Can a 401(k) plan be a qualified replacement plan?

Many employers with declining cash flows eye overfunded pension plans as a lifeline. While access to excess pension funds requires payment of an excise tax, the amount of the excise tax can be reduced from 50% to 20% if the sponsor establishes a qualified replacement plan" under Sec. 4980(d). Recent IRS letter rulings indicate that this qualified replacement plan can be a matching contribution plan, encouraging workers to save for their own retirement in order to receive a benefit.

Sec. 4980(d)(2) defines a qualified replacement plan" as a plan established or maintained by the employer in connection with a qualified plan termination into which (1) at least 95% of the active participants in the terminated plan, who remain as employees of the employer after the termination, are active participants in the replacement plan, and (2) a direct transfer is made from the terminated plan to the replacement plan before any employer reversion, and the transfer is an amount equal to 25% of the maximum amount the employer could receive as an employer reversion without regard to this section.

Active participation requirement

From time to time, the question arises whether a Sec. 401(k) plan that uses reversions to match employee deferrals could satisfy the 95% active participation requirement if a substantial portion of the participants covered by the replacement Sec. 401(k) plan did not make elective deferrals into that plan, and thus did not receive a match from the funds. Would these noncontributing participants be "active participants?" A letter ruling issued in late 1992 suggests the answer is "yes"--not by directly addressing the issue, but rather by totally ignoring the issue while finding the new plan to be a qualified replacement plan."

The plan in Letter Ruling 9252035 was a defined benefit plan (X) that was being terminated some time after Mar. 31, 1991. The employer established new Plan Y, a profit-sharing plan with a qualified cash or deferred arrangement, under which 25 % of the proposed reversions were to match employee deferrals. The issue centered on a set of union employees--the "v employees"--who, before the employer decided to terminate X, had bargained (1) to cease accruals in X as of jan. 1, 1990 for one group, and as of Nov. 1, 1990 for another group, and (2) not to participate in Y. The v employees had benefits remaining in X. The employer argued that the v employees should not be considered in determining whether Y covered 95% of X's active participants. According to the employer, only the remaining employees, the "w employees." who continued to accrue benefits under X, should be considered in calculating "active employees."

The IRS agreed: "Since the v employees were not accruing benefits under Plan X on the date of its termination, we find that the v employees were not active participants in Plan X on the date of termination. Thus, only the w employees should be considered active participants for purposes of determining whether Company M meets the 95 percent requirement in Code section 4980(d)(2)." Without mentioning the fact that under Y the w employees had to defer salary to receive a benefit, the Service concluded, "Since all of the w employees who were participating in Plan X at the time of its termination will continue to participate in Plan Y, we find that the 95 percent test is satisfied." (Emphasis added.)

Asset transfer and allocation requirements

In Letter Ruling 9302027, the IRS addressed the specific question of whether employer contributions under Sec. 4980(d)(2)(C)(i) could be applied only to matching contributions. in that case, the employer had terminated a defined benefit plan, Plan X, and established a defined contribution plan, Plan Y, covering all X participants who remained employees. (There were no facts indicating substantial employee terminations or layoffs, so presumably Y covered the same people as X.) The Service had earlier addressed the qualified replacement rule in Letter Ruling 9224033, but the taxpayer apparently felt compelled to affirm that the matching contributions satisfied Sec. 4980(d)(2)(B) and (C). The IRS stated:

The amounts transferred and credited to the suspense account under section 4980(d)(20(C) [sic] of the Code are employer contributions pursuant to Code section 4980(d)(4)(B) headed "Treatment as Employer Contributions." Employer contributions may include matching contributions pursuant to section 1.401(m)-1(f)(12) of the Income Tax Regulations.

Accordingly ... the amount transferred from Plan X into the suspense account under Plan Y as contemplated by section 4980(d)(2)(C)(i) of the Code may be used to make employer matching contributions under Plan Y without violating section 4980(d)(2)(B) and (C) requiring that the allocation of 25 percent of the maximum reversion from the defined benefit plan be transferred to the defined contribution plan and allocated to the accounts of participants.

The Service did not address the fact that some participants would not actually receive a matching contribution because they did not make their own deferral, only cautioning that "[t]his ruling is based on the assumption that the amount transferred from Plan X into the suspense account under Plan Y will be allocated from such account to accounts of participants no less rapidly than ratably over the 7-plan-year period beginning with the year of the transfer in accordance with Code section 4980(d)(2)(c)."

Given these two letter rulings, the Service apparently is not concerned--at least in these cases--about the actual level of participation in the qualified replacement plan; rather it is looking at coverage of the replacement plan. Of course, letter rulings cannot be used or cited as precedent, so these rulings do not provide a firm rule for Sec. 401(k) qualified replacement plans; however, they certainly suggest some guidance.