How to Disqualify a Pension Plan

Handing over your underfunded pension plan to a financial institution may cripple the plan's tax benefit.
Robert WillensAugust 11, 2008

It has been reported that financial institutions have been eyeing underfunded or “frozen” corporate pension plans as a new line of business. The transaction being contemplated is a sort of rescue operation that involves a transfer of the stock of a “shell” subsidiary to the financial institution, after the plan sponsor does two things: transfers sponsorship of the plan to the shell subsidiary, and injects sufficient assets into the plan to cure the underfunding.

The shell subsidiary’s stock would then be sold to a financial institution which would more astutely manage the plan’s assets and profit from the surplus the plan would generate over and above the amount needed to pay the accrued benefits to the plan participants and their beneficiaries.

The major benefit of the transaction, however, hinges on the pension plan remaining “qualified” in the eyes of the Internal Revenue Services. Indeed, qualified plans are tax-deductible and the plan’s earnings can accumulate free of any tax consequences.

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Unfortunately for companies to hang on to their tax benefit, the Internal Revenue Service in Revenue Ruling 2008-45, has indicated that such a transaction would result in the disqualification of the pension plan, a result which renders these transactions completely untenable.

The IRS ruling explains the situation through the following example. Alpha Corporation maintains an underfunded defined benefit (pension) plan with no ongoing accrual of benefits — so, the plan is essentially “frozen.” An underfunded plan is defined as one in which the accrued benefits exceed the amount of the plan assets.

Alpha transfers sponsorship of the plan to its subsidiary, Beta Corporation. Beta does not maintain any trade or business, has no employees, and has only “nominal” assets. Alpha then transfers cash and marketable securities to Beta. The amount transferred is equal to the amount of the underfunding plus “an additional margin.” Shortly thereafter, ownership of not less than 80 percent of Beta’s stock is transferred to Gamma Corporation, an unrelated company.

The transfer of Beta’s stock to Gamma will not be undertaken “in connection with” the transfer of business assets, operations, or employees from Alpha’s controlled group to Gamma’s controlled group. As a result, the ruling concludes that this transaction will lead, inexorably, to a disqualification of the plan.

Exclusive benefit rule violated

The tax code — specifically Section 401(a) — says, cryptically, that to be considered a “qualified,” the pension plan of an employer must be for the “exclusive benefit” of its employees or their beneficiaries. The ruling observes that “…unlike ordinary situations where sponsorship of a plan is transferred in connection with the acquisition of business assets or operations, Beta does not maintain a business and its assets only compensate Gamma for assuming Alpha’s responsibilities under the plan to make contributions to the plan….” Therefore, the ruling observes, any profit or loss to Gamma resulting from the transaction would be solely from the use of the assets that are transferred to its controlled group in connection with the acquisition and operation of the plan.

The ruling notes that in accordance with Section 414(b) of the tax code, all employees of all corporations which are members of a controlled group of corporations are treated as employed by a single employer. Accordingly, even though Beta has no employees of its own, it is treated as an employer with respect to the employees of the Alpha controlled group while it is part of that controlled group.

However, for purposes of Section 401(a)’s exclusive benefit rule, Beta will no longer be treated as an employer with respect to the employees of Alpha’s controlled group when it is no longer a member of that group. This result, the ruling notes, is not affected by the provisions of Section 414(a). That section provides that if an employer maintains a plan of a predecessor employer, service for such predecessor employer is treated as service for the employer.

By its terms, however, Section 414(a) only applies to an employer, and does not create employer status for a taxpayer that is not in its own right an employer. As a result, the ruling concludes, when Beta is no longer a member of the Alpha controlled group, the plan does not satisfy the exclusive benefit rule because it is not maintainedby an employer to provide retirement benefits for its employees and their beneficiaries.

In addition, the ruling holds that its conclusion would be the same in light of two other circumstances. For example, if the new controlled group had some employees covered by the plan after the transaction, or if some business assets or operations are transferred — and not withstanding these “cosmetics” — substantially all of the “business risks and opportunities” under the transaction are those associated with the transfer of the sponsorship of the plan.

In short, according to the revenue ruling, the exclusive benefit rule, found in Section 401(a), will be violated when sponsorship of a plan is transferred from an employer to an unrelated taxpayer, and the transfer of such sponsorship is not “in connection with” a transfer of business assets, operations, or employees. As far as the IRS is concerned, the legal issue is quite well-settled: a transfer of sponsorship of a plan under the circumstances outlined in Revue Ruling 2008-45 will, without doubt, disqualify the plan.

Whether as a policy matter it is appropriate to discourage placing underfunded plans in “stronger” hands is a separate question that only Congress can address. It is entirely possible that Congress will see fit to encourage these types of transactions through the enactment of legislation that would exempt these sorts of transfers from the strictures of the exclusive benefit rule.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for