What Is a Qualified Replacement Plan for Asset Reversions?

When an employer terminates an overfunded defined benefit pension plan, returning the excess funds to the company can trigger major tax consequences. A qualified replacement plan (QRP) is a strategy to manage these funds, known as an asset reversion. It involves establishing or using a retirement plan to receive a portion of the surplus assets from the terminated plan.

By transferring a percentage of the excess assets into a QRP, an employer can reduce their tax liability. The funds moved to the replacement plan continue to be held for employees, preserving their tax-deferred status. The use of a QRP is a formal process governed by Internal Revenue Code (IRC) rules.

The Asset Reversion Excise Tax

When a defined benefit plan is terminated and its assets exceed the amount needed to pay all benefits, the surplus may revert to the employer. This return of funds is an employer reversion. The Internal Revenue Code treats this reversion as a taxable event because the original plan contributions were tax-deductible, and the amount is included in the employer’s gross income.

In addition to regular income tax, the IRC imposes a 50% excise tax on the reversion amount. This high tax rate is intended to discourage employers from terminating pension plans simply to access surplus assets. For instance, on a $1 million reversion, the employer would face a $500,000 excise tax on top of corporate income taxes on the full $1 million.

Requirements for a Qualified Replacement Plan

To qualify as a QRP and achieve a lower excise tax rate, a plan must satisfy several requirements. The replacement plan can be a new or existing defined contribution plan, like a 401(k), or another defined benefit plan. The criteria revolve around participation, asset transfers, and asset allocation.

Participation Requirement

At least 95% of the active participants in the terminated plan who remain employees after the termination must become active participants in the replacement plan. This ensures continuity of retirement plan coverage for the affected workforce. An existing plan can serve as the QRP, even if it covers other employees, as long as this 95% threshold is met.

Asset Transfer Requirement

A direct transfer must be made from the terminating plan to the QRP before any assets revert to the employer. The amount transferred must be at least 25% of the maximum potential employer reversion. For example, if the total surplus is $2 million, at least $500,000 must be transferred to the QRP. This transfer is not considered a reversion and is not subject to the excise tax.

Allocation of Transferred Assets

Once assets are transferred to a defined contribution QRP, rules govern their allocation. The transferred amount can be allocated to participant accounts in the year of the transfer. Alternatively, the funds may be credited to a suspense account and allocated on a straight-line basis over a seven-year period, starting with the year of the transfer.

Establishing the Plan and Transferring Assets

The process of establishing a QRP is linked to the termination of the defined benefit plan. The first step is the employer’s formal decision to terminate the pension plan and use a QRP to manage the asset reversion. This involves amending the terminating plan documents and establishing the new plan if one does not already exist.

The transfer of assets is a regulated step. The funds must be moved in a direct trustee-to-trustee transfer, meaning the money flows from the trust of the terminated plan to the trust of the QRP. This direct path ensures the transferred amount is not considered part of the employer reversion and is not subject to income and excise taxes.

To complete the process, the employer must file Form 5310, Application for Determination for Terminating Plan. This is to receive an IRS determination letter on the plan’s qualified status at termination.

Tax Reporting and Implications

Using a qualified replacement plan changes the tax outcomes for the employer and employees. For the employer, the main benefit is a reduction in the excise tax on the asset reversion. By meeting the QRP requirements, the excise tax rate drops from 50% to 20% on the portion of the surplus that the employer retains. The amount transferred to the QRP is not subject to any excise tax.

The portion of the reversion kept by the company is still included in its gross income and is subject to corporate income tax. The amount transferred to the QRP is not deductible as a new plan contribution. The employer must report the reversion and pay the 20% excise tax using Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. This tax must be paid by the last day of the month following the month in which the reversion occurs.

For employees, the assets transferred into their new accounts within the QRP are not considered taxable income at the time of the transfer. The funds maintain their tax-deferred status. This means taxes are not due until the employee takes a distribution from the new plan, which is often during retirement.