“I have a client who set up a cash balance plan a few years ago and now wants to terminate the plan. Is that OK? Or does the IRS require a sponsor to maintain its qualified plan for a certain number of years?”
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with an advisor in Illinois is representative of a common inquiry related to plan termination and the principle of permanency.
Highlights of Discussion
It depends on the reason your client is ending the plan. The IRS has an expectation of plan permanency. “The term ‘plan’ implies a permanent, as distinguished from a temporary, program,” Treasury Regulation 1.401-1(b)(2). However, a plan sponsor reserves the right to change or terminate the plan, and discontinue contributions, but if this happens within a few years after plan establishment, the plan sponsor must document as evidence a valid business reason for terminating the plan. Without documentation of the business necessity, upon examination the IRS will presume the plan was not intended to be a permanent program from its inception. A potential consequence could be the IRS would deem the plan was never qualified and revoke its tax-favored status—making the plan’s assets immediately taxable to participants, and any tax deductions taken by the employer null and void.
What is “a few years?” The IRS gave more insight into the time requirement for plan permanency in Revenue Ruling 72-239, stating a plan that has been in existence for over 10 years can be terminated without a business necessity.
In Revenue Ruling 69-25 the IRS elaborated on what constitutes a “business necessity.” Business necessity, in this context, means adverse business conditions, not within the control of the employer, under which it is not possible to continue the plan, including bankruptcy or insolvency, and discontinuance of the business, along with merger or acquisition of the plan sponsor, provided the merger or acquisition was not foreseeable at the time the plan was created.
IRS examiners are instructed to look for evidence of plan permanency. The IRS’s Employee Plans Guidelines for Plan Terminations at 220.127.116.11 outline the steps examiners must take to evaluate plan permanency, including checking Forms 5310, Application for Determination Upon Termination to determine how long the plan has been in existence, the reason for termination and, if terminated due to adverse business reasons, an explanation detailing the conditions that require the sponsor to end the plan. The examination steps in the Internal Revenue Manual also list the valid business reasons that demonstrate “necessity” for plan termination purposes.
As a fiduciary liability mitigation strategy, a plan sponsor should thoroughly document any decision to terminate its retirement plan, and the reasons for terminating, being mindful of the need for documentation of a valid business reason if termination occurs within a few years after the plan’s initial adoption.
Business owners who have established or who may be contemplating establishing a qualified retirement plan must be aware that the IRS expects the arrangement will be a permanent one. And, although plan sponsors reserve the right to terminate their qualified retirement plans, the IRS views “business necessity” as the only legitimate reason for plan abandonment within the first few years of establishment.