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News & Press: ABTJ Article

Terminating Tax-Qualified Retirement Plans in a Chapter 7 Bankruptcy

Wednesday, January 22, 2020   (0 Comments)
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By Gayle L. Skolnik, Esq. and Elizabeth M. Little, Esq., Faegre Baker Daniels LLP, Indianapolis, Indiana

Key Points:

1. Tax-qualified retirement plans are subject to complex regulatory requirements and strict fiduciary standards with which a Chapter 7 trustee must comply in terminating a plan.

2. Accordingly, a trustee must proceed carefully—and with competent professional assistance—in carrying out its plan termination responsibilities.

3. The termination process will vary with the type and size of the plan and other facts and circumstances, but some aspects of the process—and key considerations for the trustee—are common to all retirement plan terminations.

Many businesses maintain tax-qualified retirement plans—such as 401(k) plans or pension plans—to help employees accumulate funds for retirement. When a company maintaining such a plan is liquidated in bankruptcy, the Chapter 7 trustee must oversee the termination of the plan and the application of its assets for the benefit of the plan’s participants. Retirement plans are subject to complex regulatory requirements enforced by three different federal agencies. Accordingly, the trustee must proceed carefully—and with competent professional assistance—in carrying out its plan termination responsibilities. This article examines the steps a Chapter 7 trustee must undertake to terminate a tax-qualified retirement plan in a bankruptcy case and provides practical pointers to help ensure those tasks are accomplished in accordance with all applicable federal laws, including the Bankruptcy Code, the tax code, and the comprehensive federal employee benefits law known as ERISA.

A. Background: Types of Plans and the Regulatory Scheme

Retirement plans generally fall into two categories based on how benefits are determined under the plan’s design: defined contribution plans and defined benefit plans. Defined contribution plans are individual account plans under which a participant’s benefit is determined by the contributions that have been credited to the participant’s account (whether made by the employer, the employee or both) and the investment earnings and losses on those contributions. Under a defined contribution plan, the investment risk falls on the participant, and most defined contribution plans allow participants to direct the investment of their accounts among a set of investment options selected by the employer or other plan fiduciary. A 401(k) plan is the most common type of defined contribution plan.

Under a defined benefit plan, a participant’s benefit is determined under a formula, and the employer’s required contributions to the plan are determined actuarially, based on certain assumptions set forth in the plan and selected in accordance with prescribed standards. Because plan contributions are determined actuarially—under assumptions that might not turn out to be completely accurate—defined benefit plans may be overfunded (having assets greater than required to pay the promised benefits) or (more commonly) underfunded (having assets insufficient to pay all promised benefits). Each year, the plan’s actuary must certify the plan’s funding status to determine, among other things, the amount of the minimum required contribution for the year and whether any restrictions must be placed on plan distributions. But the annual funding certification relates to the plan’s funding status on an ongoing basis, rather than if the plan were to be terminated. A plan that is adequately funded on an ongoing basis may be underfunded on a termination basis.  

Tax-qualified retirement plans are subject to a complex regulatory scheme involving two different comprehensive federal laws and three different regulatory agencies. The federal tax code (the Internal Revenue Code or IRC) imposes substantive requirements on retirement plans in exchange for the favorable tax treatment they receive. Those rules are enforced by the Internal Revenue Service (IRS). In overseeing a plan’s termination, the trustee must ensure that the termination does not adversely affect the plan’s tax-favored status (which would harm plan participants). This may include correcting any material operational failures that occurred while the debtor administered the plan. One way to ensure that a plan’s termination does not adversely affect its tax-favored status is to file an application for determination with the IRS (on Form 5310).

