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Commentary

Can A Plan Be Terminated?

Although pension plans must be established with the intention of being continued indefinitely, employers may terminate plans. If your plan terminates or becomes insolvent, ERISA provides you some protection. In a tax qualified plan, your accrued benefit must become 100 percent vested immediately upon plan termination, to the extent then funded. If a partial termination occurs in such a plan, for example, if your employer closes a particular plant or division that results in the termination of a substantial portion of plan participants, immediate 100 percent vesting, to the extent funded, also is required for affected employees.

What Happens If Your Plan Terminates Without Enough Money To Pay The Benefits? Which Benefits Are Guaranteed?

If your terminated plan is a defined benefit plan insured by Pension Benefit Guaranty Corporation, PBGC will guarantee the payment of your vested pension benefits up to the limited set by law. Benefits that are guaranteed or that exceed PBGC's limits may be paid depending on the plan's funding and on whether PBGC is able to recover additional amounts form the employer. For further information on plan termination guarantees, write to the Pension Benefit Guaranty Corporation, Administrative Review and Technical Assistance Department, 1200 K Street, N.W., Washington, D.C. 20005, telephone (202) 326-4000.

If a plan terminates and the plan purchases annuity contracts from an insurance company to pay pension benefits in the future, plan fiduciaries must take certain steps to select the safest available annuity. Thus, in accordance with Department of Labor guidance, the plan must conduct a thorough search with respect to the financial soundness of insurance companies that provide annuities, to better assure the future payment of benefits to participants and beneficiaries.

Tip About 401k
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Is Your Accrued Benefit Protected If Your Plan Merges With Another Plan?

Your employer may choose to merge your plan with another plan. If your plan is terminated as a result of the merger, the benefit you would be entitled to receive after the merger must be at least equal to the benefit you were entitled to receive before the merger. Special rules apply to mergers of multi-employer plans, which are generally under the jurisdiction of the PBGC.

Overview

  1. Guidance is provided on valuing assets in a qualified retirement plan.
  2. An accurate assessment of fair market value (FMV) is essential to a plan's ability to comply with the Internal Revenue Code requirements and Title I of ERISA. For instance, the FMV of assets must be accurately determined to preclude a(n)--
    • Prohibited transaction;
    • Exclusive benefit violation under IRC 401(a);
    • Violation of the limitation on benefits and contributions under IRC 415;
    • Excess deduction under IRC 404;
    • Violation of the minimum funding requirements under IRC 412; or
    • Discrimination violation under IRC 401(a)(4).

Valuation in Different Types of Plans

  1. In a defined benefit plan, the valuation of trust assets will determine if the plan is adequately funded and if the plan's funding assumptions are reasonable. This, in turn, will affect the employer's deduction.
  2. In a profit sharing, money purchase, or stock bonus plan, the valuation of assets will determine the value of a participant's account, and ultimately, a participant's distribution.
  3. In an Employee Stock Ownership Plan (ESOP), the valuation will affect both the deduction and distribution. Also, IRC 401(a)(28)(C) requires an ESOP to obtain valuations by an independent appraiser of employer securities which are not readily tradeable on an established securities market, with respect to activities carried on by the plan.

Formality of Valuation

  1. Whether a formal valuation is required will depend on the transactions that occur with the plan and the form of the plan.
    1. For example, the valuation in a single participant plan, a self-directed account, or frozen plan can be less formal in a year in which the plan or self-directed account receives no contribution and makes no distribution or change in investment.
  2. The reasonableness of the method for valuing plan assets is based on the surrounding facts and circumstances. Except for certain employer securities held by an ESOP, there is no absolute requirement the annual valuation be based on an independent appraisal. On the other hand, it may be reasonable for an agent to request an appraisal for hard-to-value assets under certain circumstances, such as when distributions are made to plan participants.

