Terminating the Single Employer Plan – Procedures and Issues

By Pamela D. Perdue

February 2007

I. INTRODUCTION
 
The termination of a single employer plan, that is, a plan maintained either by a single individual employer or by two or more related employers, will involve Internal Revenue Code (the Code) rules. In addition, if the plan is subject to Title IV of the Employee Retirement Income Security Act of 1974 (ERISA), the termination will also be subject to review by that organization and must be conducted in conformance with the requirements and rules of the Pension Benefit Guaranty Corporation (PBGC).
 
This outline will review the termination procedures of both the PBGC and the Internal Revenue Service as well as issues that arise with respect to the termination of a plan.
 
II. TERMINATING A PLAN WITH THE PBGC
 
A. What is the PBGC?
 
Title IV of ERISA establishes the PBGC as a self-financed government corporation. [ERISA § 4002(a)] The purpose of the PBGC is to ensure participants in covered plans a certain minimum guaranteed benefit. Thus, like an insurance company, the PBGC ensures that on-going covered plans pay premiums to the PBGC which are then pooled and used, when needed, to provide those guaranteed benefits in cases where covered plans terminate with insufficient assets.
 
Given the reasons for its establishment, it is understandable that the PBGCs participation in the termination process is much more narrow in scope than that of the Service in that the PBGC is concerned only with the sufficiency, upon termination, of covered plans, that is, plans subject to Title IV of ERISA.
 
B. Plans Subject to Title IV of ERISA
 
Only those plans subject to Title IV of ERISA will be subject to PBGC oversight and review with respect to their termination. Generally, all defined benefit plans are subject to Title IV of ERISA subject to the following exceptions:
 
1. A Governmental plan;

2. A Church plan, as defined in IRC § 414(e), that has not elected to be covered by ERISA;

3. A plan established and maintained by a society, order, or association described in IRC § 501(c)(8) or § 501(c)(9) if no part of the contributions to or under the plan are made by employers of participants in such plan, or of which a trust described in IRC § 501(c)(18) is a part;

4. A plan that has not at any time after the date of enactment of ERISA provided for employer contributions;

5. A plan that is unfunded and that is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees;

6. A plan that is established and maintained outside the United States primarily for the benefit of individuals substantially all of whom are nonresident aliens;

7. A plan that is maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by IRC § 415 on plans to which that section applies, without regard to whether the plan is funded, and, to the extent that a separable part of a plan (as determined by the PBGC) maintained by the employer is maintained for such purpose, that part shall be treated for purposes of Title IV as a separate plan that is an excess benefit plan;

8. A plan that is established and maintained exclusively for substantial owners;

9. A plan of an international organization that is exempt from taxation under the International Organizations Immunities Act;

10. A plan maintained solely for the purpose of complying with applicable workers compensation laws or unemployment compensation or disability insurance laws;

11. A plan that is a defined benefit plan, to the extent that it is treated q as an individual account plan under ERISA § 3(35)(B); or

12. A plan established and maintained by a professional service employer which does not at any time after enactment of ERISA have more than twenty-five active participants in the plan.
[ERISA § 4021(b)]

Note that individual account plans, that is, defined contribution plans, are not subject to Title IV of ERISA.
 
With respect to the exception for plans established and maintained exclusively for substantial owners, a substantial owner means an individual who owns (1) the entire interest of an unincorporated business (i.e., a sole proprietor); (2) directly or indirectly, more than 10 percent of either the capital or profits interest of a partnership; or (3) directly or indirectly, more than 10 percent in value of either the voting stock or of all of the stock of a corporation. The constructive ownership rules of IRC § 1563(e) apply; however, the exclusion for stock held by a tax-exempt trust is to be disregarded. The definition includes a five-year look-back rule under which an individual who was a substantial owner at any time within the sixty months preceding the date on which the determination is made is to be treated as a substantial owner. [ERISA § 4021(d)]
 
The exception for small defined benefit plans maintained by professional service employers results in the exclusion of many plans that would otherwise be subject to Title IV. However, many questions arise as to whether a particular employer is eligible for the exclusion as constituting a "professional service employer." That term means for this purpose any proprietorship, partnership, corporation, or other association or organization owned or controlled by professional individuals or by executors or administrators of professional individuals the principal business of which is the performance of professional services. [ERISA § 4021(c)(2)(A)] The term professional individual includes but is not limited to physicians, dentists, chiropractors, osteopaths, optometrists, other licensed practitioners of the healing arts, attorneys at law, public accountants, public engineers, architects, draftsmen, actuaries, psychologists, social or physical scientists, and those engaged in the performing arts. [ERISA § 4021(c)(2)(B)] This list is not exhaustive. According to the PBGC, a professional individual is generally one who provides services of a nature that requires advanced knowledge in a field of science or learning which is generally acquired only by a prolonged course of specialized instruction. This type of skill and knowledge is to be distinguished from that which can be learned in a general academic study or through apprenticeship or other similar training. Moreover, the rendering of a professional service generally requires the consistent exercise of discretion and judgment by the professional individual.
 
C. The Termination Process with the PBGC
 
A single-employer plan subject to Title IV may be terminated in only one of three ways: voluntary standard termination, voluntary distress termination, or an involuntary termination instituted by the PBGC pursuant to ERISA § 4042. This means that if a single-employer plan is to be terminated voluntarily, it must satisfy the requirements to constitute either a standard termination or a distress termination.

1. Standard Termination
 
A standard termination is the voluntary termination of a single employer defined benefit plan where the plan both satisfies all of the procedural requirements for a standard termination and has assets sufficient through the actual distribution to satisfy all of the plan's benefit liabilities determined as of the termination date. [ERISA § 4041(b)]
 
