IRS SPECIFIES REQUIREMENTS FOR DEFINED BENEFIT PLAN CONVERSION.

Rev. Rul. 94-75

ISSUES

(1) May a defined benefit pension plan qualified under section 401(a) of the Internal Revenue Code that is subject to the minimum funding requirements of section 412 be converted to a defined benefit pension plan qualified under section 403(a) that is described in section 412(i) (section 412(i) plan)?

(2) If the conversion described in issue (1) can be made, how is the limit under section 404(a)(1)(A) on deductible contributions to the plan determined for the year of conversion and subsequent years?

FACTS

Plan PL is a defined benefit pension plan and trust qualified under section 401(a) with a calendar plan year and a valuation date of January 1. Plan PL is maintained by employer ER, a calendar year taxpayer. As of January 1, 1994, the fair market value of plan PL's assets was one million dollars. There were no outstanding loans to participants under plan PL. Plan PL is not a top-heavy plan within the meaning of section 416 for the 1994 plan year. Before 1994, plan PL was not a section 412(i) plan.

On December 10, 1993, plan PL was amended effective as of January 1, 1994, to become a nontrusteed annuity plan intended to be qualified under section 403(a). Under these amendments, the terms of plan PL satisfy the requirements of sections 412(i)(1), (3), (4), (5) and (6) beginning on January 1, 1994. Under plan PL as amended, all benefit accruals on and after January 1, 1994, will be funded exclusively by insurance or annuity contracts that provide for level annual premium payments. Plan PL provides that level annual premium payments for each participant are to be paid for the period commencing with the later of the 1994 plan year or the first plan year of the participant's participation in plan PL and ending with the plan year the participant attains normal retirement age. Benefit accruals after normal retirement age are to be funded by insurance or annuity contracts as they accrue.

On January 1, 1994, a single premium deferred annuity contract was purchased for each plan participant. Each contract was guaranteed, beginning on January 1, 1994, by a life insurance company to provide the payment of the participant's benefits accrued prior to January 1, 1994, including any optional forms of payment at each retirement age available under the plan. The premium for each participant's single premium contract was the minimum amount required by the insurer to guarantee, beginning on January 1, 1994, the payment of that participant's accrued benefit. The total purchase price of the single premium contracts was $1,300,000.

In addition, a level annual premium deferred annuity contract was purchased for each participant in plan PL on January 1, 1994, to provide for the excess, if any, of the participant's projected normal retirement benefit over the portion of the normal retirement benefit provided by the single premium contract purchased for that participant. For purposes of determining the projected normal retirement benefit, it was assumed the amount of each participant's current compensation would not change prior to the participant's normal retirement age. For 1994, the total of the level annual premiums to provide the additional normal retirement benefits under the terms of plan PL (post-conversion benefit accruals) was $50,000.

The costs of the single premium annuity contracts purchased to fund participants' benefits accrued prior to January 1, 1994, and the level annual premium contracts purchased to fund participants' post- conversion benefit accruals were reasonable in view of the funding medium and reasonable expectations as to the effects of mortality, interest and other pertinent factors.

On January 1, 1994, in addition to the one million dollars in existing plan assets that was paid to the insurance company, employer ER paid a plan contribution of $350,000 (the total premium due of $1,350,000 less plan assets of one million dollars) to the insurer to meet the 1994 premium requirement for all annuity contracts.

Plan PL, the only defined benefit plan maintained by employer ER, does not have more than 100 participants. As of January 1, 1994, no additional amounts contributed to plan PL could be deducted by employer ER for the 1993 plan year. As of the end of 1993, there were no unamortized 10-year amortization bases with respect to plan PL for purposes of section 404(a)(1)(A), and no nondeductible contributions were carried over to 1994 under section 404(a)(1)(E).

LAW AND ANALYSIS

ISSUE (1)

Section 412 provides minimum funding requirements for qualified pension plans. Pursuant to these requirements, a funding standard account must be maintained, and a valuation date must be established to determine the minimum required funding for each plan year.

Rev. Rul. 79-237, 1979-2 C.B. 190, provides that the minimum funding requirements and the funding standard account continue to apply to a terminating pension plan until the end of the plan year during which the plan terminates.