Form 5500 Information

  1. Form 5500 requires a statement of plan assets valued at FMV as of the beginning and end of the current plan year.
  2. The income statement on Form 5500 asks for unrealized appreciation or depreciation in plan assets.
  3. A question on Form 5500-C asks whether any non-cash contributions (real estate, collectibles, and closely held stock, etc.) were made to the plan, the value of which was set without an appraisal by an independent third party.
    NOTE:
    The Service's position is that contributions of property of pension plans and certain other defined contribution plans are prohibited transactions if they are not covered by a statutory or administrative exemption. The Supreme Court ruled in favor of the Service on 5/15/93, in Keystone Consolidated Industries v. Commissioner .
  4. A question on Form 5500 asks whether the plan purchased or received any nonpublicly traded securities that were not appraised by an independent third-party appraiser.

Examination Steps

  1. A valuation problem may exist if any of these items are found on Form 5500.
  2. Determine whether the plan reports assets with level values in successive years.
    1. If the same value for an asset was reported on Form 5500 for the prior year, it may indicate a yearly valuation was not performed, requiring further examination.
    2. The value of some types of investments may not change each year, e.g., certificates of deposit and U.S. government securities.
  3. Determine whether there is a sudden jump in plan asset values in the same year a large distribution is made to highly compensated employees. The plan assets may not have been revalued in prior years, when distributions were being made to only nonhighly compensated employees, indicating there might be discrimination under IRC 401(a)(4).
    1. In the case of a plan termination, review Form 6088, Distributable Benefits Statement For Terminating Plans, to determine whether only the accounts of highly compensated employees remain at plan termination. Compare it to Form 5500 for the current year to determine whether any nonhighly compensated employees participate in the plan. If none participate, look at Form 5500 for prior years to determine whether distributions were made to only nonhighly compensated employees in such years.
    2. If the plan is not terminating, check Schedule SSA, Annual Registration Statement Identifying Separated Participants With Deferred Vested Benefits, to determine whether mostly the accounts of highly compensated employees who have separated from service remain in the trust.
  4. Refer to the question on Form 5500 on unrealized appreciation/depreciation. A valuation problem may exist if there is no response to this question when the plan reports investments in any corporate stock or security.
  5. Look at the Form 5500 question on non-cash contributions. If there is an exempt contribution of property, determine whether and by whom the property was valued in the year of the contribution.
  6. Look at the Form 5500 question on nonpublicly traded securities. If the plan purchased or received any nonpublicly traded securities not appraised by an independent third-party appraiser, determine whether the securities were valued that year and by whom.

Timing of Asset Valuation

  1. In a defined contribution plan, Rev. Rul. 80-155, 1980-1 C.B. 84, provides that since amounts allocated or distributed to a participant must be ascertainable, the plans must value their trust investments--
    • at least once a year,
    • on a specified date,
    • in accordance with a method consistently followed and uniformly applied.
  2. In a defined benefit plan, IRC 412 requires yearly valuations of plan assets for funding purposes. These valuations must be based on reasonable actuarial assumptions. See Reg. 1.401-2(b).
  3. As provided under Rev. Rul. 69-494, 1969-2 C.B. 88, when employer securities are acquired or sold, the securities must be valued at the time of the transaction.

Interim Valuations

  1. Under Rev. Rul. 80-155, in addition to the required annual valuation, interim valuations are permitted. Thus, a plan provision allowing interim valuations at a trustee's discretion is permitted as long as these valuations are not discriminatory under IRC 401(a)(4).
    1. A plan with a valuation date of January 1, the first day of the plan year, which also requires interim valuations at the end of each month in which significant market fluctuations (as defined in the plan) have taken place, would not be discriminatory on its face.
    2. However, if a defined contribution plan was amended to provide for interim valuations during a time in which plan asset values were rising and in which highly compensated employees were receiving distributions, the plan could violate IRC 401(a)(4).
  2. A decrease in benefits caused by a change in the date for valuing plan assets is not necessarily a decrease in benefits prohibited by IRC 411(d)(6). See Reg. 1.411(d)-4, Q & A-1(d)(8).

Examination Steps

  1. Determine whether there has been an annual valuation of plan assets at FMV.
  2. If there are interim valuations, determine that the plan has an annual valuation date and permits interim valuations.
  3. Check whether interim valuations are discriminatory under IRC 401(a)(4). See, for example, Rev. Rul. 80-155.