In order to satisfy the procedural requirements, the following must be observed:
 
a. The plan administrator must provide the Notice of Intent to Terminate to all affected parties at least 60 days and no more than 90 days before the proposed termination date; [Reg. § 4041.23(a)(1)]
 
b. The plan administrator must file the Standard Termination Notice (PBGC Form 500) with the PBGC on or before the 180<th> day after the proposed termination date; [Reg. § 4041.25(a)]
 
c. The plan administrator must issue the Notice of Plan Benefits to each affected party, other than the PBGC, no later than the time the plan administrator files the Standard Termination Notice with the PBGC; [Reg. § 4041.24(a)]
 
d. The PBGC must not issue a notice of noncompliance during its 60 day review period following the date of receipt of a complete standard termination package;
 
e. When the final distribution of assets occurs, the plan must have assets sufficient to satisfy all benefit liabilities, determined as of the termination date. [ERISA § 4041(b)(1)(D)];
 
f. The plan must actually be closed out by distribution of all assets of the plan generally within 180 days after the expiration of the PBGC's 60 day review period, or, if a request for approval from the Service was timely filed, 120 days after receipt of the favorable determination letter from the Service, and [Reg. § 4041.28(a)]
 
g. The plan administrator must file the Post-Distribution Certification (PBGC Form 501) within 30 days after the last distribution date. [Reg. § 4041.29(a)]
 
If the plan administrator fails to provide any information required within the specified time limit, the PBGC may assess a penalty of up to $ 1,100 a day for each day that the failure continues. In addition, the PBGC may pursue other remedies available to it including, if appropriate, issuing a notice of noncompliance. [Reg. § 4041.6]
 
The effect of the issuance of a notice of noncompliance would be to render the termination null and void. The plan would then be deemed an on-going plan and plan officials would be forced to start the termination process anew if the termination is to proceed. Moreover, since the plan would be an on-going plan, benefit accruals would continue unless benefits had been properly frozen, and a timely ERISA § 204(h) notice issued, prior to the failed termination. However, the PBGC does have the authority to ignore some failures to adhere to the strict time constraints. Specifically, if a required notice is not timely issued to an affected party (other than any employee organization), the notice will nevertheless not be deemed untimely if:
 
a. The plan administrator could not reasonably have been expected to know of the affected party and issues the notice promptly after discovering the affected party;
 
b. The failure was due to administrative error involving only a de minimis percentage of affected parties and the plan administrator issues the notice to each such affected party promptly after discovering the error; or
 
c. The plan administrator could not locate the affected party after making reasonable efforts, and issues the notice promptly in the event the affected party is located.  [Reg. § 4041.3(c)(3)]
 
With respect to the standard termination, the term "affected party" means: (i) each participant in the plan; (ii) each beneficiary of a deceased participant; (iii) each alternate payee as defined in Section 206(d)(3) of ERISA; (iv) each employee organization that currently represents any group of participants; (v) for any group of participants not currently represented by an employee organization, the employee organization, if any, that last represented such group of participants within the 5 year period preceding issuance of the Notice of Intent to Terminate, and (vi) the PBGC. In addition, if an affected party has designated, in writing, a person to receive a notice on behalf of the affected party, then, any reference to affected party in connection with the notice is considered to refer to such person. [Reg. § 4001.2]
 
The Notice of Intent to Terminate actually commences the termination process with the PBGC. The Notice of Intent to Terminate (NOIT) must be filed by the plan administrator by providing a copy to all affected parties, other than the PBGC, at least 60 days and no more than 90 days before the termination date. [Reg. § 4041.23(a)] This means that substantial advance planning is required in order to terminate a plan subject to Title IV.

Example: The Company maintains a defined benefit plan which requires that participants complete 1000 or more hours of service in order to accrue a benefit. The plan operates on the calendar year. In 1997, the Company experiences a significant economic downturn. As a result, the Company determines that it will not be able to satisfy its minimum funding obligations for the 1997 calendar year plan year if participants are allowed to accrue a benefit for the year. The Company contacts its attorney on April 15 of the calendar year and ask the attorney to proceed to terminate the plan immediately. If the NOIT could somehow be distributed on that day, that is, as of April 15, the plan could still not be terminated until at least 60 days after April 15. This is because, the proposed termination date may not be earlier than the 60th day after the issuance of the NOIT. However, the plan might be able to take steps to freeze benefit accruals by issuing the ERISA Section 204(h) notice provided it is issued within a reasonable period of time before the effective date of the amendment freezing benefits.

The regulations set forth in detail, the information required to be included in all required notices including the Notice of Intent to Terminate. All notices required are to be delivered by hand delivery, by first-class mail or courier service directed to the affected partys last known address. Posting of the notice is not sufficient. In the case of the PBGC, delivery is to be made in accordance with the instructions included with the applicable form. Currently, this means delivery by mail, postage pre-paid or hand delivery. [Reg. § 4041.3(b) and (c)]
 
Even though the general rule is that in order to terminate in a standard termination, the plan must have assets sufficient to satisfy all liabilities, a plan may terminate pursuant to a standard termination even though it does not currently satisfy this requirement if it is willing to and can in fact facilitate the plan's sufficiency before actual termination.
 
During the termination process, plan sufficiency may be facilitated in one of two ways allowing an otherwise insufficient plan to terminate in a standard termination. Under the first option, a contributing sponsor or member of the plan's controlled group may make a commitment to contribute any additional sums necessary to enable the plan to satisfy all benefit liabilities at or before the time distribution of assets is required. Any such commitment is treated as a plan asset for all purposes. The commitment must be made to the plan and must be in writing, signed by the contributing sponsor and/or controlled group members. If the contributing sponsor or controlled group member is the subject of a bankruptcy liquidation or reorganization proceeding, the commitment must be approved by the court before which the liquidation or reorganization proceeding is pending or be unconditionally guaranteed by a person not in bankruptcy. [Reg. § 4041.21(b)(1)]
 
Under the second option, a "majority owner" may agree to forgo receipt of all or part of his or her benefit until the benefit commitments of all other plan participants have been satisfied. [Reg. § 4041.21(b)(2)] "Majority owner" means with respect to a contributing sponsor, an individual who owns, directly or indirectly, 50 percent or more of (1) an unincorporated trade or business; (2) the capital or profits interest in the partnership; or (3) either the voting stock of a corporation or the value of all of the stock of a corporation. For this purpose, the constructive ownership rules of Sections 414(b) and 414(c) apply.[Reg. § 4041.2] Any such agreement by a majority owner must be in writing and, where the total value of the benefit exceeds $ 5,000 such that the survivor benefit requirements would otherwise apply, the majority owner and the majority owners spouse, if any, must consent in writing. Finally, neither the majority owner's election nor the spouse consent may be inconsistent with a qualified domestic relations order as defined in ERISA § 206(d)(3). [Reg. § 4041.21(b)(2)]
 
Note, however, that care must be taken in attempting to facilitate plan sufficiency by having a majority owner waive benefits. This is because neither the Code nor the Service has officially approved such measures. Moreover, the Service has indicated an unwillingness to approve such waivers in order to escape an accumulated funding deficiency in Letter Ruling 9146005 (Nov. 20, 1991).
 
