Avoiding excise tax on Keogh Plan reversions.

When a defined benefit plan is terminated, the present value of accrued benefits is distributed to the plan's participants. Any surplus assets are returned to the plan sponsor and are subject to an excise tax of up to 50%. This excise tax is payable to sponsors (including self-employed individuals) of defined benefit Keogh plans, or their estates, on the plan's termination. It can apply even at the sponsor's death if funds remain in the plan after all benefits have been paid. However, with proper planning, the tax can be avoided for minimized).

Sec. 4980 imposes an excise tax of up to 50% on the reversion of surplus pension assets to an employer on termination of a defined benefit pension plan. The purpose of the tax is to discourage employers from terminating their pension plans. Defined benefit plans maintained by self-employed individuals, however, are usually terminated at the death of the individual and/or a spouse, resulting in the excise tax being applied to any remaining assets.

Self-employed individuals have been able to establish similar types of qualified retirement plans as corporations since the passage of the Tax Equity and Fiscal Responsibility Act of 1989,. Plans covering the self-employed (sometimes referred to as Keogh plans) are subject to rules similar to those for corporate plans with respect to contributions and distributions. Many self-employed individuals have established defined benefit plans because they frequently allow for greater annual contributions than available under a defined contribution plan. Under a defined benefit plan, however, a participant's benefit is determined pursuant to a formula, rather than an individual account balance. Asset accumulations greater than that necessary to fund the participant's formula benefit are used by the plan to fund the benefits of other participants or, on plan termination, are returned to the employer. Because the surplus amount is not part of the. participant's promised "accrued benefit," the surplus assets cannot be rolled over to an individual retirement account (IRA) or another qualified plan. As noted, the reversion of surplus assets to an employer is subject to the Sec. 4980 excise tax.

In the case of an unincorporated closely held business, the retirement or death of the self-employed owner often results in the termination of the company's retirement plans. On termination of a defined benefit plan, accrued benefits are distributed to the participants or their beneficiaries and any surplus amounts are returned to the business (i.e., to the self-employed individual or to his estate). If the self-employed individual and spouse live until the end of their actuarial life expectancies and receive a joint-and-survivor annuity, the full accrued benefit will eventually be paid to them. If the participant dies before an actuarially expected date of death, however, a portion of the benefit is forfeited and the surviving spouse receives only a survivor's annuity (determined under Sec. 401 (a)(11) and the plan's terms). If the participant and spouse both die before their actuarially expected dates of death, the benefits not yet distributed are forfeited. At death of the participant or spouse, the plan is usually terminated and remaining assets (including the forfeited amounts) are subject to the Sec. 4980 excise tax. Planning

One way to avoid the Sec. 4980 excise tax is to terminate the defined benefit Keogh plan before the accumulation of surplus assets, i.e., when the flail acerned benefit has been accumulated for the self-employed individual. The accrued benefit could be paid to the individual as a lump-sum distribution with favorable income tax results or, alternatively, could be rolled over to an IRA or a qualified defined contribution plan. Regardless of which approach is taken, distribution of the assets from the defined benefit plan before the accumulation of surplus assets eliminates the possibility of substantial loss of accumulated wealth because of the imposition of the excise tax.

From Alan A. Nadel, CPA, New York, N.Y., and Ross Nager, CPA, Houston, Tex.