Rev. Rul. 69-24

The purpose of this Revenue Ruling is to update and restate, under the current statute and regulations, the principles set forth in Mimeograph 6136, C.B. 1947-1, 58, as modified by Revenue Ruling 55-60, C.B. 1955-1, 37. This ruling relates to the effect of terminations of pension, profit-sharing, stock bonus, and annuity plans, and of amendments resulting in the curtailment of such plans, on prior determination letters holding that the plans meet the requirements of section 401(a) of the Internal Revenue Code of 1954 and the trusts forming parts thereof are exempt from Federal income tax under section 501(a) of the Code.

The termination or curtailment of a pension, profit-sharing, stock bonus, or annuity plan intended to meet the requirements of section 401(a) of the Code may affect the qualification of the plan. The effect a termination or curtailment will have is dependent upon the facts and circumstances in each case. Two basic principles, however, affect the determination to be made, namely, (1) the existence of a valid business reason for the termination or change consistent with the assumption that the plan from its inception has been a bona fide program for the exclusive benefit of employees in general, and (2) compliance with the requirements of section 401(a) of the Code in other respects, not only at the time of the adoption of the plan but also throughout its entire operation, inclusive of the termination.

A determination letter issued with respect to the qualification of a plan under section 401(a) of the Code, is based on the information furnished by the employer. See section 601.201(o) of the Statement of Procedural Rules, C.B. 1963-1, 448. The wording contained within the four corners of a written document may spell out a theoretically qualified plan which may or may not materialize in actual operation. For example, a plan may be open to all employees who have one year of service and who will be entitled to pensions commencing at normal retirement age 65 only if they remain with the employer until that age and have at least 10 years of service at retirement. Such provisions have been found acceptable in certain cases, and favorable determination letters have been issued with respect to the qualification of the plans involved. A high rate of service separations, however, may leave relatively few of the lower paid employees but practically all of the officers, shareholders, supervisors, and highly compensated employees in the plan, resulting in discrimination in favor of the later group. Thus, in operation, such a plan does not meet the requirements of section 401(a) of the Code for some part or all of the period of its operation.

Section 1.401-1(b)(2) of the Income Tax Regulations provides that the term "plan" implies a permanent program. Accordingly, it must also be established that a valid reason exists for the termination of, or change in, a plan. Because of the varying facts in different cases, prescribed rules cannot be laid down as to the sufficiency of such reasons. A reason that has been found satisfactory in one case may not necessarily apply in another. Some of the reasons that have been found acceptable in certain cases have been bankruptcy, insolvency, change of ownership in an arm's-length transaction, a bona fide and substantial change in stock holdings and management, and financial inability to continue meeting the cost of the plan.

A plan which over the period of its operation results in disproportionate funding in favor of employees within the enumerations with respect to which discrimination is prohibited may, under certain circumstances, be appropriately amended to remove the discrimination prior to termination or curtailment so as to warrant a favorable determination letter on such termination or curtailment. For example, if certain highly compensated employees were, at the inception of the plan, within a few years of retirement age and proportionately larger contributions were made to provide benefits for such employees because of the relatively shorter intervals remaining prior to their retirements, and if the plan is amended to reallocate benefits so as to provide proportionately equal shares geared to compensation for the lower and higher paid employees, the prohibited discrimination may be removed.

In certain cases, plans are curtailed rather than terminated because of changed conditions or new requirements. A curtailment of a plan consists of a modification reducing benefits or employer contributions, or making the eligibility or vesting requirements less liberal. An amendment requiring employee contributions to provide the same benefits that previously were provided exclusively by employer contributions results in a curtailment. The mere fact that benefits are reduced does not necessarily render objectionable the amendment through which such result is accomplished. For example, the modification of a pension plan with a $6,000 salary classification extending it to an all-coverage plan, but reducing the vesting or benefit provisions, may be found acceptable.

The application of the foregoing principles may be illustrated by the facts and results obtained in the situations described below:

Situation 1. A corporation established a trusteed pension plan effective October 1, 1962, in which all employees with at least two years of service and under the age of 56 were eligible to participate. Individual contracts were purchased providing for retirement annuities equal to 40 percent of the average salary during the last five years of employment to commence at normal retirement age 65. Upon severance of employment regardless of cause the trustee assigned and turned over the contracts involved to the employees concerned. Three stockholder-employees were among those who participated in the plan. Their ages at the inception of the plan were respectively 33, 38, and 41. The average age of other employees was about 40. On the effective date of the plan, 112 employees were eligible to participate and the first year's cost on a level premium basis was $120,000.