Section 412(i) describes certain insurance contract plans that are exempt under section 412(h)(2) from the minimum funding requirements. Section 412(i)(2) requires that the insurance contracts that fund such a plan must provide for level annual premium payments to be paid commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time the increase becomes effective) and extending not later than the retirement age for each individual participating in the plan.

If an existing defined benefit plan is converted to a plan under which future accruals are funded in the manner prescribed by section 412(i), level premium payments will begin with the year of conversion. The level annual premium payments will therefore start after the dates on which existing participants became participants in the plan. Therefore, the plan would not satisfy section 412(i)(2) following the conversion and would not be exempt under section 412(h)(2) from the minimum funding requirements of section 412.

Rev. Rul. 81-196, 1981-2 C.B. 107, provides an exception to the requirement that premiums commence with participation by deeming defined benefit plans that have not been section 412(i) plans to satisfy section 412(i)(2) if certain requirements are met. The revenue ruling considers a conversion made on the first day of a plan year and provides that the level annual premium requirement will be deemed satisfied for all years after the conversion.

This revenue ruling clarifies the requirements for conversion of a plan to a section 412(i) plan that were set forth in Rev. Rul. 81-196. An existing defined benefit plan subject to section 412 that, in accordance with the requirements specified below, is converted to a plan funded in the manner prescribed by section 412(i) will be deemed not to fail the requirements of sections 412(i)(2), 403(a) and 404(a)(2) merely because of the conversion, or merely because of participation in the plan before level annual premiums commence. The date on which the conversion is deemed to occur (the conversion date) is the first day of the first plan year for which the plan satisfies these requirements:

(1) The plan otherwise satisfies the requirements of sections 412(i), 403(a) and 404(a)(2) for the plan year containing the conversion date.

(2) All benefits accruing for each participant on and after the conversion date are funded by level annual premium contracts that satisfy the requirements of section 412(i)(2).

(3) All benefits accrued for each participant before the conversion date are guaranteed through insurance or annuity contracts, the purchase price of which equals the minimum amount required by the life insurance company for a contract that guarantees, on and after the conversion date, to provide the participant's accrued benefits, including any optional forms of payment at each retirement age available under the plan.

(4) There are meaningful continuing benefit accruals under the plan after the conversion date. A plan is considered to satisfy this requirement if there are meaningful benefit accruals under the plan for at least three plan years ending after the conversion date.

(5) The following actions are taken on or before the conversion date: (a) contracts are purchased guaranteeing the benefits accrued before the conversion date; (b) any remaining plan assets are applied to the payment or prepayment of premiums for level annual premium contracts described in (2) above; and (c) any plan amendments necessary to satisfy these requirements for conversion and the requirements of sections 412(i), 403(a) and 404(a)(2) are adopted and made effective. Contracts purchased within one month after the first day of a plan year are deemed to be purchased on the first day of the plan year for purposes of this requirement.

If these requirements for conversion are not satisfied on or before the first day of a plan year, the minimum funding requirements and funding standard account of the plan continue to apply to the plan for that plan year.

Section 411(b) provides rules relating to the rate at which benefits under a qualified plan must accrue. Under section 411(b)(1)(F), where a defined benefit plan is funded exclusively by the purchase of insurance contracts and satisfies the requirements of sections 412(i)(2) and (3), the plan satisfies section 411(b) if each employee's accrued benefit as of any date is not less than the cash surrender value his insurance contracts would have on that date if the requirements of sections 412(i)(4), (5) and (6) were satisfied. A plan that is deemed converted to a section 412(i) plan in accordance with this revenue ruling is deemed to satisfy section 412(i)(2) for purposes of section 411(b)(1)(F). The requirements for conversion set forth in this revenue ruling must be satisfied regardless of whether the plan satisfies section 411(b) only by means of section 411(b)(1)(F) after the conversion.