Determining Asset Values

  1. Rev. Rul. 59-60, 1959-1 C.B. 237, provides guidance for determining the value of plan assets. Although Rev. Rul. 59-60 provides methods for valuing shares of stock of closely held corporations for estate and gift tax purposes, the factors may be used to determine values of assets in qualified plans.
    1. The factors in Rev. Rul. 59-60 are not an exclusive list of factors for valuing closely-held employer securities. Other factors may be included where appropriate. Also, not all of the listed factors will be relevant to all companies and transactions.
  2. The detail of the plan's valuation should be examined in light of the plan assets involved.
    • For example, the valuation should contain substantial detail if it values a limited partnership interest or a closely held corporation.
  3. Where appropriate, stock values should be discounted due to a lack of marketability and if appropriate, a control premium should be added to the stock value.

Factors for Determining Value

  1. There are a number of factors to consider when determining the value of an asset, for example:
    1. Nature and history of the business issuing the security
    2. General economic outlook and the outlook for the specific industry
    3. Book value of the securities and the financial condition of the business
    4. Company's earning capacity
    5. Company's dividend paying capacity
    6. Goodwill value
    7. Recent stock sales

ERISA 3(18)

  1. ERISA 3(18) applies for purposes of some prohibited transaction exemptions under both ERISA and the Code.
  2. ERISA 3(18) defines the term adequate consideration for "assets other than a security for which there is a generally recognized market" as the FMV of the asset as determined in good faith by the trustee or named fiduciary pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary.
  3. Proposed DOL Reg. 2510.3-18(b)(2) defines "fair market value" as the price at which an asset would change hands between a willing buyer and a willing seller when either party is not under any compulsion to enter into the transaction.

Examination Steps

  1. After careful review of the plan asset valuation, determine if the value assigned to an asset differs from what you expect.
  2. Determine the value of publicly traded securities by checking their price as reported in a newspaper on the valuation date. A local business library has books that publish daily stock prices of all publicly traded companies, and may have a researcher who will provide market values in response to a telephone call as a public service.
  3. In determining the FMV of closely held stock, determine how closely held company shares were valued.
    1. Check whether the share prices as reported on Form 5500 rise and fall with its earnings. If the company's earnings have fallen but the report says the price per share has risen or remained constant, it may indicate an incorrect valuation. Request an explanation.
    2. Determine whether there have been any recent sales of the company's stock. Check to ensure the sales price is consistent with the valuation.
    3. If the current valuation relies on a previous valuation, check the employer's audit report to see if the company's earnings have fallen since the valuation report was written. If they have, it is likely the value of the shares should also have fallen. The plan fiduciary can no longer rely on the price per share from the valuation report because the facts on which it was based have changed. Similar principles apply if the company's earnings have risen since the valuation report was written.
    4. Other factors to be used in determining the FMV of closely held stock include their book value, dividend paying capacity, and the goodwill value of the company.
  4. In an investment or holding company, determine whether the valuation gave the greatest weight to the assets underlying the security to be valued. In a company which sells products or services, determine whether the valuation gave the greatest weight to earnings.
  5. If the valuation appears to be inadequate, its accuracy should be verified by asking for another valuation from a fiduciary or qualified appraiser.

Types of Plan Assets

  1. Plans may invest a portion of their assets in limited partnerships and invest directly in real property, or in mortgages on real property.
  2. Described below is a specific abuse situation involving springing cash value life insurance policies. This discussion does not apply to valuing insurance contracts in general.

Partnerships

  1. The partnership itself can invest in virtually any type of asset.
  2. Generally, limited partnership interests are not listed on national securities exchanges.
  3. The valuation of a plan's interest in a partnership is especially important in a year in which the plan is making a distribution.

