Rev. Rul. 65-294

Advice has been requested whether the qualification of an employees' pension plan under section 401(a) of the Internal Revenue Code of 1954 would be adversely affected by a provision in the plan which, in addition to providing for the restrictions imposed upon contributions for the benefit of the 25 highest paid employees in the event of early termination of the plan, provides that excess reserves arising from the application of such restrictions shall be applied first to the satisfaction of benefits to unrestricted employees, and any balance remaining shall be applied to the benefit of the restricted employees.

Section 401(a)(4) of the Code provides, in pertinent part, that a trust forming part of a pension plan of an employer for the exclusive benefit of his employees shall constitute a qualified trust if the contributions or benefits thereunder do not discriminate in favor of highly compensated employees.

Section 1.401-4(c) of the Income Tax Regulations provides for the imposition of limitations to be expressly incorporated in a plan when established to preclude discrimination in favor of certain employees in the event of early termination of the plan.

P.S. No. 8, dated August 4, 1944, deals with the proper allocation of excess reserves resulting from application of the required early termination limitations. P.S. No. 8 provides, in general, that any equitable method of distribution of funds upon termination is acceptable if, upon termination of the plan within 10 years after establishment, any excess funds arising from the application of limitations imposed upon the funds for restricted employees are distributed among other employees. Such distribution need not benefit all other participants provided such distribution does not result in substantial discrimination in favor of highly compensated employees. P.S. No. 8 unquestionably contemplates that these excess reserves would be used for the benefit of other (unrestricted) employees to the exclusion of employees whose benefits are restricted. Strict adherence to the principle expounded therein, however, could result in an unrealistic windfall to the other participants.

In applying the principles contained in section 1.401-4(c) of the regulations, the acceptability of a provision for the allocation of excess reserves must be dependent on the facts in each particular case. If it can be demonstrated that the application of a proposed allocation is not likely to result in prohibited discrimination then such an allocation would be acceptable.

The employees' pension plan under consideration is a unit benefit type, providing a pension at a certain age with a minimum number of years of service. The pension is equal to a percentage of final average compensation multiplied by years of service. The average period of service for the lowest paid group, consisting of five employees, is 30 years. The average service for the 25 most highly paid employees is 26 years. For all participants, a total of 3,891 employees, the average service is 25 years. Thus, an analysis of the years of service for each compensation group discloses a uniformity in each group. Since benefits are based upon years of service the average benefit for each group upon termination of the plan, expressed as a percentage of average compensation, would be approximately the same. In this situation, therefore, it does not appear that prohibited discrimination would be likely to result from the proposed allocation of excess reserve funds.

Accordingly, it is held that the qualification of an employees' pension plan will not be adversely affected if it provides that excess reserves, arising from application of restrictions imposed upon benefits of the highest paid employees in the event of early termination of the plan, are to be applied in a nondiscriminatory manner for the benefit of other employees. After satisfaction of liabilities to such unrestricted employees, the allocation of any such excess reserves remaining, based upon the attendant facts and circumstances in each case, may also be used to benefit the restricted employees where it is not likely that prohibited discrimination will result.

P.S. No. 8, dated August 4, 1944, is hereby modified to remove the implication that reserves created by limitations on the benefits to be paid to highly compensated employee participants, in the event of early termination, can under no circumstances be reapplied to provide benefits for such participants.