Sometimes a Defined Benefit Plan may become Overfunded, so that the assets are more than sufficient to cover all the benefits that employees have accrued in the plan. In the mid-1980s, in several high-profile cases corporate "raiders" terminated pension plans just to recapture the excess assets in the plan and return this asset value to shareholders.
In order to discourage employers from terminating Defined Benefit Plans just to recapture the excess assets in the plan, Senator Howard Metzenbaum sponsored a bill to create the Section 4980 excise tax on such reversions. Unfortunately, the punitive nature of this tax makes employers highly wary of any sizable amount of overfunding in their plans, which in turn has contributed to the current common problem of Underfunded Defined Benefit Plans.
50% Tax Level
The trend for this excise tax rate has been steadily upwards. The rate is determined according to the Date Of Plan Termination.
In 1986, the excise tax started at 10%.
In 1989, it increased to 15%.
In 1990 (c urrent law) , it increased to 50% (or 20% if certain conditions are met - see below).
In 1995 an attempt to repeal the tax was roundly defeated by Congress.
In 1997 a bill was introduced to increase the tax to 65%, but failed.
So the current law imposes a confiscatory 50% tax on a simple reversion of excess assets to the employer. Because this excise tax is not deductible, ordinary income tax also applies on the entire amount of the reversion. Assuming the federal and state income taxes total 40%, this amounts to a combined 90% tax level that is levied on the reversion. If the remaining 10% of the total reversion is distributed to shareholders, it can be hit with another 40% ordinary income tax at the personal level, leaving an after-tax amount of only 6% of the total reversion that reaches the shareholders--which is why this tax scheme is routinely labeled as confiscatory.
20% Tax Level
As an alternative to the 50% tax level, the excise tax is reduced to 20% under any of these three conditions:
At least 20% of the potential reversion is used to increase plan benefits for all participants on a prorata basis.
25% of the potential reversion is transferred to a replacement plan. The replacement plan:
Must cover 95% of the prior plan participants who are still active.
Must use up the transferred amount within 7 years, starting with the year of the transfer. The transferred amount may be allocated in any manner as an employer contribution, such as Profit Sharing or Matching contributions.
There are 4 different tax scenarios under section 4980, producing 4 different net reversion amounts. The following table shows the results for a terminating plan that has $3,300,000 in assets but only $2,300,000 in lump sum payouts, leaving $1,000,000 in excess assets as a potential reversion:
20% Used to
Excise Tax Rate
Net Reversion to
% of Excess Returned to
up to 80%
This table does not demonstrate the further erosive effect of personal income taxes if the net reversion is subsequently distributed to the shareholders (in a C-Corp). See article on Overfunded Defined Benefit Plans for an illustration of the final effect of personal taxes on a straight reversion.
Note also that under the Replacement Plan strategy, if more than 25% of the potential reversion is transferred to the new plan, income tax will not be payable on the additional amount transferred; however, the 20% excise tax will still apply to the additional amount transferred over and beyond the 25% transfer required by law. That is, if 100% of the potential reversion is transferred to the replacement plan, a non-deductible excise tax of 15% (= 20% x 75% deemed reversion) will be payable by the employer.