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IRS Cautions Against “Sham” Retirements

A recent private letter ruling gave the IRS an opportunity to reemphasize its position that “pension plans” (whether defined benefit or money purchase) must not allow in-service distributions before age 62.  A participant’s “early retirement” will not support a distribution unless the participant actually terminates employment, and a pension plan that makes distributions in connection with a sham retirement may be disqualified.

Although the result announced in PLR 201147038 was not surprising, the ruling is interesting for a couple of reasons.  First, it arose in a somewhat unusual context.  Second, the IRS cited an unusual variety of sources in reaching its conclusion.

This ruling arose when a multiemployer pension plan entered into “critical” funding status.  Under the law, this forced the plan’s trustees to consider eliminating certain otherwise-protected benefits – including a heavily subsidized early retirement benefit.  The plan provided unreduced early retirement benefits to participants retiring with 20 or more years of service, regardless of their age.

The plan’s trustees proposed to eliminate this heavily subsidized benefit, but only after giving eligible participants 60 days’ advance notice of its elimination.  Participants could then exercise their right to “retire” – thereby locking in the subsidy – but then immediately return to covered employment.  Although their pensions would be suspended during this period of “reemployment,” they would thereby retain the right to terminate employment at a later date (but still before their normal retirement date) and receive the unreduced pension.  The trustees asked the IRS to rule that this approach would not disqualify the plan.

In ruling to the contrary, the IRS relied on a pre-ERISA regulation issued under Code Section 401(a).  This requires that any pension plan provide for the payment of benefits “after retirement.”  Later regulations allowed for in-service distributions after a plan’s normal retirement date, and the 2006 Pension Protection Act added yet another exception for in-service distributions commencing at or after age 62.

The task the IRS faced in issuing this ruling was to put some meat on the bones of the regulatory phrase “after retirement.”  In doing so, the IRS cited a veritable menagerie of sources, including the following:

  • Regulations issued under Code Section 409A (dealing with nonqualified deferred compensation),

  • Regulations describing the “elapsed time” method of crediting service,

  • A 1979 revenue ruling defining the phrase “separation from service” for purposes of the special tax treatment afforded certain “lump-sum distributions,”

  • The preamble to 2004 regulations concerning “phased retirement,” and

  • A 1993 decision by the Seventh U.S. Court of Appeals, which itself relied on Webster’s Ninth New Collegiate Dictionary for the definition of “retire.”

After considering these various authorities, the IRS ruled as follows:

We have concluded that employees who “retire” on one day in order to qualify for a benefit under the Plan, with the explicit understanding between the employee and employer that they are not separating from service with the employer, are not legitimately retired. Accordingly because these employees would not actually separate from service and cease performing services for the employer when they “retire” these “retirements” would not constitute a legitimate basis to allow participants to qualify for early retirement benefits (which are then immediately suspended). Such “retirements” will violate section 401(a) of the Code and result in disqualification of the Plan under section 401(a) of the Code.

Noting the Pension Protection Act change referenced above, the IRS did make clear that this conclusion does not apply after a participant’s attainment of age 62.

So what are the practical implications of this ruling? Although a PLR is binding only with respect to the taxpayer to whom it is issued, other multiemployer plans should certainly heed its warning. Participants in these plans should not be allowed to avoid the type of benefit cutbacks the Tax Code requires as a way of exiting critical funding status simply by engaging in sham retirements.

But sponsors of single-employer pension plans should heed this warning, as well. Increasingly, older employees seek to be placed on a reduced work schedule but then allowed to supplement their lower salary or wages by beginning to receive their pension benefit. Unless such an employee is at least age 62, however, an employer will want to deny this request. The risk is that the IRS will audit the plan and then revoke its qualified status on the ground that it allows impermissible in-service distributions to active employees.

To ensure that an “early retirement” is not simply a sham – designed to gain access to a pension benefit while continuing to work for the same employer – any pension plan sponsor should take steps to ensure that benefits are paid only after a bona fide retirement. For instance, each potential early retiree might be asked to represent that he or she has no present intention of returning to work for the plan sponsor. And even though the IRS has never endorsed a “safe harbor” period of non-employment that will support an early retiree’s reemployment, pension plan sponsors might consider adopting a policy that forecloses the reemployment of retirees within 90 or 180 days of their retirement.

Now that the IRS has gone to the trouble of documenting its position in this area, IRS auditors may begin focusing more closely on this sham-retirement issue. Pension plan sponsors who choose to ignore this issue may therefore find themselves caught up in an unpleasant dispute with the IRS.