An employer who wishes to terminate a defined benefit pension plan must make sure that the plan is fully funded in order to do so. Sometimes the employer must contribute funds to the plan in order to provide sufficient assets to pay all the benefits on plan termination. A recent private letter ruling addressed the situation of an employer who over contributed to the plan on plan termination.

Generally speaking, on plan termination, an employer can take a reversion of assets not needed to pay benefits if the plan so provides. However, the amount of the reversion is subject to an excise tax of 50 percent (20 percent if a qualified replacement plan is established) under Section 4980 of the Internal Revenue Code. Therefore, employers are often careful to make certain that they do not over contribute to the plan, particularly as the time for final payout approaches.

In the private letter ruling, the employer selected an insurer to provide an annuity to fund the benefits for the plan participants. Based on the data provided to the insurer, the employer made an initial and a subsequent contribution to the plan in order to make sure that the plan had sufficient assets to fully pay for the annuity. However, because of changes in the participant data, the insurer later revised the premium amount and issued a refund to the plan. The refund was less than the amount of the final contributions that the employer made to fund the annuity. The employer asked the IRS if it could take the reversion without having to pay the reversion tax.

The IRS first determined that the refund was in effect a contribution made under a mistake of fact. The mistake was an error in the calculation of the amount of the annuity premium. Under ERISA and the tax code, contributions made under a mistake of fact can be returned within one year of when they were made. However, more than a year had passed since the employer had requested the private letter ruling so the employer could not take advantage of that rule. The IRS then concluded that a reversion does not include an amount distributed to an employer by reason of a mistake of fact. The IRS concluded that the refund fit in that category and so therefore was not a reversion subject to the reversion tax.

In the situation described in the private letter ruling, because the final contributions were clearly in excess of what was needed to fund the annuity, the IRS could easily conclude that the excess contribution was a mistake of fact. In a more typical situation, a reversion might be attributable to actuarial assumptions that resulted in plan overfunding (not a typical situation in these days of low interest rates, but in years past, there were overfunded plans). An employer might argue that contributions based on erroneous actuarial assumptions are contributions based on a mistake of fact – the mistake being the actuarial assumptions that turned out to be incorrect.

The reversion tax was added to the Internal Revenue Code to prevent employers from taking deductions for contributions not needed to fund a plan, which allowed the assets of the plan to grow tax free, and then which also allowed the employer to take back the excess assets on plan termination. In this case, it was clear that the employer was not attempting to use the plan as a way to build tax free assets since the excess amounts were contributed only on plan termination and only in an amount necessary to pay the insurer what the insurer had requested. However, the logic could be used by employers where the reversion may have been based on “mistaken” contributions made long before the plan termination.

Employers should remember that only the taxpayer who requests and receives the private letter ruling can rely upon it. An employer would not want to rely upon this ruling to avoid a reversion tax without its own legal opinion or its own private ruling from the IRS.