Examination Steps

  1. Ask for information regarding how and when the FMV of the partnership was determined.
    1. Ask whether there were sales of or offers for the partnership interests, secondary market trades or quotes, and whether the fiduciary used the general partner's valuation.
    2. Determine the basis for the valuation of the partnership, i.e., if the partnership's value was based on the original cost of the investment, or the capital account (reported on the Schedule K-1, which shows the partner's pro rata share of the partnership's income, losses, credits and deductions). Such valuations may not reflect the FMV of the partnership.
  2. The fact a partnership has had no earnings may indicate the partnership is worthless. To determine whether the partnership had earnings, request the plan's K-1's. Depending on the circumstances, the specialist may want to request K-1's for prior years.

Real Estate

  1. Mortgages valued at cost may be incorrectly valued if based solely on the purchase price of the real estate.
  2. Under special circumstances, the mortgage's valuation should reflect the current value of the real property.
    1. For example, if the FMV of property held for investment by the plan is lower than the indebtedness secured by the property, the value of the mortgage should be marked down. Also, the value of the mortgage is based on the loan balance.

Examination Steps

  1. To ascertain the value of real estate held by the plan, check the appraisal report, tax assessment document, and the property insurance policy.
  2. Compare the loan or mortgage balance to the appraised value of the property.
  3. The property's best use is one criteria in valuing the asset. Determine what the property is actually used for. If the property's best use is different than the property's actual use, the property may not have been properly valued.
  4. In a defined contribution plan, ascertain if any sudden increases in value coincided with distributions to highly compensated employees.

Springing Cash Value Life Insurance

  1. These principles apply to a specific abuse situation regarding springing cash value life insurance policies, and do not apply to valuing insurance contracts in general.
  2. Certain qualified plans purchase a life insurance product known as a "springing cash value" life insurance policy.
    1. Springing cash value life insurance may be purchased for an employee who is about to retire or when the plan is about to terminate.
    2. Advance premiums are paid by the trust to acquire the policy. The cash surrender value reported in the policy document for the first few years during which the policy is in effect is generally low. However, the death benefit is high to protect the employees' beneficiaries in the policy's early years. Thus, for the first few years, the cash surrender value reflected in the policy is much lower than the value of the premiums paid or the reserve accumulations. Later, the cash value increases to reflect the advance premiums paid or other reserve accumulations.
  3. When the policy is distributed, the policy's cash surrender value is reported as the amount of the distribution to the employee. However, Reg. 1.72-16(c)(2)(ii) provides that the reserve accumulation in a life insurance contract is the source of and approximates the amount of its cash value.
  4. In view of the high death benefit and springing cash value, participants might be seeking not to be taxed on the full value of the policy because the cash surrender value does not reflect the advance premiums paid until after the year of distribution. See Q&A-10 in Notice 89-25, 1989-1 C.B. 662.

Examination Steps

  1. Determine whether a life insurance policy being distributed by a plan is a springing cash value policy:
    1. Compare the premium(s) paid for the policy or the reserves with the cash surrender value as reported in the policy, especially in the year of distribution.
    2. The cash surrender value should reflect the policy's replacement cost (which should be about equal to the premium(s) paid or the reserves) ensuring that the policy's value is included in gross income upon distribution to the recipient.
    3. Protect the statute of limitations on the related Form 1040 resulting from any adjustments to the recipient's taxable income. See the Discrepancy Adjustment Procedures in IRM 7.6.
Effects of Improper Valuation

  1. Rev. Rul. 80-155 requires that a defined contribution plan's assets be revalued at least annually. If the requirements of Rev. Rul. 80-155 are not met, the plan is not qualified.
  2. If assets are valued more frequently than annually in a way that favors distributions to highly compensated employees, prohibited discrimination under IRC 401(a)(4) could occur.
  3. An improper valuation of qualified plan assets can cause a plan to exceed the limitations on benefits and contributions under IRC 415.
    1. This could occur, for example, if there was an exempt contribution of undervalued property to a plan and the resulting annual additions to participant accounts based on the improper valuation are within the limits of IRC 415, but the annual additions based on FMV of the contributed property would exceed the IRC 415 limits.
    2. Similarly, there could be excess annual additions if property were sold by the plan for more than FMV.
  4. In extreme cases, an exclusive benefit violation under IRC 401(a)(2) may occur if a qualified plan engages in a prohibited transaction in which it acquires property for more than FMV.
Funding and Deductions

  1. Although a contribution of property to a plan may be a prohibited transaction if it is not subject to an exemption, a contribution need not be paid in cash to be deductible under IRC 404. If overvalued property is contributed to the plan, the employer may have deducted an amount in excess of that allowed under IRC 404.
  2. Another possible result of contributing overvalued property either to a money purchase pension plan or a defined benefit plan is the plan may not satisfy the minimum funding standards of IRC 412. This may cause the plan to have an accumulated funding deficiency subject to IRC 4971, the two-tier excise tax.

