In a recent client representation, McDermott Will & Emery successfully obtained a significant excise tax refund from the Internal Revenue Service (IRS). It was argued that no Section 4980 excise tax is due when 100 percent of the excess assets of a terminating defined benefit pension plan are transferred to a qualified replacement plan, in this case an ESOP. Various IRS rulings were argued followed by a suit in federal district court. The government apparently reversed a longstanding IRS ruling position and conceded the case. Although the current IRS National Office position on this issue is not clear, the government’s concession in this case may provide other taxpayers an opportunity to achieve the same result.
Internal Revenue Code Section 4980 generally imposes a 50 percent excise tax on the amount of any “employer reversion” in connection with the termination of a defined benefit pension plan. The term “employer reversion” is defined as the amount of cash or other assets “received (directly or indirectly) by an employer from the qualified plan.” In the typical case, this reversion amount consists of the assets remaining (and reverted to the employer) when a terminated overfunded defined benefit plan has otherwise provided for all benefits owed under the plan. In addition to the excise tax, the employer ordinarily owes federal and any state income taxes on the amount of a reversion.
The 50 percent excise tax amount can be lowered to 20 percent if the employer transfers an amount equal to 25 percent of the excess assets to a “qualified replacement plan.” Moreover, Section 4980 indicates that excess assets actually transferred to a qualified replacement plan are not treated as employer reversions for purposes of Section 4980 and are not included in the gross income of the employer. A qualified replacement plan is a qualified plan that must satisfy several requirements, including a requirement that 95 percent of the active participants in the terminated plan be active participants in the qualified replacement plan. Amounts transferred to the qualified replacement plan can be assigned to a suspense account and allocated ratably over a period of up to seven years.
At no point in this case did the government explain its position or its response to arguments. The IRS stated it would decline to rule on the requests and return the taxpayer’s user fees. The IRS representative indicated further that there were no other pending ruling requests in which these issues were presented, and that they would “deal with” any effect of the concession in this case the next time it is presented with an opportunity to do so.
The concession of this case is significant, however, and should be an important factor the next time the IRS is presented with this issue in a ruling request. Moreover, it is fairly clear that the U.S. Department of Justice (DOJ), which is charged with handling refund cases, holds the view that no excise tax is due on amounts transferred from a terminating defined benefit plan directly to a qualified replacement plan. It is reasonable to expect that if confronted with a decision in the future about whether to resist such a refund claim, the DOJ would reach the same conclusion as it did in this case. Moreover, the government’s concession required consultation with the IRS National Office, suggesting some wavering in that office’s ruling position.
Until the IRS National Office position is clarified, it is recommended that a company interested in terminating its overfunded defined benefit plan and transferring the excess assets to an ESOP or other type of plan follow the same path as the taxpayer in this case. This would include applying for a private letter ruling at the same time that the defined benefit plan termination process is initiated. The termination process normally takes about 9 to 12 months, and in this period it is possible that IRS would reverse its prior ruling position and issue a favorable ruling. Barring a favorable ruling, any other company interested in obtaining a refund should be prepared to file a suit claiming the refund.