Magazine article The CPA Journal

Funded Severance Plans - the New Defined-Benefit Plans

Magazine article The CPA Journal

Funded Severance Plans - the New Defined-Benefit Plans

Article excerpt

During the past several years, many factors have limited the usefulness of defined-benefit pension plans for the closely held employer. Most readers are aware of legislation restricting benefits, limiting compensation for benefit purposes, and defining current liabilities for funding purposes. In addition, Congress has tightened coverage and discrimination rules, requiring employers to spread a greater percentage of plan contributions among rank and file employees. The IRS has taken an increasingly aggressive audit posture, discouraging formation of new plans and encouraging the termination of existing ones. As a result of this trend, many practitioners witnessed a precipitous drop in the number of defined-benefit plans serviced by their organizations.

Spurred by client's requests, professionals continue to search (for the most part in vain) for opportunities to fund employee benefits on a tax-referred basis. The quest has acquired new intensity in light of the expectation that combined federal, state and local income tax rates will rise to approximately 50%. One possibility is a funded severance plan. Similar arrangements had some popularity in the early 1980s when employers were able to fund them through Voluntary Employee Benefit Associations (VEBAs).

The Tax Reform Act of 1984 (TRA '84), eliminated many abuses by sponsors of VEBAs by imposing strict prefunding limitations on employer contributions. Prior to TRA '84, many aggressive programs designed for closely held employers "pushed the envelope" in terms of plan funding and the expansiveness of the definition of a "severance event."

However, in restricting prefunding of welfare benefits, Congress fashioned a limited exemption, IRC Sec. 419A(f)(6) for "10 or more employers plan[s]." The IRC defines a "10 or more employers plan" as: a plan i) to which more than one employer contributes; and ii) to which no employer normally contributes more than 10% of the total contributions of all employers. The IRC further prohibits the use of experience-rated arrangements with respect to individual employers.

Notwithstanding these safeguards, in the years since enactment of the IRC Sec. 419(f)(6) exemption, several aggressive severance programs were marketed in an attempt to bring tax-deductible pre-funding to closely held employers. While a these programs suffered from some of the same defects as the pre-TRA '84 VEBA arrangements, there is no reason why a sensibly designed, reasonably funded severance arrangement could not qualify under IRC Sec. 419(f)(6).

PLAN DESIGN

ERISA's coverage and discrimination rules do not apply to severance plans. Thus, severance plans can discriminate in favor of highly compensated employees (although the plan trustee may insist on token participation by rank and file employees). The controlled group, affiliated severance group and employee leasing rules of IRC Secs. 414 (b), (c), (m), (n), and (o) do not apply. Moreover, stock attribution rules among family members do not extend to severance plans. Aside from a 200% compensation limit on benefits (based on the employee's final year of compensation), there are no maximum benefit limitations. Most importantly, benefits are neither subject to IRC Sec. 415 limitations nor aggregated with their retirement benefits for IRC Sec. 415 purposes. In sum, employees can participate on a selective basis without regard to discrimination or controlled group rules.

FUNDING, ADMINISTRATION, AND OPERATION

Conceptually, funded severance arrangements operate like defined-benefit plans with one exception: interest rate, turnover and mortality assumptions are established b the plan trustee to minimize the possibility of "cross-employer subsidization." Otherwise, the actuary's role is substantially the same as with a defined-benefit plan: collection and verification of census data, calculation of plan benefits and contributions, and preparation of an actuarial report and Form 5500 (although no Schedule B is required). …

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