ERISA (the Employee Retirement Income Security Act of 1974, as amended) imposes fiduciary responsibilities on the plan administrator, including duties to act prudently, solely in the best interests of plan participants and beneficiaries and in accordance with the plan’s governing documents (to the extent not inconsistent with ERISA). Enforced by the U. S. Department of Labor’s Employee Benefits Security Administration (DOL/EBSA), these fiduciary standards also require that all plan assets be held in trust and used solely for the provision of benefits to participants and beneficiaries and the payment of reasonable administrative expenses. ERISA also prohibits certain fiduciary transactions (such as loans, sales and exchanges and certain other uses of plan assets) between a plan and a party closely related to the plan (such as fiduciaries, service providers, and sponsoring or participating employers), unless an exemption applies. Plan fiduciaries may be personally liable for losses resulting from a breach of their fiduciary duties. The Bankruptcy Code limits a trustee’s liability under ERISA when it acts as a plan administrator, and a trustee may be held personally liable only if the trustee willfully and deliberately violates the trustee’s fiduciary duties. The willful and deliberate standard requires trustees to possess the requisite intent to breach their fiduciary duties. Out of an abundance of caution, a trustee may wish to seek an order from the bankruptcy court specifically limiting the trustee’s liability as a fiduciary with respect to the administration of the debtor’s benefit plans.

Title IV of ERISA creates an insurance system for defined benefit pension plans, administered by a separate agency, the Pension Benefit Guaranty Corporation (PBGC). Defined benefit plans pay required premiums to the PBGC, which guarantees the payment of plan benefits (up to certain maximum limits) in the event a defined benefit plan terminates without funds sufficient to pay all plan benefits. The PBGC oversees termination of all defined benefit plans (whether or not underfunded) and steps in to help provide for benefit continuity in terminations of underfunded plans through payment of guaranteed benefits and enforcement actions against persons who may be responsible under ERISA for unfunded plan obligations. As discussed in greater detail in Part D. below, if the PBGC determines that a debtor’s defined benefit plan has sufficient assets to pay all benefit liabilities upon termination, the PBGC will direct the trustee to terminate the plan in a “standard termination,” with PBGC oversight. If the PBGC determines that the debtor’s defined benefit plan is underfunded on a termination basis, however, the PBGC will either approve and oversee a distress termination of the plan, or it will take trusteeship of the plan and conduct an involuntary termination of the plan, depending on whether or not the plan has sufficient assets to pay all benefits guaranteed by the PBGC. The PBGC will also take over trusteeship of a plan in certain distress terminations.

B. General Considerations and Practical Pointers for
All Plan Terminations

The particular actions a trustee must take to terminate a retirement plan—and the issues the trustee will confront in doing so—will vary with the facts and circumstances of the particular case, including the type and size of the plan, the plan’s funding status, the size of the bankruptcy estate, the extent to which plan assets may be used to pay administrative expenses in connection with the termination (such as the cost of filing an application for determination with the IRS), and the extent to which the trustee is confident that the plan was previously administered in compliance with its terms and applicable law. But there are certain actions that a Chapter 7 trustee must take or consider when the debtor maintained any type of qualified retirement plan that will need to be terminated. They include the following:

  • Identify the type(s) of retirement plan(s) maintained by the debtor. Today, most retirement plans are defined contribution plans (particularly 401(k) plans, which have employee elective deferrals), but employers in some industries still maintain defined benefit pension plans, some of which are still active but many of which have been frozen to new participants or accruals.
  • Evaluate each plan’s funding status and identify any funding issues. With respect to a 401(k) plan, that will include determining whether all elective deferrals and plan loan repayments withheld from employees’ pay have been timely deposited in the plan’s trust.
  • Determine the location of, obtain access to, and arrange for the retention of, all plan documents and records. Some plan records will be held by third party recordkeepers, such as the records of contributions and earnings credited to, and loans and disbursements taken from, individual participant accounts and records of vesting and forfeitures. Other records, however, are typically retained by the employer, including records relating to eligibility, payroll deductions, marital status (relevant to beneficiary determinations and available forms of benefit), and in many cases beneficiary designations. Also, because ERISA generally requires record retention for at least 6 years (longer than the typical bankruptcy case), the trustee may need to arrange with a third party for retention of plan records for some period following plan termination.
  • Locate and review all plan-related service contracts, including trustee and custodian agreements, administrative services (recordkeeping) agreements, and agreements with other service providers (such as investment managers, investment advisors, consultants, actuaries, and accountants).
  • Determine whether all required annual reports (on Form 5500) have been filed (along with audited financial statements, if required) and when the next annual filing is due. Determine whether and to what extent the debtor engaged service providers (e.g., record keepers and accountants) to prepare the annual reports and any required audits.
  • Determine what orders should be requested from the bankruptcy court in connection with the plan termination. This should include an order authorizing the trustee to perform all necessary actions to administer, terminate and wind up the debtor’s benefit plans to comply with section 704(a)(11) of the Bankruptcy Code. The trustee may also wish to seek an order limiting the trustee’s liability as a fiduciary with respect to the administration of the benefit plans. Such a “comfort order” protects the trustee from exposure to acts or omissions of prior administrators or agents and protects the trustee from being held personally liable for issues relating to the administration of the benefit plans prior to the date of appointment as trustee in the bankruptcy case and from the petition date to the date of substantial completion of the termination of the plans. Finally, the trustee should seek approval to retain key professionals in the bankruptcy case for assistance in administering, terminating and winding up the benefit plans and handling participant inquiries. The professionals retained by the trustee should file fee notices and applications for services performed even when the fees are paid out of the plan.
  • Retain qualified professional service providers to assist with the evaluation and termination of the plan. This will include legal counsel (preferably ERISA counsel with experience in the bankruptcy context) and may also include consultants or investment services providers, actuaries (for defined benefit plans) and independent accountants (if audited financial statements are required in connection with annual reports). The trustee should consider whether to retain some of the same service providers that were previously retained by the debtor, to maintain continuity of service, facilitate continued access to records and obtain institutional knowledge of the plan’s historical operations. Also, depending on the circumstances, the trustee may want to consider retaining the services of an experienced professional plan administrator (firm or individual) to fulfill the administrative support role formerly performed by the debtor’s human resources or finance staff. Even where most administrative services have been outsourced to a third party recordkeeper, the debtor’s staff likely performed some plan administration tasks that may need to continue through completion of the plan’s termination.
  • Consider whether to retain the services of former member(s) of the debtor’s human resources or finance staff to assist with plan administrative tasks, facilitate access to historical records and provide institutional knowledge about the plan.
  • Continue to maintain an ERISA bond for the plan and consider whether to obtain/retain fiduciary liability insurance. Under ERISA, a plan administrator must obtain a fidelity bond to protect the plan against theft by persons handling plan funds. The trustee must ensure that the plan continues to maintain an ERISA fidelity bond until all plan assets have been distributed. In addition, some plan sponsors obtain fiduciary liability insurance (often as a rider to a directors and officers liability insurance policy). A trustee should investigate whether the debtor maintained such insurance and, if so, whether and at what cost the trustee can continue to maintain the coverage (or purchase tail coverage under the policy). Where no such coverage has been obtained or where it has been canceled, the trustee should consider whether it would be advisable and feasible to obtain the trustee’s own fiduciary liability insurance coverage.
  • Respond to governmental audits and investigations of the plan. Where a debtor maintained a tax-qualified retirement plan, a bankruptcy filing typically triggers an examination or investigation by DOL/EBSA and, if the plan was a defined benefit pension plan, the bankruptcy will trigger an investigation by the PBGC. A DOL/EBSA investigation will typically examine, among other things, whether the debtor complied with its fiduciary responsibilities under ERISA in operating the plan, including, in the case of a 401(k) plan, whether the debtor timely remitted all employee deferrals and loan repayments to the plan’s trust and, for all types of plans, whether the trustee is taking appropriate steps to locate missing plan participants/beneficiaries and ensure they receive their plan benefits. A PBGC investigation will seek information required for the agency to determine the plan’s funding status on a termination basis so that it can determine whether to direct the trustee to undertake a standard or distress termination of the plan or take trusteeship of the plan and initiate an involuntary termination.
  • If the trustee maintains a website for the bankruptcy, consider whether to include a section for plan participants, to provide information on the process for and status of the plan termination. Particularly if the debtor had a large number of employees or multiple or complex plans (such as a defined benefit plan), the trustee may want to consider including on the bankruptcy website a set of frequently asked questions and answers (FAQs), updated periodically, to address the most common questions participants will have about the effect of the bankruptcy on their plan benefits.