Section 416 provides minimum benefit and vesting requirements for a top-heavy plan. A top-heavy plan is a plan under which more than 60 percent of the present value of the benefits earned under the plan are for key employees, who are employees meeting criteria relating to minimum compensation or minimum ownership interest in the employer. Under question-and-answer M-17 of section 1.416-1, a top- heavy plan may be described in section 412(i) despite the fact that certain benefits that must be provided to satisfy the minimum benefit requirement of section 416 are funded through either deferred annuity contracts or an auxiliary fund (subject to section 412). If a top- heavy plan satisfies the requirements for conversion to a section 412(i) plan set forth above but for the fact that certain plan benefits are funded through deferred annuity contracts or an auxiliary fund as provided in question-and-answer M-17 of section 1.416-1, the plan is considered to satisfy the requirements for conversion to a section 412(i) plan pursuant to this revenue ruling.

Section 403(a) provides that, if an annuity contract is purchased under a plan that satisfies the requirements of section 404(a)(2), the benefits under the contract are treated in a manner similar to the treatment of benefits under a trusteed plan qualified under section 401(a).

In the present case, the single premium deferred annuity contracts guaranteeing the payment of prior benefit accruals were purchased for $1,300,000 during the first month of the 1994 plan year, all remaining plan assets ($50,000) were applied to purchase level annual premium contracts during the first month of that plan year, and plan amendments were made before and effective on the first day of that plan year. January 1, 1994, is therefore the conversion date. Accordingly, the minimum funding requirements of section 412 do not apply to plan PL for the 1994 plan year and later years. This conclusion is based upon the assumptions that plan PL provides meaningful continuing benefit accruals after the conversion date and that plan PL satisfies all the requirements of sections 403(a), 404(a)(2), and 412(i)(1),(3),(4),(5) and (6) on and after the conversion date.

ISSUE 2

Section 404(a)(2) provides that employer contributions paid toward the purchase of retirement annuities are deductible in accordance with section 404(a)(1) if the applicable requirements of section 401(a)(3) through (20), (22), (26), (27), and (31) and section 401(d) are satisfied and if any refunds of premiums are used in the current or next succeeding taxable year to purchase retirement annuities.

Section 404(a)(1)(A) limits the amount deductible for contributions to a qualified pension trust. Three separate deductible limits are set forth in sections 404(a)(1)(A)(i), (ii) and (iii).

Section 404(a)(1)(A)(i) provides that the amount necessary to satisfy the minimum funding requirement under section 412 is deductible even if it is greater than the amount determined under section 404(a)(1)(A)(ii) or (iii), whichever is applicable with respect to the plan.

The alternative limit determined under section 404(a)(1)(A)(ii) is the amount necessary to provide the remaining unfunded cost of all participants' past and current service credits as a level amount, or as a level percentage of compensation, over the remaining future service of each participant. However, if the remaining unfunded cost with respect to any three individuals is more than 50 percent of all remaining unfunded cost, the amount attributable to those individuals is distributed over a period of at least five years.

The alternative limit determined under section 404(a)(1)(A)(iii) is the normal cost of the plan plus, if past service or other supplementary pension or annuity credits are provided by the plan, the amount necessary to amortize the unfunded costs attributable to those credits in equal annual payments over 10 years.

Section 404(a)(1)(D) provides in general that, for a defined benefit plan that has more than 100 participants, the maximum amount deductible under the limitations of section 404(a)(1) is not less than the unfunded current liability determined under section 412(l).

Section 1.404(a)-3(b) of the Income Tax Regulations provides that in no event shall the limitations under section 404(a)(1) for pension or annuity plans exceed costs based on assumptions and methods that are reasonable in view of the funding medium and reasonable expectations as to the effects of mortality, interest and other pertinent factors.

Section 1.404(a)-14 provides rules for determining the deductible limits under section 404(a)(1)(A)(i), (ii) and (iii). The regulations provide in general that the limit on deductible amounts contributed for an employer's taxable year is based on the amounts determined for purposes of section 412 for the applicable plan year or years.

Section 404(a)(1)(E) provides that an amount contributed to a plan that would otherwise be deductible, but that exceeds the limitations of section 404(a)(1), is deductible in future tax years to the extent of the difference between the amount contributed and the maximum amount deductible for each succeeding year under section 404(a)(1).