In January 1967, the employees were granted a 20 percent salary increase. At that time, the corporation's capital stock was $2,000,000 and its surplus was $700,000. Its net profit for 1966, after making its contribution of $136,000 under the pension plan for 123 employees who were then participants, was $46,000. A 20 percent salary increase, based on compensation for 1966, would amount to $144,000. Although the corporation was not insolvent, it pointed out that if the results of operations in 1967 were comparable to those of 1966, and if it were required to contribute $136,000 under its pension plan as well as to pay the salary increase of $144,000, it would sustain a loss of $98,000, and, if that continued, its surplus would disappear in a few years. It therefore terminated the plan as of January 31, 1967.

Upon analysis of data for the entire period of operation of the plan, it was found that the values of the benefits actually made available were equal to 12, 14, and 17 percent, respectively, of the salaries of the three stockholder-employees over the entire period, 18 percent for employees among the highest 25, other than stockholders, and 22 percent for all other employees. It was also found that during its operation the plan met all the requirements of section 401(a) of the Code.

It is held, upon the above-stated facts, that the termination of the pension plan of the corporation did not adversely affect its prior qualification under section 401(a), or the exempt status of the trust under the provisions of section 501(a).

Situation 2. The profit-sharing plan of a company, which was put into effect on January 1, 1960, provided for participation of all employees with two years of service. Out of a total of 51 employees, 42 were eligible and were covered under the plan. Company contributions were equal to 10 percent of the annual profits and were allocated among participants in proportion to compensation, with a ceiling of $1,600 on the amount that could be allocated to any one participant in one year, the excess being reallocated among the remaining participants. Employees were granted nonforfeitable rights in all company contributions.

The administrative head of the company was a stockholder who owned 98 percent of its outstanding stock. He became ill early in 1965 and entered into negotiations for the sale of the business. In July of that year, a corporation that was engaged in a similar line of business purchased all of the stock of the company, had it dissolved, took over all the assets, assumed the liabilities, and retained the people who previously were employed by the company.

The purchasing corporation did not have a profit-sharing or similar plan of its own, and, rather than continue benefits for those who had previously been employed by the company and cause dissension among employees, it terminated the plan.

Under the foregoing facts, it is held that the termination of the profit-sharing plan of the acquired company did not result in its retroactive disqualification.

Situation 3. A company commenced business in 1946. Its entire operating force consisted of three individuals who owned all of the company's stock. In the early part of 1962 it entered into a five-year contract to manufacture a product for a purchaser who expected to have his own plant in production at the end of this five-year period. To produce this product the company engaged a force of 260 people.

In November 1962, the company adopted a profit-sharing plan under which all employees with six months of service and who were under the age of 56 were covered. There were 224 people who met these requirements and became participants in the plan. The plan provided that, regardless of cause, severance of employment, prior to the time an employee reached the stated age, 65, would result in the forfeiture of his interest and the reallocation of that interest to the accounts of the remaining participants.

The company's contract expired in the early part of 1967 and all employees, except the three stockholders and a bookkeeper, were discharged. The company terminated its plan in 1968 on the ground that it no longer had a force of employees who could benefit thereunder, and the trustee used all the trust funds to purchase retirement annuity contracts for the four remaining participants. None of the other employees had ever become eligible to receive benefits.

It is held, on the basis of the foregoing facts, that the plan, from its inception, was not a bona fide program for the exclusive benefit of employees in general, but an arrangement to siphon off a substantial portion of the company's profits for subsequent distribution primarily of to the stockholders.

Situation 4. A corporation adopted a pension plan effective July 1, 1962, which provided for participation of all employees with one year of service. Benefits commencing at normal retirement age 65 were to be equal to 50 percent of the average annual compensation. Employees whose services were terminated prior to five years of participation under the plan received no benefits. Those who remained beyond that period were entitled to 10 percent, for each additional year of participation, of the cash surrender value of the individual retirement annuity contracts purchased for employees covered under the plan. Forfeitures were used to reduce subsequent premiums which were paid quarterly. There was also a provision that, upon termination of the plan, the contracts for the then remaining participants were to be distributed to them. Out of a total of 318 employees, 262 were eligible for participation at the inception of the plan.

