structuring, there may be a better answer than watching most of the surplus disappear to tax.

Harvey Katz is a Partner and Co-Chair of Fox Rothschild’s Employee Benefits practice. He advises employers on complex pension, benefits and transaction issues, including strategies for addressing overfunded defined benefit plans. He can be reached at 973.403.0552.

This information is intended to inform firm clients and friends about legal developments, including the decisions of courts and administrative bodies. Nothing in this article should be construed as legal advice or a legal opinion. Readers should not act upon the information contained in this alert without seeking the advice of legal counsel. Views expressed are those of the author(s) and not necessarily this law firm or its clients.