“My client is in the process of acquiring another company, which has a 401(k) plan. I’m concerned about a partial plan termination situation because of a reduction in force. What constitutes a partial plan termination and how might it affect the plan?”
ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
Highlights of discussion
- When a significant number or percentage of employees who are participating in a business’s qualified plan are terminated and/or are no longer eligible to participate in the plan, a partial termination may have occurred in the eyes of the IRS.
- Similar to a situation involving a complete plan termination, the IRS requires that all participants covered under the portion of the plan deemed terminated become 100% vested in matching contributions and other employer contributions [IRC 411(d)(3)]. Failure to fully vest participants could result in underpayments from the plan upon distribution of former participants’ account balances. These underpayments could, potentially, cause the IRS to disqualify the plan if the error is not corrected.
- The IRS makes it clear that the determination of a partial plan termination is based on the facts and circumstances of the particular scenario [Treasury Regulation § 1.411(d)-2(b) [1]]. However, within Revenue Ruling 2017-43 [2] the IRS provides the following guidance in helping to determine if a partial plan termination has occurred.
- A partial termination may be deemed to occur when an employer reduces its workforce (and plan participation) by 20%.
- The turnover rate is calculated by dividing employees terminated from employment (vested or unvested) by all participating employees during the applicable period.
- The applicable period is generally the plan year, but can be deem longer based on facts and circumstances. An example would be if there are a series of related severances of employment the applicable period could be longer than the plan year.
- The only severance from employment that is not factored in determining the 20% are those that are out of the employer control such as death, disability or retirement.
- Partial plan termination can also occur when a plan is amended to exclude a group of employees that were previously covered by the plan or vesting is adversely affected.
- In a defined benefit plan partial plan termination can occur when future benefits are reduced or ceased.
- The IRS adopted the 20% guideline in Rev. Proc. 2007-43 from a 2004 court case Matz v. Household International Tax Reduction Investment Plan, 388 F. 3d 577 (7th Cir. 2004), which, ironically, was dismissed in 2014 after its fifth appeal [Matz v. Household Int’l Tax Reduction Inv. Plan, No. 14-2507 (7th Cir. 2014)]. The 20% threshold still stands under the IRS’s revenue procedure.
- If a partial termination may be an issue, a plan sponsor may seek an opinion from the IRS as to whether the facts and circumstances amount to a partial termination. The plan sponsor can file, IRS Form 5300, Application for Determination for Employee Benefit Plan [3] with the IRS to request a determination of partial plan termination.
Conclusion
Based on facts and circumstances, a company could be deemed to have a partial plan termination. The participants affected by the partial plan termination must become 100% vested upon termination. Plan sponsors should monitor their companies’ turnover rates to ensure they are not experiencing a partial plan termination and, if they are, ensure affected former participants receive proper distributions from the plan.