Tag Archive for: termination

Governance
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Plan Termination and the Principle of Permanency

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“I have a client who set up a cash balance plan a few years ago and now wants to terminate the plan. Is that OK? Or does the IRS require a sponsor to maintain its qualified plan for a certain number of years?”

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 an advisor in Illinois is representative of a common inquiry related to plan termination and the principle of permanency.

Highlights of Discussion

It depends on the reason your client is ending the plan. The IRS has an expectation of plan permanency. “The term ‘plan’ implies a permanent, as distinguished from a temporary, program,” Treasury Regulation 1.401-1(b)(2). However, a plan sponsor reserves the right to change or terminate the plan, and discontinue contributions, but if this happens within a few years after plan establishment, the plan sponsor must document as evidence a valid business reason for terminating the plan. Without documentation of the business necessity, upon examination the IRS will presume the plan was not intended to be a permanent program from its inception. A potential consequence could be the IRS would deem the plan was never qualified and revoke its tax-favored status—making the plan’s assets immediately taxable to participants, and any tax deductions taken by the employer null and void.

What is “a few years?” The IRS gave more insight into the time requirement for plan permanency in Revenue Ruling 72-239, stating a plan that has been in existence for over 10 years can be terminated without a business necessity.

In Revenue Ruling 69-25 the IRS elaborated on what constitutes a “business necessity.” Business necessity, in this context, means adverse business conditions, not within the control of the employer, under which it is not possible to continue the plan, including bankruptcy or insolvency, and discontinuance of the business, along with merger or acquisition of the plan sponsor, provided the merger or acquisition was not foreseeable at the time the plan was created.

IRS examiners are instructed to look for evidence of plan permanency. The IRS’s Employee Plans Guidelines for Plan Terminations at 7.12.1.3 outline the steps examiners must take to evaluate plan permanency, including checking Forms 5310, Application for Determination Upon Termination to determine how long the plan has been in existence, the reason for termination and, if terminated due to adverse business reasons, an explanation detailing the conditions that require the sponsor to end the plan. The examination steps in the Internal Revenue Manual also list the valid business reasons that demonstrate “necessity” for plan termination purposes.

As a fiduciary liability mitigation strategy, a plan sponsor should thoroughly document any decision to terminate its retirement plan, and the reasons for terminating, being mindful of the need for documentation of a valid business reason if termination occurs within a few years after the plan’s initial adoption.

Conclusion

Business owners who have established or who may be contemplating establishing a qualified retirement plan must be aware that the IRS expects the arrangement will be a permanent one. And, although plan sponsors reserve the right to terminate their qualified retirement plans, the IRS views “business necessity” as the only legitimate reason for plan abandonment within the first few years of establishment.

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Partial Plan Termination and the Applicable Period

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“My client suffered an accident and cannot keep employees on at his business. He was wondering if he could lay off employees over time to avoid triggering full vesting for a partial plan termination?”

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 an advisor in Ohio involved a case related to a partial plan termination.

Highlights of Discussion

  • The IRS will determine whether a partial plan termination has occurred based on the facts and circumstances of a particular scenario [Treasury Regulation § 1.411(d)-2(b)]. According to Revenue Ruling 2007-43, one of the circumstances considered is the employee turnover rate during “the applicable period.”
  • The applicable period is a plan year (or, in the case of a plan year that is less than 12 months, the plan year plus the immediately preceding plan year) or a longer period if there are a series of related severances from employment. Consequently, in your client’s situation, because the layoffs would all occur as a result of a single event—the IRS would consider them related severances.
  • There are other guidelines in Revenue Ruling 2007-43 that are helpful in determining 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 percent.
  • 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 deemed 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 severances from employment that plan sponsors DO NOT factor in when determining the 20 percent ratio are those that are out of the employer’s control (e.g., an employee death, disability, retirement or depressed economic conditions).
  • Partial plan terminations 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 percent guideline in Rev. Rul. 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 percent threshold still stands under the IRS’s revenue ruling.
  • Keep in mind that employee turnover is not the only reason for a partial termination. A partial termination can also happen if a sponsor adopts amendments that adversely affect the rights of employees to vest in benefits under the plan, excludes a group of employees that previously had been included, or reduces or ceases future benefit accruals that can result in a reversion to the employer (in the case of a defined benefit plan), the IRS may find that a partial termination occurred, even if the turnover rate is under 20 percent (Issue Snapshot-Partial Plan Termination).
  • 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 Instructions for Form 5300, Application for Determination for Employee Benefit Plan with the IRS to request a determination of partial plan termination.