If the PBGC does not issue a notice of non-compliance within the required period, or if a notice of noncompliance is originally issued but revoked by the PBGC, the plan administrator must complete the termination by distributing all of the assets of the plan. The distribution must be completed within 180 days following the end of the PBGCs sixty-day review period or any extended period, or if applicable, the date of the revocation of the notice of noncompliance. [Reg. § 4041.28(a)] However, this time requirement for closing out the plan can sometimes pose a problem where the plan has also been submitted to the Service for a favorable determination letter with respect to the termination but has not yet received a letter. In recognition of this concern, provided the plan administrator submits a valid request for a determination of the plan's qualified status upon termination by the time the Standard Termination Notice is filed, then the plan will have until 120 days after receipt of a favorable determination letter from the Service in which to complete the distribution of all assets and thus close out the plan. [Reg. § 4041.28(a)(1)]

2. Distress Termination
 
The distress termination is the second method of voluntary termination of a single-employer plan subject to Title IV of ERISA. In many ways, it is very much like a standard termination except it occurs where assets are not sufficient to satisfy all benefit commitments and neither of the two allowable methods for facilitating plan sufficiency is or can be used. However, in order to complete termination through the distress termination process, plan assets must in all events be sufficient to satisfy the PBGC guaranteed benefits.
 
A plan may be terminated in a distress termination only if:
 
a. The plan administrator provides a Notice of Intent to Terminate to each affected party, including the PBGC, (with respect to the filing with the PBGC, this is to be filed on PBGC Form 600) at least sixty days and no more than ninety days before the proposed termination date;
 
b. The plan administrator files a distress termination notice with the PBGC (PBGC Form 601) on or before the 120<th> day after the proposed termination date;
 
c. The PBGC determines that the contributing sponsor and each member of its controlled group satisfy one of the necessary distress criteria [Reg. § 4041.41(a)]
 
d. The PBGC issues a tentative determination of compliance;
 
e. The PBGC issues a distribution notice indicating that upon review of all information submitted, the plan is sufficient at least for all PBGC guaranteed benefits; [Reg. § 4041.47(c)]
 
f. The plan administrator issues Notices of Benefit Distributions to all affected parties, other than the PBGC and any employee organization, no later than 60 days after receiving the distribution notice from the PBGC; [Reg. § 4041.48]
 
g. The plan administrator closes out the plan in much the same way as is required in the case of a standard termination; [Reg. § 4041.50]
 
h. The plan administrator files a Certification of the issuance of the Notices of Benefit Distribution no later than 15 days after completion; [Reg. § 4041.48(b)]
 
i. The plan administrator files a Post-Distribution Certification with the PBGC.  [Reg. § 4041.50(a)]

However, the PBGC may, on its own motion, waive any requirement with respect to the NOIT or Notice of Distress Termination to be filed with the PBGC where it concludes that it will be less costly or administratively burdensome to the PBGC to do so. However, the PBGC will not entertain request for such waivers. [Reg. § 4041.41(b)(2)(i)]
 
With respect to the requirement that the contributing sponsor and each member of its controlled group satisfy one of the necessary distress criteria, this means that each contributing sponsor and each member of its controlled group must satisfy at least one (but not necessarily the same one) of the following distress criteria:
 
a. Liquidation;

b. Reorganization;

c. Inability to continue in business; or

d. Unreasonably burdensome pension costs.  [Reg. § 4041.41(c)]
 
The liquidation criterion is met if, as of the proposed termination date, a person has filed or had filed against it a petition seeking liquidation in a case under Title 11 of the U.S. Code, or under a similar state or local law of a state or political subdivision of a state, or a reorganization has been converted to such a case, and the case has not been dismissed (a term of art under federal bankruptcy law, resulting in negation of the bankruptcy filing as opposed to the closing of the bankruptcy case). [Reg. § 4041.41(c)(1)]
 
The reorganization distress criterion is satisfied if, as of the proposed termination date, a person has filed or had filed against it a petition seeking reorganization in a case under Title 11 of the U.S. Code, or under a similar law of a state or a political subdivision of a state, or a liquidation has been converted to a reorganization and, as of the proposed termination date, the case has not been dismissed. In addition, the person must notify the PBGC of any request to the bankruptcy court, or other appropriate court in a case under similar law of a state or political subdivision of a state, for approval of the plan termination by concurrently filing with the PBGC a copy of the motion requesting court approval, including any documents submitted in support of the request. In addition, the bankruptcy court or other appropriate court must determine that unless the plan is terminated, such person will be unable to pay all of its debts pursuant to a plan of reorganization and will be unable to continue in business outside the reorganization process and approves the plan termination. [Reg. § 4041.41(c)(2)]
 
The "inability to continue in business" criterion is met if the person demonstrates to the satisfaction of the PBGC that unless a distress termination occurs, the person will be unable to pay its debts when due and continue in business.[Reg. § 4041.41(c)(3)]
 
The unreasonably burdensome pension cost distress criterion is met if a person demonstrates to the satisfaction of the PBGC that the costs of providing pension coverage have become unreasonably burdensome solely as a result of declining covered employment under all single-employer plans for which that person is a contributing sponsor. [Reg. § 4041.41(c)(4)]
 
In accordance with the Pension Protection Act of 2006, whenever in the course of a distress termination filing, the PBGC request additional information from the plan, any information so provided must also be provided to other affected parties not later than 15 days after: (i) receipt of a request from the affected party for the information or (2) the provision of the new information to the PBGC. [ERISA Section 4041(c)(2)(D)]

3. Involuntary Termination
 
Finally, in addition to the ability of the plan administrator to terminate a plan subject to Title IV of ERISA voluntarily through either a standard or distress termination, whichever is applicable, the PBGC may involuntarily terminate a plan whenever it determines that:

a. The plan has failed to satisfy the minimum funding requirements of the Code or has been notified by the Secretary of the Treasury that a notice of deficiency has been mailed with respect to the first-tier tax for failure to satisfy the minimum funding requirements;
 
b. The plan will be unable to pay benefits when due;
 
c. The plan makes a distribution to a substantial owner which constitutes a reportable event as defined in Section 4043(b)(7); or
 
d. The possible long-term loss to the PBGC with respect to the plan may reasonably be expected to increase unreasonably if the plan is not terminated.  [ERISA § 4042(a)]
 
