A sole proprietor has a defined benefit plan in which he is the only participant. What happens to the plan when he dies?
Rev. 09/15/05 and 09/29/05, E-mail Alert 2005-18 and -19

In the last alert, our FAQ (below) discussed some of the issues that arise when a sole proprietor dies with a defined benefit plan in which he or she is the only participant. In this alert, we will add some additional options that may be utilized.

One of our E-mail Alert recipients wrote to us to say he did not believe that we fully covered the situation where the DB plan's sole participant is the sole proprietor. We indicated the possibility that there would be excess assets at the death of the participant (or, if married, after the death of the participant and spouse), leaving no alternative but a reversion.

Options other than the reversion are available, provided the sole proprietor arranges for them prior to his or her death.

One option would be to design the defined benefit plan to include a lump sum payout option and for the sole proprietor to roll over the lump sum to an IRA.

Another option would be for the sole proprietor to select a joint life payout option with a period certain feature for the participant and beneficiary (which is permitted in 1.401(a)(9)-6 of the final regulations issued June 15, 2004.

Further, the period certain where there is a spousal beneficiary can be over a period that equals the joint life and last survivor expectancy of the participant and spouse.

A major issue for a sole proprietor (one person) defined benefit is the death benefit. A defined benefit plan pays a benefit during the participant’s lifetime from the pool of defined benefit plan assets. If the participant is married, the normal form of benefit is a qualified joint and survivor annuity, paying benefits for the life of the participant, and upon his or her death a benefit would continue to his or her surviving spouse.

If the participant and his or her surviving spouse both die before the assets in the defined benefit plan have been fully paid out, what happens to the remainder of the funds in the defined benefit plan? Under current required minimum distribution regulations, there is some ambiguity. It appears that the money would have to remain in the defined benefit plan as an experience gain, because there is no provision for paying a defined benefit plan to an alternative beneficiary after both the participant and his or her primary beneficiary have died. The passing of the sole proprietor and his or her spouse, is a particularly difficult issue for a solo plan because the plan would be in the position of having assets with no one to pay them to due to the lack of other participants in the plan.

One possible solution would be to revert the assets to the “employer” which would end up being the estate of the participant or the spouse (depending upon who was the last to die). However, there is a 50% penalty on reversions. Would such a penalty apply in this instance?

A different scenario is possible, if there is no spouse at time of commencement of payments or, if the spouse waived his or her payments, then the possible solution in the event that there were a surviving child or children, would be to establish a life annuity for the surviving child or children. If this were the preferred solution, what age would be used for the purchase of such an annuity? (The answer is the age of the child or children.)

Why are sole proprietor plans so popular today?

Sole proprietor defined benefit plans are very popular due to the fact that elective deferrals are no longer part of the deduction limit. For example, a sole proprietor who is in his or her late 40s or early 50s with no employees and a six-figure income could have an actuarially large defined benefit minimum funding requirement. Once the amount exceeds the defined contribution annual additions limitation (currently $42,000), the defined benefit addition would eliminate the defined contribution plan deductible allocation. However, since elective deferrals are not included in the deduction limit, the 401(k) deferrals, including catch-up contributions for those eligible, may be made in addition to the defined benefit contribution.

Click here for the RMD DB Final Regulations