DB Lump-sum Distributions
Rev. 03/09/07, E-mail Alert 2007-3

The Pension Protection Act of 2006 changed the rules for lump-sum distributions from defined benefit plans. This was addressed in IRS Notice 2007-7. Distributions made between January 1, 2006, and September 1, 2006, from DB plans (other than those terminated in 2006) need to be addressed ASAP.

The IRS has issued Notice 2007-7 to provide guidance, in question and answer format, on a number of PPA distribution issues. This guidance specifically clarifies the tax treatment of lump sum distributions from defined benefit plans that occurred during early 2006.

The calculation of lump sum distributions from defined benefit plans has been in a continuing state of flux since enactment of GATT in 1994. The Pension Funding Equity Act of 2004 (PFEA) temporarily changed the interest rate for this calculation, but this law was only effective for distributions made in 2004 and 2005. The mandated interest rate changed again in August 2006 when PPA was enacted. While PPA applies to lump sum distributions made after December 31, 2005, Congress did not specify what, if any, transition rules would apply to lump sum distributions paid after December 31, 2005 and before August 17, 2006 when the applicable interest rate became known.

This eight-month gap created a dilemma for actuaries because from January to August 2006 only the PFEA interest rate was available. Although PPA was wending its way through Congress, it was impossible to know its final interest rate provisions.

Because many of the lump sum distributions calculated under the PFEA rate were larger than allowed under PPA, this resulted in terminated participants paid during this period receiving “excess” amounts. What corrections would the IRS require considering that Congress made the effective date of a law enacted in mid-August retroactively effective to January 1?

Many practitioners hoped that the IRS would not require corrective action because of its administrative complexity. Unfortunately, this was only applied to plans that terminated before August 17, 2006. On-going plans must take corrective steps.

Correction methods were provided by the Notice.
The first method applies to plans that made excess distributions before September 1, 2006. Such plans do not have to seek repayment; however, they must provide the affected participants with notice of the problem and corrected 1099-Rs by March 15, 2007.
The treatment is similar to a DC plan that makes a distribution only later to realize that all or a portion thereof is an excess contribution or excess aggregate contribution.

The plan will issue two 1099-R Forms, one for the amount eligible for rollover treatment and the second for the amount that must be disgorged from any rollover arrangement (plan or IRA) and that amount will be included in the participant's current taxable income. The deadline for providing the notice to participants and the correct Form 1099-Rs is March 15, 2007. In theory, the affected participants will have until April 15, 2007 to remove excess amounts from their IRA to avoid excise tax liability.

Different correction procedures will apply if the March 15 deadline is not met.

Although post-March 15th corrections are allowed, corrections must be made using the EPCRS procedures for correction of excess distributions under IRC §415(b). The exact procedures that will apply depend on whether correction is completed by December 31, 2007, or after that date. Further, a corrective employer contribution may also be required for unrecovered amounts.

For further explicit details, the applicable section of Notice 2007-7 and EPCRS follow.

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Q&A 3 and 4 from Notice 2007-7, which specifically discuss this issue and provide the guidelines for the correction are reproduced below.

Q&A 3
Three methods are available for correcting a §303 excess distribution.

First, Q&A-4 of this notice sets forth a special correction method that is available for a §303 excess distribution made prior to September 1, 2006, provided that the correction is completed by March 15, 2007.

Second , if correction is completed by December 31, 2007 (even if the § 303 excess distribution occurs after September 1, 2006), a plan may correct a §303 excess distribution by using the correction method for a § 415(b) excess distribution described in the Employee Plans Compliance Resolution System (“EPCRS”) (see section 2.04(1) in Appendix B in Rev. Proc. 2006-27, 2006-22 IRB 945) even if the plan does not meet the requirements specified in Rev. Proc. 2006-27, including the special requirements for self correction under Part IV of Rev. Proc. 2006-27.

Finally, a plan that meets the requirements of Rev. Proc. 2006-27 may correct §303 excess distributions by using the correction method for §415(b) excess distributions under EPCRS even after December 31, 2007. A plan that is amended retroactively to comply with §303(a) of PPA '06 will not fail to satisfy the requirement in §1107(b)(2)(A) of PPA '06 (that the plan be operated in accordance with the terms of the amendment) merely because it made a §303 excess distribution, provided the §303 excess distribution is corrected using one of these three correction methods.