Section 4972 imposes a ten-percent excise tax on nondeductible contributions to a qualified plan, including nondeductible contributions carried over from preceding years.

Rev. Rul. 81-196 states that an additional contribution made to guarantee the benefits accrued prior to the conversion of a defined benefit plan to a section 412(i) plan is deductible in accordance with the rules under section 404(a)(1)(A).

When a defined benefit plan that has been subject to section 412 is deemed converted to a section 412(i) plan, the deduction limitations under section 404(a)(1)(A) with respect to plan years ending prior to the conversion date are derived from the funding standard account requirements in accordance with section 1.404(a)-14. Accordingly, with respect to any plan year ending prior to the conversion date, the deductible limit under section 404(a)(1)(A) with respect to the plan is the greater of (1) the amount necessary to satisfy the minimum funding requirement under section 412, as provided in section 404(a)(1)(A)(i), or (2) the deductible limit calculated under section 404(a)(1)(A)(ii) or (iii), whichever applies to the plan. Except for the funding of the additional benefits described in question-and-answer M-17 of section 1.416-1, for the conversion year and succeeding plan years in which the plan is deemed a section 412(i) plan, section 404(a)(1)(A)(i) no longer applies because the minimum funding requirements of section 412 no longer apply to the plan.

After a defined benefit plan is deemed converted to a section 412(i) plan, all benefits accrued as of the conversion date will have been guaranteed through contracts issued by an insurance company without any required future premiums. Therefore, only the costs of future benefit accruals (including future benefit increases) are allocated to future service. All other costs are allocated to prior years. This type of allocation is consistent with the cost allocation under a reasonable funding method for a defined benefit plan that is subject to section 412, with an accrued liability equal to the actuarial present value of accrued benefits and to which section 404(a)(1)(A)(iii) applies. Therefore, to determine the deductible limit with respect to plan years beginning on or after the conversion date, section 404(a)(i)(A)(iii) is applicable.

The employer's deductible limit with respect to the conversion year and succeeding plan years, other than for any contribution to fund additional benefits described in question-and-answer M-17 of section 1.416-1, is the sum of (1) the normal cost for a section 412(i) plan established on the conversion date for post-conversion benefit accruals, (2) the limit adjustments, if any, for any 10-year amortization bases remaining unamortized as of the conversion date that are maintained for purposes of section 404(a)(1)(A)(iii), and (3) the limit adjustment, if any, for any 10-year amortization base created on account of treating the plan as if terminated for purposes of section 412 as of the last day of the plan year immediately preceding the conversion year (pre-conversion year). Normal cost under section 404(a)(1)(A) and section 1.404(a)-14 is based on the annual premiums for level annual premium contracts providing for the post-conversion benefit accruals (and any increases in benefits) that are reasonable in view of the funding medium and reasonable expectations as to the effects of mortality, interest and other pertinent factors. Ten-year amortization bases under section 1.404(a)-14 remain or are established based on treating the conversion as a change to the unit credit funding method (if that was not the funding method of the plan for the pre-conversion year) with the accrued liability as of the conversion date deemed to be equal to the reasonable cost of single premium contracts guaranteeing benefits accrued prior to the conversion date (conversion accrued liability).

If, as of the conversion date, there are no unamortized 10-year amortization bases under section 404(a)(1)(A)(iii) and section 1.404(a)-14 with respect to the plan, a new 10-year amortization base is established on conversion equal to the excess, if any, of (1) the conversion accrued liability over (2) the value of plan assets minus the sum of (a) any carryover under section 404(a)(1)(E) from the prior taxable year plus (b) any contribution made for the current taxable year that is included in plan assets. The sum of (a) plus (b) is referred to as undeducted contributions.