C. Defined Contribution Plan Terminations

The following is a list of additional steps a trustee should take or consider in connection with the termination of a 401(k) plan or other defined contribution plan (in addition to those discussed in Part B, above):

  • Review the plan documents, trust agreement and recordkeeper services agreement to determine the steps required to amend the plan to provide for its termination and to provide timely notice to the recordkeeper and trustee of the plan’s termination.
  • Notify participants of the termination of the plan and the effect of the termination on their plan accounts. All plan accounts become 100% vested upon the plan’s termination.
  • Determine whether to apply to the IRS for a determination letter, on Form 5310 (Application for Determination for Terminating Plan) to confirm that the plan’s termination will not adversely affect the plan’s qualified status. Obtaining a determination can help protect the interests of plan participants (by confirming the tax-qualified status of their benefits) and help the trustee identify and address potentially disqualifying errors before the plan’s assets are distributed—important considerations particularly where the trustee is uncertain whether the debtor appropriately administered the plan. The application process can take as long as a year, however, and an IRS user fee and other costs will apply. The trustee should consult with counsel to determine whether an application is prudent, appropriate and feasible under the facts and circumstances.
  •  If an application for determination will be filed, provide advance notice of the application to participants (in the form of a “notice to interested parties,” with content and timing prescribed by IRS rules). A cover letter to the notice, or other appropriate communication, should also explain the nature and reason for the application and any suspension of benefit distributions that will apply pending issuance some of the favorable determination letter.
  • If application for determination will be filed, determine whether distributions will be suspended pending receipt of a favorable determination. As a part of their standard procedures, many recordkeepers automatically suspend benefit distributions pending receipt of a favorable determination letter. Suspending distributions may be prudent and appropriate, because adjustments to participants accounts may be required to address issues discovered during the termination process (and particularly where the plan sponsor is bankrupt, necessary adjustments may not be possible once plan assets have been distributed). Suspension, however, may spark complaints from plan participants who have lost their jobs and want access to their plan accounts. Whether to suspend distributions is ultimately a fiduciary decision about which the trustee should consult counsel.
  • If plan distributions will be suspended pending issuance of a favorable IRS determination letter, consider and decide whether any exceptions will apply (for example, for hardship withdrawals or required minimum distributions), and work with the plan’s recordkeeper to develop and implement appropriate administrative procedures.
  • In cooperation with the plan’s recordkeeper, implement a procedure for orderly distribution of participant accounts and preparation and distribution of appropriate distribution notices/election forms to all participants and beneficiaries.
  • Provide oversight of distribution of plan accounts in accordance with participants’ elections and, where applicable, forced cash-outs of small accounts.
  • Address legal and administrative issues arising in the distribution process, including issues relating to qualified domestic relations orders and determination of beneficiaries of deceased participants.
  • Select and contract with a qualified custodian of rollover individual retirement accounts (IRAs) for forced cash-outs over $1,000, missing participants’ accounts, and accounts of those who fail to make timely distribution elections.
  • Design and implement procedures to address missing participant issues, including search protocols and procedures for distribution of missing participant accounts to rollover IRAs

D. Defined Benefit Plan Terminations

If the debtor maintains a defined benefit pension plan, the PBGC will play a prominent role in the plan’s termination. Under Title IV of ERISA, the PBGC becomes responsible for payment of a certain portion of participants’ benefits (known as “guaranteed benefits”) when an underfunded plan terminates. Accordingly, the PBGC oversees all defined benefit plan terminations, and in some situations, the agency assumes trusteeship of the plan and takes over the termination process. The degree of PBGC oversight, and the Chapter 7 trustee’s role with respect to the plan termination, will depending on the extent to which the plan’s assets are sufficient to pay plan benefit liabilities. 