If the PBGC decides to institute involuntary termination proceedings, it may, upon notice to the plan, apply to the appropriate U.S. District Court for the appointment of a trustee to administer the plan pending the issuance of a court decree ordering the termination of the plan. If within three business days after the filing of an application for the appointment of a trustee, or such other period as the court may order, the administrator of the plan consents to the appointment of a trustee or fails to show why a trustee should not be appointed, the court may grant the application and appoint a trustee to administer the plan in accordance with its terms until the PBGC determines that the plan should be terminated or that termination is unnecessary. The PBGC may request that it be appointed as the trustee. [ERISA § 4042(b)(1)]. A trustee appointed will have the power to do any act authorized by the plan or Title IV to be done by the plan administrator or any trustee of the plan. The trustee will have the power to limit the payment of benefits under the plan to PBGC guaranteed benefits or to continue payment of some or all of the benefits which were being paid prior to the trustee's appointment.[ERISA § 4042(d)(1)(A)]
 
In addition, where a termination begins as a distress termination but the PBGC is unable to determine that the plan is sufficient for guaranteed benefits, the PBGC is to commence involuntary termination proceedings pursuant to ERISA § 4042.[ERISA § 4041(c)(3)(B)(iii)]

4. Employer Continued Liability in the Case of a Distress of Involuntary Termination
 
Although an employer can complete the termination of a PBGC covered plan where the plan is only sufficient for guaranteed, but not all promised benefits, or may shuttle the plan to PBGC trusteeship, the employer, and related employers, will remain liable for all promised benefits. Specifically, where a single-employer plan terminates in either a distress termination or an involuntary termination instituted by the PBGC, any person who is, on the termination date, either a contributing sponsor of the plan or a member of a contributing sponsor's controlled group will be jointly and severally liable to the PBGC and/or the trustee appointed, if any, in an involuntary termination for the difference between the benefits paid by the plan and the benefits promised. [ERISA § 4062(a)]
 
Generally, the liability due to the PBGC is due and payable as of the plan's termination date, in cash or securities acceptable to the PBGC. However, to the extent that the liability exceeds 30 percent of the collective net worth of those persons liable (i.e., the contributing sponsor and controlled group members), payment is to be made upon commercially reasonable terms prescribed by the PBGC.[ERISA § 4062(b)(2)]
 
There is a lien in favor of the PBGC for the amount of the liability, including interest, upon all property, whether real or personal, belonging to the person, except that the lien may not be in an amount in excess of 30 percent of the collective net worth of all liable parties upon all property and rights to property belonging to such person. The lien arises on the date of the termination of the plan and continues until the liability is satisfied or becomes unenforceable by reason of lapse of time. [ERISA § 4068(a)]

III. Selecting a Proposed Termination Date
 
While a plan is not actually terminated until it has been closed out and all assets distributed, assuming that the plan complies with all termination requirements in the case of a plan subject to Title IV of ERISA, it is as of the plan's proposed termination date that all benefits will cease to accrue or, in the case of a defined contribution plan, allocations will cease to be made, unless benefits were previously frozen. As such, the selection of a proposed termination date is of critical importance.
 
The selection of a plan's proposed termination date will in turn depend upon whether the plan is subject to Title IV of ERISA, and if so, whether the termination is being made pursuant to the standard termination procedures, the distress termination procedures or an involuntary termination.
 
In the case of a plan subject to Title IV that is terminating pursuant to a standard termination, a plan's proposed termination date is the termination date proposed in the NOIT. [ERISA § 4048(a)(1)] In the case of a distress termination, the proposed termination date is the date established by the plan administrator and agreed to by the PBGC. [ERISA § 4048(a)(2)] Where a single-employer plan is terminated involuntarily by the PBGC, the termination date is the date established by the PBGC and agreed to by the plan administrator. However, if, in a distress termination or an involuntary termination of a single-employer plan, the plan administrator and the PBGC cannot agree as to the date of termination, then the termination date is to be established by a court of competent jurisdiction. [ERISA § 4048(a)(3) and (4)]
 
In the case of a plan not subject to Title IV, the above rules for determining a plan's proposed termination date do not apply. Rather, such a plan's proposed termination date will be the date upon which the plan is voluntarily terminated by the employer. [Treas. Reg. § 1.411(d)-2(c)(3)] This means, for example, that a defined contribution plan or, for example, a small defined benefit plan maintained by a professional service employer, there is a presumption that the date of termination is the date selected by the employer, essentially, the proposed termination date selected by the employer. However, this presumption may be rebutted, where other evidence indicates that the plan was terminated previously, such as in the case of a profit-sharing plan where the employer has previously ceased to make significant contributions for an extended period.
 
In the case of a plan subject to Title IV of ERISA, there will be no question but that the plan can not be terminated retroactively. This is because, both the standard and the distress termination procedures require substantial advance notice prior to the proposed termination date. In the case of a plan not subject to Title IV of ERISA but subject to the minimum funding requirements, for example, in the case of a money purchase plan, a target benefit plan or a defined benefit plan exempt from the PBGC termination insurance program, retroactive termination is also effectively precluded by the provisions of ERISA Section 204(h). This section requires that, within a "reasonable period of time" prior to the effective date of an amendment significantly reducing the rate of future benefit accruals, participants must be given notice of the amendment.
 
IV. IRS issues in Terminating a Defined Contribution or Defined Benefit Plan
 
A. Differences Between the Roles of the PBGC and IRS
 
There are two major differences between the role of the PBGC and the role of the IRS in the termination process. First, the PBGC's role is limited solely to those defined benefit plans that are subject to Title IV of ERISA. On the other hand, the Service is concerned with the termination of any plan treated as tax qualified, including both defined benefit plans and defined contribution plans. Secondly, filing with the PBGC for covered plans is mandatory whereas obtaining prior review and approval from the Service is discretionary. Of course, without regard to whether the plan is voluntarily submitted for review, the Service is not precluded from auditing and subsequently disqualifying a plan that is not voluntarily submitted for review.
 
The Service is concerned with ensuring that the plan remains tax qualified through the complete termination process. Issues which may affect the plan's qualified status include those dealing with whether the plan satisfied the permanency requirement for a qualified plan, whether the plan has satisfied its funding obligations, whether all accrued benefits have become fully vested to the extent funded, and whether the plan's assets have been allocated properly and in a nondiscriminatory manner.
 