Q & A 4
A special correction method is available for a §303 excess distribution made prior to September 1, 2006, provided the correction is completed by March 15, 2007. Under the special correction method, a plan may use the EPCRS correction method for a §415(b) excess distribution (as described in section 2.04(1) in Appendix B in Rev. Proc. 2006-27, even if the plan does not otherwise meet the requirements of Rev. Proc. 2006-27, including the special requirements for self correction) with the following modifications. The excess amount (i.e., the amount by which the distribution actually made exceeds the distribution permitted using the interest assumption specified in §415(b) as amended by PPA '06) is not required to be returned to the plan (as otherwise required under the EPCRS correction method). Instead, a plan must issue two Forms 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) to a participant who has received a §303 excess distribution. The first Form 1099-R should include only the amount that would have been distributed had the benefit payable been adjusted using the interest assumptions specified in §415(b) as amended by PPA ‘06. The second Form 1099-R should include only the excess amount that was distributed, and should include code “E” in box 7 to identify the amount as an excess distribution. As provided in the EPCRS correction, this excess amount is not an eligible rollover distribution, and therefore must be included in gross income in the year distributed from the plan.

For the situation when the correction method in Notice 2007-7 requires the employer (or another person) to make the plan whole, if the excess is not returned by employee; the procedure in EPCRS (Rev. Proc. 2006-27) for 415 failures on page 81 (presented below) is specified to be used.

EPCRS B2.04 415 Failures

Return of overpayment to plan.

2.04 §415 Failures .

(1) Failures Relating to a §415(b) Excess.

(a) Correction Methods. (i) Return of Overpayment Correction Method. Overpayments as a result of amounts being paid in excess of the limits of §415(b) may be corrected using the return of Overpayment correction method set forth in this paragraph (1)(a)(i). The employer takes reasonable steps to have the Overpayment (with appropriate interest) returned by the recipient to the plan and reduces future benefit payments (if any) due to the employee to reflect §415(b). To the extent the amount returned by the recipient is less than the Overpayment, adjusted for earnings at the plan's earnings rate, then the employer or another person contributes the difference to the plan. In addition, in accordance with section 6.05 of this revenue procedure, the employer must notify the recipient that the Overpayment was not eligible for favorable tax treatment accorded to distributions from qualified plans (and, specifically, was not eligible for tax-free rollover).
See Examples 18 and 1

NOTE: The fact set for example 16 follows because it is used for examples 18 and 19.
Employer F maintains a defined benefit plan funded solely through employer contributions. The plan provides that the benefits of employees are limited to the maximum amount permitted under §415(b), disregarding cost-of-living adjustments under §415(d) after benefit payments have commenced. At the beginning of the 1998 plan year, Employee S retired and started receiving an annual straight life annuity of $140,000 from the plan. Due to an administrative error, the annual amount received by Employee S for 1998 included an Overpayment of $10,000 (because the §415(b)(1)(A) limit for 1998 was $130,000). This error was discovered at the beginning of 1999.

Example 18:
The facts are the same as in Example 16, except that the benefit was paid to Employee S in the form of a single-sum distribution in 1998, which exceeded the maximum §415(b) limits by $110,000.

Correction :
Employer F uses the return of overpayment correction method to correct the §415(b) failure. Thus, Employer F notifies Employee S of the $110,000 Overpayment and that the Overpayment was not eligible for favorable tax treatment accorded to distributions from qualified plans (and, specifically, was not eligible for tax-free rollover). The notice also informs Employee S that the Overpayment (with interest at the rate used by the plan to calculate the single-sum payment) is owed to the plan. Employer F takes reasonable steps to have the Overpayment (with interest at the rate used by the plan to calculate the single-sum payment) paid to the plan. Employee S pays the $110,000 (plus the requested interest) to the plan. It is determined that the plan's earnings rate for the relevant period was 2 percentage points more than the rate used by the plan to calculate the single-sum payment. Accordingly, Employer F contributes the difference to the plan.

Example 19:
The facts are the same as in Example 18.

Correction :
Employer F uses the return of overpayment correction method to correct the §415(b) failure. Thus, Employer F notifies Employee S of the $110,000 Overpayment and that the Overpayment was not eligible for favorable tax treatment accorded to distributions from qualified plans (and, specifically, was not eligible for tax-free rollover). The notice also informs Employee S that the Overpayment (with interest at the rate used by the plan to calculate the single-sum payment) is owed to the plan. Employer F takes reasonable steps to have the Overpayment (with interest at the rate used by the plan to calculate the single-sum payment) paid to the plan. As a result of Employer F's recovery efforts, some, but not all, of the Overpayment (with interest) is recovered from Employee S. It is determined that the amount returned by Employee S to the plan is less than the Overpayment adjusted for earnings at the plan's earnings rate. Accordingly, Employer F contributes the difference to the plan.