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

• Author: Walker, Deborah

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

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

Active participation requirement

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

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