B. IRS Submission
 
As is the case with all determination letter request, a plan may, but is not required to, seek IRS review and approval in the form of a favorable determination letter on termination. A plan that seeks to terminate must ensure that the plan is amended, prior to termination, to comply with any and all then applicable statutory and regulatory changes even if the plan would otherwise have had an extended period in which to adopt the changes had it remained an on-going plan.
 
The submission to the Service must satisfy all then applicable requirements which currently requires submission of the following:

 1. Treasury Form 5310 (Application for Determination for Terminating Plan) with original signatures on pages 1 and 2 and any appropriate attachments to the form;
 
2. Treasury Form 2848 (Power of Attorney) if applicable;
 
3. Treasury Form 6088, (Distributable Benefits from Employee Pension Plans) if applicable, (only required currently for defined benefit plans and underfunded defined contribution plans);
 
4. Treasury Form 8717 with check for the amount of the appropriate user fee;
 
5. One copy of the Plan and all amendments or most recent copy of plan as amended and restated;
 
6. Copy of the most recent Favorable Determination Letter previously issued to the Plan;
 
7. Schedule Q and any demonstrations or attachments as required, and
 
8. Copies of all records and actions taken to terminate the plan (generally, in the case of a corporate sponsor this would mean the Minutes authorizing the termination of the Plan).
 
Even if a plan receives a favorable determination letter upon termination, a plan will not be treated as terminated unless all of its assets are distributed as soon as administratively feasible. In accordance with Revenue Ruling 89-87, [Rev. Rul. 89-87, 1989-2 C.B. 81] whether a distribution is made as soon as administratively feasible is to be determined under all of the surrounding facts and circumstances. However, a distribution that is not completed within one year following the date of plan termination specified by the employer is presumed not to have been made as soon as administratively feasible. A plan that fails to adhere to this requirement is treated as an ongoing plan for all purposes under the Code.
 
C. Issues of Permanence
 
A plan is required to be established with the intent to be a permanent, as opposed to a temporary program. This is a condition of tax qualification. [Treas. Reg. § 1.401-1(b)(2)] While a plan sponsor is not precluded from terminating a plan, it may be required to prove that where the plan is terminated within a few years of its establishment, the brief time of its existence does not result in prohibited discrimination. This could pose a problem, for example, where the evidence indicates that the plan was established and maintained only so long as the employer had few if any non-highly compensated employees.
 
If application is made to the Service for approval on termination, the Form 5310 will require that the sponsor disclose the reason for the termination. The alternatives set forth in the form as possible reasons are change in ownership or merger, liquidation or dissolution of the employer, change in ownership by sale or transfer, adverse business conditions, adoption of a new plan, or other. If the reason checked is adverse business reasons, adoption of a new plan, or other, additional information must be included explaining the basis of the selection. Over the last several years, since the enactment of legislation requiring massive changes in qualified plans, the Service has routinely accepted the effect of new legislation on the plan as an acceptable "other" reason.
 
D. Issues of Vesting
1.  Generally
 
In the case of the termination or partial termination of a plan (or in the case of a plan not subject to the minimum funding requirements of Section 412, upon the complete discontinuance of contributions), the rights of all affected participants to benefits accrued to the date of such event, to the extent funded in a defined benefit plan, or credited to the participants accounts in the case of a defined contribution plan, must be fully vested. [IRC § 411(d)(3)]. Further, the plan document must provide for the allocation of any previously unallocated funds to the employees in the event of the occurrence of one of these events. [Treas. Reg. § 1.411 (d)-2(a)(2)]
2.  Former Employees
 
However, the question will often arise on plan termination as to who constitutes a participant required to be vested. For active participants, the determination is a simple one. However, where participants are inactive, i.e., where they have terminated employment but still maintain an account under the plan, the determination is not so simple.
 
Consider the following statutory provisions.

 a. Five Consecutive 1-Year Breaks in Service
 
In the case of a participant in a defined contribution plan, or an insured defined benefit plan, who has 5 consecutive 1-year breaks in service, years of service after such 5 year period shall not be required to be taken into account for purposes of determining the nonforfeitable percentage of his accrued benefit derived from employer contributions which accrued before such 5 year period. [IRC § 411(a)(6)(C)]
 
b.  Rule of Parity
 
In the case of a nonvested participant, years of service with the employer or employers maintaining the plan before any period of consecutive 1 year breaks in service shall not be required to be taken into account if the number of consecutive years of service 1 year breaks in service within such period equals or exceeds the greater of: (I) 5, or (II) the aggregate number of years of service before such period. [IRC § 411(a)(6)(D)]

In General Counsel Memorandum 39310, [Gen. Couns. Mem. 39310 (Apr. 4, 1984)], the Service addressed the necessity of vesting terminated participants upon plan termination under different scenarios. The basic premise of the memorandum is that separation from service does not, in and of itself, create a forfeiture of any then unvested benefits. Rather, there must be some other event that would bring the termination within the purview of the forfeiture break-in-service rules.
 
The memorandum discusses two situations. In the first, a partially vested participant terminates employment and receives a cash out of the participant's partially vested interest. Subsequent to the cash out but prior to the time that the participant would have incurred a break-in-service, the plan is terminated. The issue addressed is whether the participant must become fully vested upon plan termination. The cash out rules in effect at the time of the memorandum's issuance provided that for purposes of determining an employee's accrued benefit, the plan may disregard service attributable to an employee who is involuntarily cashed out or who voluntarily cashes out, provided certain conditions are met. [Former IRC § 411(a)(7)(C)]. One of the primary conditions was that the plan afford the participant the opportunity to repay the benefit cashed out. However, a plan could require that the repayment be made before the participant incurred a one year break-in-service following the withdrawal. [Id.] Relying upon the cash out provisions, the memorandum concludes that in such case, the participant had no interest in which to vest upon termination of the plan. That is, the net result of the cash out provision is that the participant has zero years of service in determining the participant's accrued benefit. Thus, in a plan that uses years of service to determine a participant's accrued benefit, an employee who is cashed out, whether voluntarily or involuntarily, has no accrued benefit in which to vest upon plan termination. Since the issuance of this memorandum, the cash out buy-back provisions have been amended to allow the participant up to five consecutive one year breaks-in-service to repay the distribution. [IRC § 411(a)(7)(C)]. However, the memorandum's rationale should continue to apply.
 
