Rev. Rul. 59-241

Advice has been requested whether the modification of an employees pension plan, by deleting a provision relating to the limitation of benefits necessary to preclude termination of the plan within the first ten years from effecting discrimination in favor of a prohibited class of employees, prior to the expected termination of the plan, will affect the qualification of the plan under section 401(a) of the Internal Revenue Code of 1954, when the plan is terminated by reason of the liquidation of the employer.

A corporation established an employees' pension plan which was funded by means of a group annuity contract. The contract contained a provision, complying with the requirements of Mimeograph 5717, C.B. 1944, 321, requiring that benefits under the plan be recomputed, in the event of its termination within ten years of the date of its establishment, to preclude discrimination in favor of the class of employees specified in section 401(a)(3)(B) and (4) of the Code. The plan was held to meet the qualifications of section 401(a) of the Code.

After the plan had been in operation for only four years, approximately 96 percent of the capital stock of the employing corporation was purchased by another corporation and the stockholders agreed to adopt a plan of complete liquidation of the employer corporation. A resolution was also passed authorizing the employer's officers to modify the group annuity contract so as to remove the provision guarding against discrimination in favor of the employer's 25 highest paid employees.

In order for a pension plan to qualify under section 401(a) of the Code it must not only be a permanent plan but contributions or benefits under the plan must not discriminate in favor of officers, shareholders, supervisory employees, or highly paid employees. In this respect, the Income Tax Regulations state, in section 1.401- 1(B)(3), that the law is concerned not only with the form of a plan but also with its effects in operation. Discrimination may be accomplished in a number of ways, one of them being by the abandonment of the plan within a few years after its inception where the benefits of the higher paid employees, who usually are the older employees, have been almost completely funded. Thus, it was concluded that employee pension and annuity plans should be required to contain some automatic provision to prevent or mitigate discrimination in the event the plans should terminate within a few years after their establishment.

The position of the Internal Revenue Service with respect to the provisions necessary in pension and annuity plans to preclude termination from effecting discrimination in favor of certain employees is set forth in Mimeograph 5717, supra. While, in many cases, the inclusion in pension plans of provisions giving effect to the limitations specified in the mimeograph, does not prevent all of the prohibited discrimination, it has a mitigating effect.

Discontinuance of contributions to a plan has the same effect as that of termination, in that all credits are required to be fully vested in a nondiscriminatory manner. Whether or not a final contribution is made before discontinuance, the effect is the same. An original plan is set up to provide benefits for all its participants on a permanent and continuing basis. Even if an annuity contract, as in the present case, were to be amended so as to provide benefits only for past service credits for present participants, a termination or curtailment of the original plan would take place and the termination requirements must be met.

Disqualification would not necessarily result from the deletion, from a plan, of provisions giving effect to the limitations set forth in Mimeograph 5717, supra, if such limitations were replaced by provisions requiring an allocation of benefits among the participants on a basis which will not result in the prohibited discrimination or if the deletion will not result in such discrimination.

In a case where a plan is terminated but the employer continues in business or where the business is continued by a successor who continues the employment of the employees, it is the position of the Service that, although each participating employee would receive proportionately the same benefit per year of service up to the time of discontinuance of the plan, the plan is discriminatory if the ratio of benefits to compensation is higher with respect to the higher compensated classes of employees where funding of benefits is discontinued after a few years, so that no further service credits can be earned. The test to be used in determining whether the prohibited discrimination results is similar to that used in I.T. 3685 and I.T. 3686, C.B. 1944, 324 and 326. The test is illustrated as follows:

                               Number     Aggregate    Annual Annu-

While the position of the Service is applicable in cases where the employer continues in business or the enterprise and employment continues, this position would not necessarily be applicable where the business of the employer ceases upon liquidation. In the latter case, the earning of further service credits until normal retirement age is not prevented by the termination of the plan, but rather by reason of the necessity for the discontinuance of the employees' services.

Accordingly, it is held that the deletion, prior to the expected termination of an employees' pension plan of the provision relating to the limitation of benefits necessary to preclude termination of the plan within the first ten years of its existence from effecting discrimination in favor of a prohibited class of employees, will not adversely affect the qualification of the plan under section 401(a) of the Code when such termination, within the first ten years, is by reason of the liquidation of the employer, provided the ratio of benefits to current compensation, per year of service, is not discriminatory within the meaning of section 401(a) and all past service credits are fully funded.