Conclusion

Based on facts and circumstances over the applicable period, a company could be deemed to have a partial plan termination. The participants affected by the partial plan termination must become 100 percent vested in their account balances upon termination. Plan sponsors should monitor their companies’ turnover rates and amendment activities to be aware of potential partial plan terminations.

 

 

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Reduction in Workforce and Partial Plan Terminations

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“My client had a 35 percent reduction in workforce in January 2020. Does that automatically mean the business suffered a partial plan termination?”

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 an advisor in Massachusetts is representative of a common inquiry related to reductions in workforce.

Highlights of Discussion

Not necessarily; it all depends on the facts and circumstances, and whether those terminated employees are rehired by the end of 2020.

The IRS presumes there is a partial plan termination when an employer reduces its workforce (and plan participation) by at least 20 percent during the plan year. This presumption is rebuttable, however. The IRS makes it clear that an actual determination of a partial plan termination is based on all the facts and circumstances of a particular scenario [Treasury Regulation § 1.411(d)-2(b)]. The IRS’s Revenue Ruling 2007-43 provides further guidelines to help determine if a partial plan termination has occurred. For additional coverage, please see RLC’s related Case of the Week.

The most recent guidance on this issue comes from the IRS’s Coronavirus-related relief for retirement plans and IRAs questions and answers, Q&A 15 (added July 2020). As a result, for purposes of determining whether a partial termination of a retirement plan occurred during the 2020 plan year, the IRS will not treat plan participants who were furloughed as having an employer-initiated severance from employment during the year if the business rehires them by the end of 2020. If that is the case, then immediate vesting of employer contributions would not apply.

Determining whether a plan is partially terminated is important because the IRS requires that all participants covered under the portion of a plan that is deemed terminated become 100 percent vested in matching and other employer contributions if the contributions were subject to a vesting schedule [IRC §411(d)(3) and Treasury Regulation 1.411(d)-2]. That could be very expensive, and something to think about if rehiring is a viable option.

Conclusion

The determination of whether or not a partial plan termination has happened depends on the facts and circumstances that occur over (at least) a full plan year. Although not binding legal authority, the IRS’s FAQ on rehires during 2020 provides plan sponsors insight into how the IRS will view such activities this year.

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Sham termination of employment and distributions

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“What are the rules regarding firing an employee, allowing the individual to take a distribution from his 401(k) account and then rehiring the same individual? Is it a valid distribution? If not, is the plan in jeopardy of processing an impermissible withdrawal?”

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, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, 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 West Virginia is representative of a common inquiry related to severance of employment and distributions.

Highlights of the Discussion

The IRS could view the firing and re-hiring of an employee who has taken a distribution of plan assets due to separation of service or severance of employment[1] as either a “sham” or a “bona fide” termination depending on the facts and circumstances. Qualified retirement plan assets, typically, are not distributable until the participant incurs a distribution triggering event as outlined in the governing plan document, for example, separation of service or severance of employment (see pages 196-197 from the pdf for Revenue Ruling 56-214). In the case of a sham termination, the processing of an impermissible distribution without a legitimate distribution triggering event is an operational failure that, potentially, could put the plan at risk of disqualification, resulting in possible adverse tax consequences to the participant and the employer (see Private Letter Ruling 2000-0245).