The second situation concerns an unvested participant in a money purchase plan. Under the plan's terms, the participant was required to have at least four years of service before obtaining any vested benefit. The participant in question terminated employment prior to completing four years of service. Thus, the participant was non-vested. However, during the relevant plan year, the participant did not incur a break-in-service. The memorandum reiterates the IRS's position that termination of employment is not sufficient to cause of forfeiture of unvested benefits. Under the break-in-service rules then in effect, the benefits attributable to an unvested participant could be forfeited upon the occurrence of a one year break-in-service. [See Former IRC § 411(a)(6)(D)]. Further, in a defined contribution plan or a defined benefit plan funded solely by insurance, years of service after a break-in-service were not required to be taken into account for purposes of determining the participant's vested interest in the benefit that accrued before the break. [Former IRC § 411(a)(6)(C)]. Because the participant had not incurred a break-in-service before the termination of the plan, the benefits were not deemed forfeitable. Thus, the participant was required to become fully vested upon plan termination.
 
The lesson of this second situation is that where a defined contribution plan terminates, employees who have previously separated from service without receiving a cash-out of their vested benefit or without being deemed to have received such a distribution and who have not suffered a forfeiture under the applicable break-in-service rules will be required to become fully vested upon plan termination. This result can likely be avoided where the plan provides for a "deemed cash-out," that is, where a participant who terminates with a zero vested interest is deemed, under the terms of the plan, to receive a distribution of their entire distributable benefit.
 
In general, it should be noted that benefits are not deemed forfeitable until a participant incurs five consecutive breaks in service. However, if the memorandum's rationale is applied to partially vested participants in a defined benefit plan not funded solely by insurance, the result becomes unclear. Because such a plan could not take advantage of either the five-year break-in-service rule available to defined contribution plans or, in the case of partially vested participants, the rule of parity available with respect to totally unvested participants, this memorandum could be read to require full vesting of all partially vested participants in such plans.
 
Because of the possibility of having to vest nonvested participants upon plan termination who terminate with a zero vested benefit, the plan should specifically provide when distribution of zero vested benefits are deemed to occur. A deemed immediate distribution, particularly in a defined contribution plan, may be sufficient to avoid vesting such participants in the event of a plan termination prior to the incurrence of five consecutive breaks in service. Some key district offices have specifically indicated that they will accept such an approach.

3.  Partial Termination
 
As indicated above, it is not just the official and total termination of the plan that will necessitate full vesting of all participants. Rather, in the event of a partial termination of a plan (or in a plan not subject to the minimum funding requirements of Section 412 (i.e., a profit-sharing or stock bonus plan), the complete discontinuance of contributions), the rights of all affected participants to benefits accrued to the date of such event, to the extent funded in a defined benefit plan, or credited to the participants accounts in a defined contribution plan, must also be fully vested. [IRC § 411(d)(3)]
 
These rules are designed to preclude an employer from allowing participation to dwindle substantially before formally declaring a plan termination, thus avoiding full vesting of all affected participants. Unfortunately, neither the statute nor the regulations provide any substantial guidance as to what constitutes a partial termination. As a result, the law has developed through the case law and less official IRS guidance such as revenue rulings.
 
As a result of these two approaches, the courts and the Service now recognize two different types of partial terminations: (i) the "vertical partial termination", and (ii) the "horizontal partial termination".
 
The regulations provide that both the determination as to the existence of, as well as the determination as to the date of the occurrence of a partial termination are to made by the Commissioner based upon all of the surrounding facts and circumstances. The surrounding facts and circumstances specifically referenced in the regulations include the exclusion, by reason of a plan amendment or severance by the employer, of a group of employees who were previously covered by the plan. [Treas. Reg. § 1.411(d)-2(b)(1)] This, that is, an exclusion by reason of a plan amendment or severance by the employer, has become known as a vertical partial termination. However, not every plan amendment that results in the exclusion of previously covered participants will constitute a vertical partial termination. Rather, the amendment or the severance by the employer must affect a "significant number or percentage" of employees in order for it to result in a vertical partial termination.
 
Example: The ABC Company maintains a pension plan which benefits 165 employees with ninety-five of the covered employees working in the company's Division A. The remaining 70 work in Division B. ABC closes down Division A. As a result, the 95 employees of Division A previously covered by the plan ceased to be covered by the plan. Because a significant number of employees previously covered by the plan no longer benefit under the plan, the plan has incurred a vertical partial termination. [Rev. Rul. 81-27, 1981-1 C.B. 228]
 
Example: The Company maintains a profit sharing plan for the benefit of its full-time employees. Five years after the plan was established, the nonsalaried employees were unionized. As required by the union contract, the employer amended its profit sharing plan to eliminate non-salaried employees from future participation. This amendment resulted in 120 of the plan's 170 participants being made ineligible to participate in future employer contributions under the plan. Relying upon the percentage of employees who ceased to be covered by the plan, the IRS ruled that the plan had undergone a partial termination. [Rev. Rul. 72-439, 1972-2 C.B. 223]
 
As a practical matter, the vast majority of IRS pronouncements and court cases determine the existence of a partial termination based upon whether a significant percentage of employees were affected, rather than, a significant number. [See, e.g., Rev. Rul. 73-284, 1973-2 C.B. 139; Tipton & Kalmbach, Inc. v. Comm., 83 T.C. 154 (1984); Halliburton Co. v. Comm., 100 T.C. No. 15 (1993)]
 