Because a contributing plan sponsor’s Chapter 7 bankruptcy filing is a “reportable event” under Title IV of ERISA, the plan administrator must provide certain information to the PBGC within 30 days of the event, including information and documents relating to the plan, the sponsoring employer, all members of the plan sponsor’s controlled group and the Chapter 7 trustee. The PBGC uses the information to assess the plan’s funding status and the status of all controlled group members. This leads to a determination of whether plan assets are sufficient for the trustee to apply for a standard termination, whether the circumstances would permit the trustee to apply for a distress termination, or whether the PBGC will assume trusteeship of the plan and undertake an involuntary plan termination.

1. Standard Terminations

If the PBGC determines that plan assets are sufficient to pay all benefit liabilities, the Chapter 7 trustee may proceed with a standard termination of the plan. The following is a list of steps a trustee will need to take or consider in connection with the standard termination of a defined benefit pension plan (in addition to those discussed in Part B, above):     

  • Review the plan documents, trust agreement and service provider agreements to determine the steps required to amend the plan to provide for its termination and provide notice to the trustee and other service providers of the plan’s termination. The trustee will need to work closely with legal counsel and the plan’s actuary to ensure the amendment includes all necessary provisions relating to the termination.  
  • Retain all necessary professional service providers to assist with the plan termination process, including a qualified actuarial firm to assist with the termination process and the calculation of plan benefits and an advisor or consultant to assist with the selection of an annuity carrier to pay plan benefits after the termination. To comply with its fiduciary responsibilities, the trustee may need to conduct a search and request for proposal (RFP) process to ensure that the actuarial firm and other service providers are appropriately qualified and experienced and that the fees they will charge are reasonable for the services they will perform. Where prudent and appropriate, the trustee should consider, among others, the actuary and other service providers that have previously provided services to the plan, because they will have institutional knowledge and historical records that may make the termination process more efficient.
  • Develop a timeline for the termination process and select the proposed termination date, in consultation with the plan’s actuary and legal counsel to ensure adequate time to prepare and distribute all required notices and complete all required governmental filings. The plan termination process includes many required steps, some of which have strict deadlines, so the trustee must develop and adhere to an appropriate timetable to ensure that all required steps are timely completed.
  • Amend the plan to provide for its termination and adopt resolutions to approve and adopt the amendment. If the plan does not normally permit lump sum distributions or distributions before a participant has reached normal or early retirement age, the trustee may want to consider including in the termination amendment a provision for a “lump sum window,” assuming the actuary determines that plan assets would be sufficient to support that option.
  • Prepare and timely distribute to participants the required Notice of Intent to Terminate the plan and the notice to interested parties of the intent to apply to the IRS for a determination letter in connection with the plan termination.
  • Prepare and file a Form 5310 Application for Terminating Plan with the IRS, seeking a determination that termination of the plan will not adversely affect its tax-qualified status and respond to all IRS inquires and requests for additional information in connection with the application.
  • File Form 500 with the PBGC in connection with the standard termination.
  • If requested, enter into an agreement with the PBGC for a pre-distribution audit of the termination process and complete the audit in accordance with the terms of the order. The PBGC generally conducts a post-distribution audit in connection with a standard termination, but where a standard termination occurs in the bankruptcy liquidation context, the PBGC typically asks the trustee to enter into an agreement and jointly apply to the bankruptcy court for an order to conduct a pre-distribution PBGC audit of the plan.
  • Prepare and send Notices of Plan Benefits and Notices of Annuity Information to plan participants and beneficiaries in accordance with PBGC requirements.
  • If the termination process includes a lump sum window, implement the lump sum window process upon receipt of a favorable IRS determination letter. The trustee will need to provide oversight of the distribution of participants’ benefits in accordance with elections made during the window period and will also need to address legal and administrative issues that arise during the election and distribution process.
  • Address legal and administrative issues arising in the termination process, including issues relating to qualified domestic relations orders and determination of beneficiaries of deceased participants.
  • Design and implement procedures to address missing participant issues, including search protocols and procedures for distribution of missing participant benefits to the annuity carrier (discussed below) or, in the case of small benefits, to rollover IRAs.
  • Select an insurance company from which to purchase a group annuity contract to pay future benefits after completion of the termination and notify participants of the carrier selection. Strict fiduciary standards apply to the evaluation and selection of the annuity carrier, so the trustee must enlist the services of a qualified consultant to assist in the evaluation and selection of the annuity carrier and documentation of the selection process. The trustee must also select a qualified custodian of rollover IRAs for participants who fail to make timely elections with respect to the forced cash-out of small benefit amounts.
  • File Form 501 with the PBGC following the distribution of all plan benefits.
  • Finalize the group annuity contract with the selected insurance carrier and ensure that the insurance carrier distributes certificates to participants and beneficiaries covered by the contract.