If, as of the conversion date, there is at least one unamortized 10-year amortization base under section 404(a)(1)(A)(iii) and section 1.404(a)-14 with respect to the plan and the conversion accrued liability is greater than the value of plan assets minus any undeducted contributions, a new 10-year amortization base is established on conversion equal to (1) the conversion accrued liability minus (2) the sum of (a) the value of plan assets less any undeducted contributions plus (b) the net unamortized balance of any existing 10-year amortization bases under section 404(a)(1)(A)(iii) (treating negative bases as having negative unamortized amounts). This new 10-year amortization base may be negative. Any existing 10- year amortization base under section 404(a)(1)(A)(iii) for a plan that remains unamortized as of the conversion date must continue to be maintained. These new and existing 10-year amortization bases are maintained in the same manner as bases maintained following the termination of a plan subject to section 412. The bases may be combined or replaced in accordance with the general method or the fresh start alternative under section 1.404(a)-14(i).

If, as of the conversion date, a plan's conversion accrued liability is not greater than the value of plan assets minus any undeducted contributions, no new base is established and all existing bases are considered fully amortized.

In the present case, plan PL was deemed converted to a section 412(i) plan as of the first day of the 1994 plan year. Accordingly, the funding standard account for plan PL was terminated as of December 31, 1993. In connection with the conversion of plan PL, employer ER contributed $350,000 to the plan on January 1, 1994. This amount, combined with existing plan assets of one million dollars, was used to purchase single premium deferred annuity contracts for $1,300,000 and to pay the level annual premium of $50,000 for 1994.

The deductible limit under section 404(a)(1)(A) with respect to plan PL for the conversion year and thereafter is determined under section 404(a)(1)(A)(iii). The conversion process is treated under section 404(a)(1)(A)(iii) and section 1.404(a)-14 as creating a 10- year amortization base of $300,000. This is equal to (1) the conversion accrued liability ($1,300,000) minus (2) the sum of (a) the value of plan assets less any undeducted contributions ($1,350,000 in plan assets, less $350,000 in undeducted contributions) plus (b) the net unamortized balance of any existing 10-year amortization bases under section 404(a)(1)(A)(iii) ($0). This 10-year amortization base of $300,000 is maintained under section 404(a)(1)(A)(iii) and section 1.404(a)-14 in the same manner as a base would be maintained following the termination of a plan subject to section 412.

Section 404(a)(1)(D) does not apply to the plan because all defined benefit plans of employer ER, including plan PL, do not have more than 100 total participants. Therefore, the deductible limit under section 404(a)(1) with respect to the plan is calculated solely under section 404(a)(1)(A), regardless of whether the plan's unfunded current liability exceeds the amount deductible under section 404(a)(1)(A).

The contributions paid by employer ER as premiums for the annuity contracts that are not deductible under section 404(a)(1)(A) for the 1994 taxable year are nondeductible contributions for 1994 and are subject to the excise tax on nondeductible contributions under section 4972.

HOLDINGS

ISSUE (1)

An existing defined benefit plan under which participants have accrued benefits may not be converted to a section 412(i) plan because the plan would fail to satisfy section 412(i)(2). However, any plan that satisfies the requirements for conversion to a section 412(i) plan enumerated in this revenue ruling will be deemed not to fail section 412(i)(2) merely because individuals participated in the plan before the conversion.

ISSUE (2)

If a defined benefit plan is deemed converted to a section 412(i) plan by satisfying the requirements for conversion enumerated in this revenue ruling, the deductible limit under section 404(a)(1)(A) is determined under section 404(a)(1)(A)(iii) for plan years beginning after the date of termination of the funding standard account.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 81-196 is clarified and superseded.

PROSPECTIVE APPLICATION

Under the authority of section 7805(b), the provisions of this revenue ruling under sections 404, 412, and 4972 shall not apply to a plan for a plan year if all requirements for a plan to be considered converted to a section 412(i) plan under Rev. Rul. 81-196 are satisfied on or before the last day of the plan year and before December 31, 1994, and there are meaningful continuing benefit accruals under the plan after the conversion.

DRAFTING INFORMATION

The principal author of this revenue ruling is Kenneth R. Conn of the Employee Plans Division. For further information regarding this revenue ruling, please contact the Employee Plans Division's taxpayer assistance telephone service or Mr. Conn between the hours of 1:30 p.m. and 4 p.m. Eastern Time, Monday through Thursday, by calling (202) 622-6074/6075 or (202) 622-6214, respectively. (These telephone numbers are not toll-free numbers.)