RESTRICTIONS ON A PENSION PLAN PARTICIPANT'S ABILITY TO ELECT A LUMP SUM PAYMENT OPTION MAY BE DISCRIMINATORY; FOUR EXAMPLES ARE GIVEN

ISSUE

In the situations described below, do the restrictions on the availability of a single sum option cause the retirement plans to fail to satisfy the nondiscrimination requirements of section 401(a) of the Internal Revenue Code?

FACTS

In each of the situations described below, the retirement plan provides that when a participant attains normal retirement age, the participant may elect (and, if required by the Retirement Equity Act of 1984, with spousal consent), as an alternative to the normal form of benefit provided under the plan to receive his or her benefit in a single sum that is actuarially equivalent (as specified in the plan) to the normal form. However, each of the plans places certain eligibility conditions on this election.

Situation 1: Plan A provides that a single sum is available only to employees earning $50,000 or more in the final year of employment. Based on the facts and circumstances of the employer maintaining Plan A, employees earning $50,000 or more per annum are highly compensated and employees earnings less than $50,000 are not highly compensated.

Situation 2: Plan B provides that a single sum is available only to employees who furnish evidence that they have a net worth above a certain specified amount.

Situation 3: Plan C provides that a single sum is available only to employees who present a letter from their accountant or attorney declaring that it is in the employee's best interest to receive a lump sum.

Situation 4: Plans D, E, and F provide that the trustees will determine whether any participant may receive a single sum distribution. Although the Plans do not specify what selection criteria the trustees will use, the trustees uniformly and consistently apply the standards in Situation 1, 2, and 3, respectively.

LAW AND ANALYSIS

Section 401(a) of the Code provides that a qualified plan must be for the exclusive benefit of employees or their beneficiaries.

Section 401(a)(4) of the Code provides that a qualified plan must provide either contributions or benefits that do not discriminate in favor of employees who are officers, shareholders, or highly compensated (the prohibited group).

Section 1.401-1(b)(3) of the Income Tax Regulations provides that a plan is not for the exclusive benefit of employees in general if, by any device whatever, it discriminates either in eligibility requirements, contributions, or benefits in favor of the prohibited group.

Section 1.401-4(a)(2)(iii) of the regulations provides that variations in benefits may be provided, so long as the plan, viewed as a whole, does not discriminate in favor of the prohibited group.

Nothing in the law or regulations precludes the providing of certain options subject to certain restrictions. However, when these restrictions may operate to provide the restricted option primarily to the prohibited group, such restriction causes the plan to become discriminatory within the meaning of section 401(a)(4) of the Code.

Rev. Ruls. 71-296, 1971-2 C.B. 202 and 71-540, 1971-2 C.B. 206 hold that pension and profit-sharing plans (respectively) will not fail to satisfy the requirements of section 401(a) of the Code (particularly section 401(a)(4)) merely because they grant discretion to the trustee to choose between actuarially equivalent benefit payment options for each participant.

Although these revenue rulings indicate that trustee discretion in those circumstances is not necessarily discriminatory, this does not mean that the use of the discretion might not result in discrimination in operation. Thus, if the trustee selects benefit payment options for participants in a way that favors the prohibited group, the plan will fail to satisfy section 401(a) of the Code.

Under Plan A a single sum is available only to those employees who earn at least $50,000. Under the applicable facts and circumstances, the Plan thus provides a benefit (the option to receive a single sum) to highly compensated employees that is not available to employees earning less than $50,000. Accordingly, Plan A fails to satisfy the requirements of section 401(a) of the Code.

Under Plan B and Plan C a single sum is paid only to employees who satisfy certain conditions. These conditions are not discriminatory per se. However, these plans will fail to satisfy the requirements of section 401(a) of the Code if, in operation, the percentage of prohibited group employees who receive single sums is significantly higher than the percentage of rank and file employees who receive single sums.

The conclusions for Plans A, B, and C apply also for Plans D, E, and F, respectively. The fact that the conditions on the availability of single sum payments are not written into the Plans, but instead are applied administratively, does not prevent these plans from being discriminatory in operation.

HOLDINGS

Situation 1: The retirement option provision in Plan A causes that plan to fail to satisfy the nondiscrimination requirements of section 401(a) of the Code.

Situations 2 and 3: The retirement option provisions in Plans B and C do not result in discrimination per se. However, these plans will fail to satisfy the requirements of section 401(a) of the Code if, in operation, the provisions cause those plans to discriminate in favor of the prohibited group.

Situation 4: The provisions allowing the trustees to use discretion in administering the retirement option provisions in Plans D, E, and F do not result in discrimination per se. However, these plans will fail to satisfy the requirements of section 401(a) of the Code if, in operation, administrative practices cause the Plans to discriminate in favor of the prohibited group.

EFFECT ON OTHER DOCUMENTS

Because the positions in those revenue rulings are restated in this revenue ruling, Rev. Ruls. 71-296 and 71-540 are superseded.