Successor Plan Rule
Rev. 07/23/04, E-mail Alert 2004-15

Click here for an updated article on successor plan rules.

Under the successor 401(k) plan rule, an employer may not terminate a 401(k) plan and then start a new one for at least 12 months after the original plan is terminated. The 12-month waiting period begins on the date that all elective deferrals have been distributed from the terminated 401(k) plan, not the date of the resolution terminating it.

Why do we have the successor plan rule?
Generally, in-service distributions of elective deferrals may not occur before attainment of age 59½. Congress did not want employers avoiding this restriction by terminating a plan, making distributions and then immediately restarting another plan. Thus, the rule that the employer may not establish a “successor plan” and still receive favorable tax treatment on the distribution of the original plan amount.

What is the successor plan rule?
Generally, a successor plan is defined as any other defined contribution plan established or maintained by the employer that is in existence at any time from the termination date of the 401(k) plan until 12 months after the distribution of all the 401(k) plan’s assets. If a successor plan is established within 12 months of the distribution of the elective deferrals from the terminated plan, a distributable event is deemed to have never occurred for the elective deferrals from the supposedly terminated 401(k) plan. Thus, both the original 401k plan and the supposed successor plan would be subject to disqualification, which would result in substantial penalties to the plan sponsor and possibly the participants.

Are there any exceptions to the successor plan rule?
Currently, there are two regulatory exceptions to the successor plan rule. They are as follows:

1. The establishment of an Employee Stock Ownership Plan (ESOP), a Defined Benefit Plan, or a Simplified Employee Pension Plan (SEP).
   
   
2. 401(k) plan 2% rule
   This exception applies if less than 2% of the eligible employees in the terminating 401(K) are eligible under another plan of the employer for a period beginning 12 months before the termination and ending 12 months after the termination. Under those circumstances, the other employer plan is not considered a successor plan. Eligible employees in the 401(k) plan being terminated are those who were benefiting under the plan as of the termination date of the plan
   

How would the proposed 401(k) regulations affect the successor plan rule?
The proposed 401(k) regulations issued in July 2003, but which will not take effect earlier than January 1, 2006, for calendar year plans, modify the list of plans that may be maintained or established after termination of a 401k plan without violating the successor plan rules. Under this proposal, SIMPLE IRAs, 403(b) contracts and governmental 457 plans could be established in addition to ESOPs, SEPs and DB plans.

Caveat : A Cash Balance Plan is a defined benefit plan and thus could have been established without violating the successor plan rule. However, the future viability of cash balance plans has been thrown into question.

How does the successor plan work?
Following are two examples of how the successor plan rule works:

Example 1. An employer terminates its 401(k) plan on August 19, 2009 and distributes all elective deferrals by December 23, 2009. A new 401(k) plan may not be established until 12 months after the distribution of all the elective deferrals. Hence, a new 401(k) plan may not be established before December 23, 2010.

Example 2. Assuming the above facts, instead of waiting until December 23 the employer establishes a money purchase pension plan as of January 1, 2010. This will result in the loss of tax benefits for both the terminated 401(k) plan and the new money purchase plan, because the new plan was established during the restricted period and under the rules a successor plan is defined as a money purchase, profit sharing or other qualified defined contribution plan. Similarly, until the proposed 401(k) regulations are finalized, a new 457, 403(b), or SIMPLE IRA would fall under the prohibition. The employer would have escaped this result had it established an ESOP, a SEP or a defined benefit plan.

An exception to the successor plan rule is the termination of a qualified plan that has no elective deferrals.

Example 3. A profit sharing plan is being terminated and a 401(k) plan is then established within 12 months of the distribution of the profit sharing plans assets.

What timing considerations apply if plan termination is due to a sale of employer assets or stock?

The timing of the termination of a 401(k) plan is crucial in determining whether the “successor plan” rule applies to the proposed distributions. If the 401(k) plan is terminated before the sale of the assets of the business or the entity becomes part of the buyer’s controlled group (because of the acquisition of its stock), there are no “successor plan” issues. However, if the plan is terminated after the acquisition is completed, then the employer who maintains another plan or establishes a new plan will be subject to the “successor plan” rules.

What are other examples of when the successor plan rule does not apply?

The mere acceptance of rollovers from a former employer’s plan (assuming a distributable event has occurred) does not constitute the creation of a “successor plan”. [Treas. Reg. §1.401(k)-1(d)(4)(i)]

In addition, if the original 401(k) plan is not terminated and continues to be maintained by the seller, then the employees who are employed by the buyer are deemed to have terminated employment with the original employer and may receive distributions and may roll them over to the new employer’s plan.

If the original plan is terminated after the sale of assets to an unrelated employer who does not allow the seller’s employees to participate in the purchaser’s plan, then again, the “successor plan” rules do not apply.

Bill Grossman, QPA