While, according to the Internal Revenue Service Plan Termination Handbook used by its agents as an auditing tool, there exists no bright-line-fixed percentage or number of employees at which a partial termination will automatically be deemed to have occurred [See Former Internal Revenue Manual Plan Termination Handbook, § 252(6) (4/20/96)], most courts have looked to whether the percentage reduction is at least 20% or more before concluding that the reduction is substantial. [See, e.g., Halliburton v. Comm., 100 T.C. No. 15 (1993) where the Tax Court held that a reduction of 19.85% did not give rise to a partial termination. The court concluded that there were no egregious circumstances which would justify concluding that a percentage less than the 20% rule-of-thumb was significant; see also, In re Gulf Pension Litigation, 764 F. Supp. 1149, 1164 (S.D. Tex. 1991)]. While a reduction of 20% or more does not per se mean that a vertical partial termination has occurred, it will raise the question. However, most courts hold that there must be some employer action in conjunction with a significant reduction in order that a partial termination will be found. That is, the regulations require the significant reduction must also be attributable to a plan amendment or a severance by the employer. That is, most courts and the IRS have required some employer action or corporate event which results in the significant reduction for a finding of a partial termination. [See, for example, Kreis v. Charles Townley, M.D. & Associates, 833 F. 2d 74 (6th Cir. 1987); G.C.M. 39344 (Oct. 16, 1984), published March 6, 1985] Normally, this employer action takes the form of a corporate event, such as a plant closing, merger or similar event. The necessity of employer action or a corporate event does not require that the action be malicious, however. Rather, the types of corporate events usually involved include such actions as a corporate merger, or layoff or similar restructurings. As such, even actions taken as a result of situations beyond the control of the employer, such as layoffs due to economic pressures, are sufficient to constitute corporate events. [Rev. Rul. 81-27, 1981-1 C.B. 228] A similar approach has been taken by most courts. [See, e.g., Weil v. Retirement Plan Administrative Committee of the Terson Co., Inc. 933 F. 2d 106 (2d Cir. 1991)]
 
The second type of partial termination is called a horizontal partial termination. Unlike the vertical partial termination which results in previously covered participants ceasing to be covered, a horizontal partial termination affects participants who continue to be covered under the plan. A horizontal partial termination can arise in one of two ways.
 
First, if a defined benefit plan ceases or reduces future benefit accruals, a horizontal partial termination will be deemed to occur if, as a result of this cessation or reduction, a potential reversion to the employer is created or increased. [Treas. Reg. § 1.411(d)-2(b)(2)] If a reversion to the employer is not created or increased as a result of the cessation or reduction of future benefit accruals, a horizontal partial nation is not deemed to result under this special rule solely as a result of the cessation or reduction in future benefit accruals. [Internal Revenue Manual, Plan Termination Guidelines, § 7.7.2.2.7(3)]
 
While this special rule is limited under the regulations to defined benefit plans, the Internal Revenue Manual Plan Termination Handbook provides that the potential for reversion is a factor, although not determinative, in determining whether there has been a horizontal partial termination in the case of a defined contribution plan. [Internal Revenue Manual, Plan Termination Guidelines, § 7.7.2.2.7(4)]
 
The second manner in which a horizontal partial termination may arise is where a plan amendment adversely affects the rights of employees to vest in benefits under the plan. [Treas. Reg. Section 1.411 (d)-2(b)(1)]. The Internal Revenue Manual Plan Termination Handbook further provides that this concept applies not only where the amendment adversely affects the vesting rights of employees, but also in the case of an amendment which reduces benefits or employer contributions or where the plan's eligibility requirements are made more restrictive. [Internal Revenue Manual, Plan Termination Guidelines, § 7.7.2.2.7(2)]

4.  Vesting in the Event of Plan Conversion?
 
As stated above, upon the termination or partial termination of a plan (or in the case of a plan not subject to the minimum funding requirements of Section 412, upon the complete discontinuance of contributions), the rights of all affected participants to benefits accrued to the date of such event, to the extent funded in a defined benefit plan, or credited to the participants' accounts in the case of a defined contribution plan, must be fully vested. [IRC § 411(d)(3)]. The question arises as to the impact of these rules where a plan is converted into another type of plan. That is, does the conversion cause a termination of the prior plan and thus, necessitate full vesting?
 
According to the IRS Manual, Plan Termination Guidelines, the IRS will consider a defined benefit plan to be terminated if it is considered terminated by the PBGC because it has been amended to become an individual account plan. [IRS Manual, Plan Termination Guidelines, § 7.7.2.2.7.2(5)] The resulting effect would be to necessitate full vesting of all affected participants, generally all participants under the plan. However, no clear guidance is provided where, for example, a money purchase plan is converted into a profit sharing plan.
 
The Internal Revenue Manual, Plan Termination Guidelines provides at Section 7.7.2.2.7.2(5) that the amendment of a plan to change it into a different kind of plan, without affecting PBGC jurisdiction, does not, of itself, cause a partial termination.
 
The Service has now confirmed that in most circumstances, the merger of a money purchase plan into a profit sharing plan or the conversion of a money purchase plan into a profit sharing plan will not result in a partial termination.
 
Specifically, in Revenue Ruling 2002-42, IRB 2002-28, July 15, 2002, the Service reviewed two situations: one involving the conversion of a money purchase plan into a profit sharing plan and the other involving the merger of a money purchase plan into an existing profit sharing plan. In both cases, the same participants covered by the money purchase plan were covered by the profit sharing plan and both plans contained the same vesting schedules. Given that the same participants remained covered under the profit sharing plan and the same vesting schedule applied, plus the fact that the money purchase money, post merger or conversion, retained its characteristics as money purchase assets, the Service ruled that neither situation resulted in a partial termination. As such, the participants in the money purchase plan were not required to become fully vested.
 
E. Asset Reversions
 
Both ERISA and the Code require that a plan be established for the exclusive benefit of participants. [ERISA § 404(a)(1); IRC § 401(a)] In addition, in order to satisfy the exclusive benefit requirement of the Code, it must be impossible at any time before the satisfaction of all liabilities for any part of the corpus or income to be used for, or diverted to purposes other than for the exclusive benefit of employees or their beneficiaries. [IRC § 401(a)(2)] This requirement generally precludes the reversion of assets to an employer under most qualified plan.
 
However, an exception exist for defined benefit plans where there is a balance due to erroneous actuarial computation such that the excess, that is, assets in excess of all plan liabilities, may revert to the employer so long as it occurs after the satisfaction of all plan liabilities, that is, after payment of benefits, and so long as the plan provides for the reversion.
 
While the regulations speak in terms of excess assets resulting from erroneous actuarial calculations, as a practical matter, provided the plan first satisfies all benefit liabilities, the Service generally takes no exception to the reversion of excess assets, without regard to their origin, upon termination of a defined benefit plan provided the plan has language providing for such a reversion.
 
