The Overfunded Spin-Off and the Shrinking Controlled Group
Northwind Manufacturing sponsors a defined benefit plan that is 96% funded on a termination basis. It sells its profitable Instruments division to a private buyer. The buyer will not assume any pension liability, so Instruments' 340 participants remain in Northwind's plan as terminated vested or deferred participants. Northwind retains its unprofitable Plastics division (410 participants) and a small distribution subsidiary. After the sale, Northwind's actuary reports that the plan's participant count drops from 1,180 to 760, and the ratio of terminated vested participants to active participants rises sharply. Northwind's CFO wants to terminate the plan, recover the surplus, and use it to fund a new 401(k) match. The actuary warns that the plan may now be subject to additional funding rules it previously avoided, and that the buyer's controlled group status matters.
1. Identify the funding-based restrictions that may now apply after the spin-off, and explain how the participant-count change affects them.
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The key issue is whether the plan is now subject to the at-risk funding rules and the benefit restriction rules under IRC section 436.
Under the at-risk rules (IRC 430(i)), a plan is generally treated as at-risk if, on any day during the plan year, it is in a controlled group with an employer that has a credit rating below investment grade, or if it has fewer than 500 participants and is not a multiemployer plan. Northwind's post-sale count of 760 participants exceeds 500, so the small-plan trigger does not apply on its face. However, the at-risk determination is made on an aggregated controlled group basis, and the sale may have changed the group's financial profile. The actuary must confirm whether the remaining controlled group includes any member with a below-investment-grade rating.
More importantly, the section 436 benefit restrictions apply when the plan's adjusted funding target attainment percentage (AFTAP) falls below 80%, 60%, or 0%. A 96% termination-basis funded ratio does not equal the AFTAP, which is computed on a funding-target basis with prescribed actuarial assumptions. If the AFTAP is below 80%, the plan cannot increase benefits or pay a shutdown benefit; below 60%, lump sums and other accelerated distributions are restricted.
The CFO's plan to terminate and recapture surplus is also constrained: a plan termination does not automatically allow reversion of surplus to the employer. A standard termination requires the plan to be sufficient for benefit liabilities, and any residual assets attributable to employee contributions must be allocated before any employer reversion. Any reversion is subject to a 20% excise tax under IRC 4980 (reduced to 20% only if a qualified replacement plan is established and certain conditions are met), and the surplus cannot simply be redirected to a 401(k) match without satisfying those rules.
2. The buyer insists that Instruments' participants be removed from Northwind's plan. Evaluate whether a spin-off plan is available and what ERISA section 4204 withdrawal liability issues arise.
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A plan spin-off under ERISA section 4204 is available only if the plan is a multiemployer plan; Northwind's plan appears to be a single-employer plan, so section 4204 does not apply. For a single-employer plan, the sale of a division does not by itself remove participants from the plan. The buyer's refusal to assume pension liability means Instruments' participants remain participants in Northwind's plan unless and until a plan termination occurs.
If the plan were a multiemployer plan, section 4204 would permit a sale of assets to escape withdrawal liability only if: (1) the buyer assumes the obligation to contribute for substantially the same number of contribution base units; (2) the buyer posts a bond or escrow for five years; and (3) the sale agreement provides that the seller is secondarily liable if the buyer withdraws within five years. None of these conditions is satisfied here.
The practical consequence is that Northwind retains the full pension obligation for Instruments' 340 participants. The CFO cannot unilaterally transfer that liability. Any attempt to do so through a spin-off to a new plan sponsored by the buyer would require the buyer's consent and would be a partial termination event for the transferred group, triggering full vesting for affected participants under IRC 411(d)(3).
Finally, the sale may create a partial termination for the Instruments participants if the turnover is significant enough, which would require 100% vesting for those participants. The actuary should quantify this exposure before the sale closes.
3. Assess the CFO's proposal to use surplus assets to fund a 401(k) match, including the tax consequences and the qualified replacement plan alternative.
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The proposal implicates IRC section 4980, which imposes a 20% excise tax on any employer reversion from a terminated defined benefit plan. The tax can be reduced to 20% (from the otherwise applicable 50% rate) only if the employer establishes a qualified replacement plan (QRP) or increases benefits to participants.
A QRP must be a defined contribution plan that: (1) is established or maintained by the employer; (2) covers at least 95% of the active participants in the terminated DB plan; and (3) receives a transfer of at least 25% of the maximum reversion amount (or 25% of the plan's surplus, whichever is less). The QRP must also satisfy minimum allocation and vesting requirements.
The CFO's proposal to fund a 401(k) match is not automatically a QRP. If the existing 401(k) plan is amended to accept a transfer and meets the QRP requirements, the excise tax on the reversion is reduced. But the 401(k) match itself is an employer contribution subject to IRC 401(a)(4) nondiscrimination testing and IRC 404 deduction limits, and the transfer must be allocated in a nondiscriminatory manner.
If no QRP is established, the full reversion is subject to the 20% excise tax plus ordinary income tax. The CFO should model both scenarios: the net reversion after tax versus the cost of funding a QRP. Given the plan's 96% funded status, the surplus may be modest relative to the administrative cost of a QRP, and the employer should also consider whether the surplus is attributable to employee contributions, which must be returned to participants before any reversion.