“Because of the current economic uncertainty, my client, a small business owner, may have to lay off a sizable portion of her workforce, with the hope of rehiring the individuals sometime down the road. How could this affect the 401(k) plan for the business?”
ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.
A recent call with a financial advisor from Pennsylvania is representative of a common inquiry related to plan terminations.
Highlights of the Discussion
- Many business owners are in the same unsteady boat as your client right now. It is important for them to consider that 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. More simply put, the IRS could view the portion of the plan that covered the terminated employees as closed, while the other portion remains active.
- 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 and other employer contributions if the contributions were subject to a vesting schedule [IRC §411(d)(3) [1] and Treasury Regulation 1.411(d)-2 [2]]. (Of course, employee salary deferrals cannot be subject to a vesting schedule00so they are always fully vested.)
- Failure to fully vest the affected participants in their employer contributions to which they are entitled as of the termination date could result in underpayments from the plan when distributions to these individuals occur. These underpayments could, potentially, cause the IRS to disqualify the plan if the error is not corrected. This vesting failure can be corrected using the Employee Plans Compliance Resolution System [3].
- Whether a partial termination exists may not be an easy call. 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) [4]]. However, within Revenue Ruling 2007-43 [5], the IRS provides the following guidance in helping to determine if a partial plan termination has occurred.
- The IRS presumes there is a partial termination when an employer reduces its workforce (and plan participation) by at least 20%. This presumption is rebuttable, however. For example, if the situation is such that the turnover rate is routine for the employer, that favors a finding that there is no partial termination (See Rev. Ruling 2007-43).
- 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’s 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 greater than 20% presumption threshold still stands under the IRS’s revenue ruling.
- 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 [6] with the IRS to request a determination of partial plan termination. According to the Instructions to Form 5300 [7], one should follow the instructions under line 4a for Partial Termination Request.
- Regarding the question on terminated employees who are later rehired, any new employer contributions to the plan after rehire would be subject to the plan’s vesting schedule. The IRC and regulations merely require full vesting for the amount in the plan as of the date of the partial plan termination. Consequently, if a terminated employee leaves behind his or her plan balance and is later rehired, the plan would have to apply two vesting schedules.
Conclusion
Based on the given 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.