However, in the case of a defined benefit plan subject to Title IV of ERISA, in order that a plan provision providing for the reversion of excess assets to the employer, or providing for an increase in the amount of any such reversion, to be given effect, the provision must have been in effect for five years. Specifically, no such provision will be given effect in the case of a Title IV plan prior to the end of the fifth calendar year following the date of adoption of the amendment. [ERISA § 4044(d)(1)] However, if the plan has itself been in effect less than five years, the plan must have always provided for such a reversion. [ERISA § 4044(d)(2)(B)]
 
Even if the reversion is permissible, there are substantial tax consequences to the employer. In addition to whatever federal, state and local income taxes otherwise apply with respect to the reversion, an excise tax of up to 50% of the amount of the reversion will also apply. The amount of the excise tax will be reduced to 20%, however, if the employer either: (i) transfers 25% of the maximum reversion, reduced by any termination benefit increases, to a qualified replacement plan covering at least 95% of the employees under the terminated plan, or (ii) applies at least 20% of the maximum reversion amount to increase benefits to all participants under the plan on a pro rata basis in proportion to the present value of their termination benefits. [IRC § 4980(d)(1)]
 
IV. FREEZING A PLAN AS AN ALTERNATIVE TO TERMINATION
 
In some instances, an employer will prefer to merely freeze rather than terminate the plan. Freezing involves amending the plan to cease all future benefit accruals (or contributions, in the case of a defined contribution plan) while allowing the plan assets to remain in the plan. Because freezing a plan does not rise to the level of an actual termination, the plan will continue to be treated as an on-going plan for all qualification purposes. This means that the plan must still be amended to conform with changing law and must continue to satisfy, in operation, all of the qualification requirements of the Code. Moreover, since freezing constitutes a significant reduction in the rate of future benefit accruals, before a plan subject to the minimum funding requirements of the Code and ERISA can be frozen, the ERISA Section 204(h) notice must first be given to all affected participants.
(Sample Notice of Intent to Terminate)
NOTICE OF INTENT TO TERMINATE THE
THE (insert name of plan) (the "Plan")
(Insert date of issuance)
 
   , the Plan Administrator of the Plan, intends to terminate the Plan in a standard termination as of (insert proposed termination date). The law requires that we provide you with written notice of the proposed termination.
 
In order for the Plan to terminate in a standard termination, plan assets must be sufficient to provide all plan benefits. If the proposed termination date is changed to a later date, or if the proposed termination does not occur, the Plan Administrator will notify you in writing.
 
The following is provided for your information and requires no action on your part.
 
PLAN IDENTIFYING INFORMATION

Name of the Plan:
 
Plan number assigned to the Plan:
 
Name of each contributing Plan sponsor and its Employer Identification Number:
 
Name, address and telephone number of person to be contacted with questions concerning the termination:

OBTAINING A SUMMARY PLAN DESCRIPTION:

 If you wish to obtain a copy of the latest updated Summary Plan Description of the Plan, you may [call or write...]

STATEMENT REGARDING CESSATION OF ACCRUALS: [Include one of the following statements, whichever applies]
 
- Benefit accruals will cease as of the proposed termination date, but will continue if the plan does not terminate;
 
- A plan amendment has been adopted under which benefit accruals will cease, in accordance with section 204(h) of ERISA, as of [insert either the proposed termination date or a specified date before the proposed termination date, whichever applies], whether or not the plan is terminated, or
 
- Benefit accruals ceased, in accordance with section 204(h) of ERISA, as of [insert specified date before the Notice of Intent to Terminate was issued]
 
FOR CURRENT RETIREES: [Include whichever statement applies]
 
- The proposed termination will not affect your [monthly/or other periodic] benefit amount.
 
- The proposed termination will affect your [monthly/or other periodic] benefit amount as follows: [explain]
 
BENEFIT INFORMATION:
 
The Plan Administrator will provide you, at a later date, written notification regarding your benefits.
 
IDENTITY OF INSURERS: [Include whichever statement applies]
 
- If you will receive a benefit in the form of an annuity, the Plan Administrator intends to purchase the annuity contract for your benefit from (one of) the following insurer(s) listed below. If the Plan Administrator subsequently decides to select a different insurer, you will be notified, in writing, no later than 45 days before we purchase the annuity:
 
[Insurer(s) Name and Address]
 
- If you will receive a benefit in the form of an annuity, the Plan Administrator intends to purchase the annuity contract for your benefit from an insurer to be selected at a later date. You will be notified, in writing, of the name and address of the insurer(s) from whom, or from among whom, the Plan Administrator intends to purchase the annuity at least 45 days before we make the purchase.
 
END OF PBGC GUARANTEE:
 
After Plan assets have been distributed to provide all of your benefit, either through the purchase of an annuity contract or in another form permitted by the Plan, the Pension Benefit Guaranty Corporation's guarantee of part or all, as applicable, of your benefit, ends.

STATE GUARANTY ASSOCIATION COVERAGE:

See the enclosed Notice of State Guaranty Association Coverage
(Sample Notice of State Guaranty Association Coverage)
NOTICE OF STATE GUARANTY ASSOCIATION COVERAGE OF ANNUITIES
THE (insert name of plan) (the "Plan")
(Insert date of issuance)
Once the Plan distributes a benefit in the form of an annuity purchased from an insurance company, the insurance company takes over the responsibility for paying that benefit.
All states, the District of Columbia and the Commonwealth of Puerto Rico, have established "guaranty associations". The purpose of a guaranty association is to protect policyholders, up to specified limits, in the event the insurance company is financially unable to meet its obligations.
If you receive your pension benefits in the form of an annuity and the insurance company becomes unable to pay, a guaranty association may be responsible for all, part or none of your annuity. Generally, where you live at the time the insurance company is unable to pay determines which guaranty association is responsible. In certain circumstances, other factors, such as where the insurance company is licensed to do business, determine which guaranty association may be responsible.
Each guaranty association has dollar limits on the extent of its coverage. In many states, guaranty association coverage limits are $ 100,000 for individual annuities and $ 300,000 for all insurance contracts with the same insurance company combined. However, state laws vary and can change over time, and different states may calculate the value of annuities differently.
This notice is to help you understand the general nature of the guaranty association protection of the annuity you may receive. It is only a summary. If you need information now or in the event the insurance company fails, a list of the addresses and telephone numbers of guaranty association offices is available by contacting PBGC's Customer Service Center at 1200 K Street N.W., Washington, D.C. 20005-4026 (telephone #: (202) 326-4000) or by visiting PBGC's home page at http://www.pbgc.gov.