2. Distress and Involuntary Terminations

The PBGC will generally expect the Chapter 7 trustee to apply for a distress termination of the plan if (1) the plan sponsor and all controlled group members are in bankruptcy liquidation or insolvency proceedings, and (2) the PBGC concludes that plan assets are not sufficient to satisfy all benefit liabilities but are sufficient to pay all guaranteed benefits. Many of the steps in a distress termination are similar to those in a standard termination, but there is greater PBGC oversight, and different PBGC forms and timelines apply. The PBGC’s website (www.pbgc.gov) includes a forms package for distress terminations (as well as for standard terminations.) Steps in a distress termination include the following:

  • Select a proposed termination date.
  • Prepare and timely send a Notice of Intent to Terminate (PBGC Form 600) to participants and beneficiaries and the PBGC.
  • Reduce the benefits of participants in pay status (those who are already receiving periodic pension payments) to their estimated guaranteed benefit amounts, beginning on the proposed termination date.
  • File a Distress Termination Notice (PBGC Form 601) with the PBGC no later than 120 days after the proposed termination date.
  • File participant and benefit information with the PBGC by the later of (1) 120 days after the proposed termination date, or (2) 30 days after receipt of the PBGC’s notice that the requirements for a distress termination have been satisfied.
  • Notify participants and distribute benefits in accordance with PBGC requirements, assuming the PBGC has determined that the plan has sufficient assets to pay all guaranteed benefits. 
  • File a Post-Distribution Certificate (PBGC Form 602) with the PBGC.

If the PBGC determines that a plan does not have sufficient assets to pay at least the guaranteed benefits, it will initiate an involuntary termination of the plan or, if a distress termination has commenced, convert the distress termination to an involuntary termination. The PBGC will also initiate an involuntary termination if it determines that the plan does not have sufficient assets to pay current benefits when due. In an involuntary termination, the PBGC (or an independent trustee appointed by the PBGC) takes over trusteeship of the plan. In such a case, the Chapter 7 trustee’s role will be to cooperate with the PBGC, including by providing all requested documents and records and entering into a trusteeship agreement with the PBGC. The Chapter 7 trustee will need to consider whether to seek an order from the bankruptcy court approving and authorizing the Chapter 7 trustee to execute the trusteeship agreement with the PBGC.


About the Authors

Gayle L. Skolnik is a partner at Faegre Baker Daniels LLP. She represents employers, plan fiduciaries and service providers with respect to all aspects of employee benefits law, and she regularly works with the firm’s Finance and Restructuring group to address benefits issues arising in the context of bankruptcy and restructuring. Her experience includes advising bankruptcy trustees and other plan fiduciaries in benefit plan matters arising in bankruptcy and insolvency, including plan terminations. Gayle graduated with highest distinction from Indiana University and summa cum laude from Indiana University Maurer School of Law. She has been listed in The Best Lawyers in America since the 2005-2006 edition.

Elizabeth M. Little is an attorney with Faegre Baker Daniels LLP in Indianapolis. She represents clients in financial matters, including complex financial transactions, corporate debt restructurings, and related litigation matters. Little holds a bachelor’s degree from Indiana University-Purdue University of Indianapolis and a law degree from Indiana University Robert H. McKinney School of Law.