During January 1967, employees demanded salary increases and other welfare benefits, the total cost of which was about equal to the cost of maintaining the pension plan. The company's financial status did not permit it to undertake the additional burden and it thereupon decided to terminate the plan. At that time there were 223 participants, which included 61 of the original 262 employees. Among the 61 who remained in the plan throughout the entire period of operation were three stockholder-employees, one of whom was near retirement and one other within a few years therefrom, and 11 other employees who were highly compensated.

Since none of the employees had five years of participation, none had vested rights in the contemplated benefits. Accordingly, the plan was amended prior to termination to provide a ceiling on benefits for any one of the stockholder-employees equal to 18 percent of compensation over the entire period of participation, with the excess to be distributed among employees in the lowest group. An analysis of compensation and contemplated benefits, both before and after the amendment, indicated the following results:

                                                Percentage of

It is held, under the foregoing facts, that the termination of the pension plan, after amendment, did not result in its disqualification.

Situation 5. A company established a pension plan effective July 1, 1963, under which all employees with five years of service were covered. Benefits were provided equal to 50 percent of total compensation commencing at normal retirement age 65. There were 88 employees who were covered under the plan at its inception. Included among such employees were two stockholders, compensated at $50,000 and $70,000 a year, as well as 12 others, compensated above $20,000 a year, who had been receiving cash bonuses ranging from 10 to 15 percent of compensation. Since the bonus arrangement had been in effect for many years prior to the inception of the pension plan, retirement benefits were computed on the total of basic compensation and bonuses.

In the later part of 1966, the company found itself in need of funds for expansion purposes and amended its plan by placing a ceiling of $40,000 on compensation for the purpose of computing retirement benefits and excluding bonuses from this compensation.

Based on the foregoing observations, it is held that since the curtailment of the plan applied only to the stockholders and highly compensated employees, its modification did not adversely affect its status as a plan for the benefit of employees in general.

Situation 6. A corporation commenced business in 1948 and realized profits through 1961 that averaged $100,000 a year. The profits in the best year during that period were $170,000. Early in 1962 the corporation entered into a contract to produce a new product for a four-year period and its profits from January 1 to November 30, 1962, amounted to $560,000. In December 1962 the company established a profit-sharing plan, effective as of January 1, 1962, that provided for employer contributions equal to 50 percent of profits in excess of $200,000 per year, but not to exceed 15 percent of the compensation otherwise paid or accrued to all participants under the plan. All employees with one year of service were covered under the plan and shared in contributions in proportion to the annual compensation of each. The annual contributions from 1962 to 1965, inclusive, were $200,000, $300,000, $350,000, and $420,000, respectively.

The contract to produce the new product expired in 1966. An unprecedented demand for the corporation's old product, however, resulted in a net profit, before profit-sharing contribution, of $400,000 by November 30, 1966. In December 1966, the corporation proposed to amend its plan, effective as of January 1, 1966, increasing the exclusion factor in its contribution formula from $200,000 to $700,000 and requested a determination letter as to the effect of such amendment on the status of its plan under section 401(a) of the Code.

On the basis of the foregoing facts, the following findings and conclusions are made:

(A) That prior to the effective date of its plan, the corporation's profits were well under $200,000, the exclusion factor provided for in the contribution formula contained in the plan;

(B) That profits rose sharply above such factor during the years that its new product was manufactured and that 50 percent of such profits, in excess of $200,000, was contributed under its plan; and

(C) That the exclusion factor was sought to be increased to such an extent that although, theoretically, the plan would merely be curtailed, for all practical intents and purposes it would be completely terminated since, for 1966, based on available data, no contribution would be made, and, in accordance with the company's experience, there was no indication that contributions would subsequently be continued.

It is, accordingly, held that if the plan should be amended as proposed it would result in a conclusion that, from its inception, it was not a bona fide permanent program for the exclusive benefit of employees in general.

Mimeograph 6136 is hereby superseded, since the position stated therein is restated under current law in this Revenue Ruling.

¹ Prepared pursuant to Revenue Procedure 67-6, C.B. 1967-1, 576.