Prohibited Transactions

  1. Under IRC 4975(d)(13) and ERISA 408(e), a plan may acquire and hold qualifying employer securities and qualifying employer real property.
  2. The acquisition of qualifying employer securities or qualifying employer real property is exempt under IRC 4975(d)(13), only if the securities or real property is sold or acquired for "adequate consideration" as defined under ERISA 3(18). This requires a proper valuation. See the Examination Guidelines For Prohibited Transactions.

Examination Steps

  1. Evaluate purchases of employer securities and employer real property for compliance with prohibited transaction exemption requirements and the exclusive benefit requirements.
  2. If a contribution of property to a plan is subject to a prohibited transaction exemption, determine whether an employer exceeded contribution or deduction limitations by contributing undervalued property to a qualified defined contribution plan. The IRC 4972 excise tax may apply.
  3. Determine whether an improper valuation has caused the plan to violate IRC 415.

ESOP ISSUES

  1. ESOPs must satisfy the annual valuation requirements of Rev. Rul. 80-155 for defined contribution plans.
  2. ESOPs have special valuation rules in certain circumstances. See 8.7.2.

Independent Appraiser Rules

  1. IRC 401(a)(28)(C) provides that an ESOP is not a qualified plan unless all valuations of employer securities that are not readily tradeable on an established securities market, with respect to activities carried on by the ESOP, are performed by an independent appraiser.
    1. Valuation by an independent appraiser is not required by IRC 401(a)(28)(C) in the case of employer securities that are readily tradeable on an established securities market (as defined at Reg. 54.4975-7(b)(1)(iv)). See ESOP Examination Guidelines on valuation of employer securities that are readily tradeable.
    2. Valuation by an independent appraiser is not required unless the ESOP holds employer securities acquired after 12/31/86.
  2. An appraiser is independent if requirements similar to those found under IRC 170(a)(1) for a "qualified appraiser" are satisfied. Reg. 1.170A-13(c)(5) provides that a "qualified appraiser" must make a declaration on the appraisal summary that the appraiser:
    1. Holds himself/herself out to the public as an appraiser or performs appraisals on a regular basis;
    2. Is qualified to make appraisals of the type of property being valued; and provides a description of his/her qualifications pursuant to Reg. 1.170A-13(c)(3)(ii)(F).
  3. An appraiser is not independent if:
    1. The appraiser is the taxpayer that maintains the ESOP (or a member of the controlled group of corporations that includes such taxpayer);
    2. The appraiser is a party to the transaction in which the ESOP acquired the property;
    3. The appraiser is employed by the taxpayer maintaining the ESOP (or any entity described in subparagraphs a. or b., above);
    4. The appraiser is regularly used by any entity described above and does not perform a majority of his/her appraisals for entities other than those described above.
  4. A valuation of employer securities by an independent appraiser is required with respect to any activities carried on by the plan. These activities include the contribution of employer securities to an ESOP, the purchase of employer securities by an ESOP and distributions to participants.
    1. Employer securities are not necessarily required to be valued by IRC 401(a)(28)(C) as of the date of the plan activity. The plan can use the most recent annual valuation done on the plan's valuation date by an independent appraiser.
    2. Plan activities requiring valuations also include the offer of employer securities to the employer by a participant under a right of first refusal, the exercise of a put option by a participant to sell shares to the employer and the allocation of assets to participants' accounts. See Reg. 54.4975-11(d)(5).
    3. A participant's diversification election under IRC 401(a)(28)(B) is a plan activity requiring a valuation by an independent appraiser.
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