There is no definitive rule prohibiting the rehiring of an employee who has received a plan distribution as a result of leaving employment. For example, at least one court ruled that a participant had a true termination, even though he returned to employment with his former employer five months after he retired, because at the time of his retirement he had no intention of returning to work and was only able to return to employment following an unforeseen change in circumstances (see Barrus v. United States, 23 AFTR 2d 990 (DC NC 1969)).  And in Revenue Ruling 69-647 (see pages 100-101 of Internal Revenue Cumulative Bulletin 69[2] , the IRS ruled that a senior executive who retired from full-time employment and continued to render services to the same company, but on a part-time basis as an independent contractor, was considered to have terminated employment.

However, if the IRS determines the termination is a ruse merely to facilitate a distribution not otherwise available, and both the plan sponsor and participant know in advance that the fired individual will be rehired, the IRS may view such action as a sham termination. The IRS specifically “does not endorse a prearranged termination and rehire as constituting a full retirement” (see the preamble to REG-114726-04 ).

The basic rule is that, to receive a distribution from a 401(k) plan on account of a severance of employment, the participant must have experienced a bona fide termination of employment in which the employer/employee relationship is completely severed.

Facts and circumstances the IRS will consider include the following:

  1. Did the plan sponsor follow the terms of the plan document? (Allowing a distribution as a result of a sham termination would constitute a failure to follow the terms of the plan document because plan assets were distributable in a situation not provided for under the terms of the plan).
  2. Did the termination of employment and processing of the distribution follow all the established administrative procedures?
  3. How long was the time interval between termination and rehire?
  4. What documentation exists to substantiate the termination and distribution?
  5. Did the alleged sham termination involve a highly compensated employee?

Conclusion

A plan sponsor and participant(s) who collude to stage a firing/re-hiring scenario to facilitate a qualified plan distribution are potentially putting the qualified status of the plan at risk. Under investigation, the IRS could determine the termination is a sham and impose sanctions.

Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

[1] Prior to January 1, 2002, most plans used the term “separation from service” rather than “severance of employment.” Separation of service carried the “same desk rule,” which prevented many 401(k) plans from making distributions to former employees who continued working at the same job but for a different employer as the result of a merger, acquisition or similar transaction. The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed plan sponsors to replace the separation from service/same desk requirement to allow for distribution upon a participant’s severance from employment with the employer sponsoring the plan.

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Complete discontinuance of profit sharing plan contributions

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“I came across a prospect that froze it’s profit sharing plan several years ago, and has not made contributions since. Are there any concerns regarding 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, qualified retirement plans and other types of retirement savings plans. 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 Colorado is representative of a common inquiry related to on going contributions to a profit sharing plan.

Highlights of Discussion

While contributions to profit sharing plans are generally discretionary, meaning a plan sponsor can decide from year to year whether to make a contribution or not, the IRS expects that contributions will be “recurring and substantial” over time in order for a plan to be considered ongoing and remain viable [Treas. Reg. § 1.401-1(b)(2)].

If contributions cease, a complete “discontinuance of contributions” has occurred in the IRS’s eyes, which triggers a plan termination and complete (100%) vesting of participants’ accounts [Treas. Reg. § 1.411(d)-2(a)(1)].  Contrast this with a “suspension of contributions” under the plan, which is merely a temporary cessation of contributions by the employer. A complete discontinuance of contributions still may occur even though the employer makes contributions if such contributions are not substantial enough to reflect the intent on the part of the employer to continue to maintain the plan (e.g., only forfeitures are allocated).

The IRS makes a determination as to whether a complete discontinuance of contributions under a plan has occurred by considering all the facts and circumstances in the particular case, and without regard to any employee contributions (i.e. pre-tax deferrals, designated Roth or after-tax contributions). According to the IRS’s exam guidelines at Part 7.12.1.4, examiners are to review IRS Form 5310, line 19a, which indicates employer contributions made for the current and the five prior plan years, to determine if the plan has had a complete discontinuance of contributions. In a profit sharing plan, if the plan sponsor has failed to make substantial contributions in three out of five years, there may be a discontinuance of contributions. Other considerations include whether the employer is calling an actual discontinuance of contributions a suspension of such contributions in order to avoid the requirement of full vesting, and whether there is a reasonable probability that the lack of contributions will continue indefinitely.

Under Treas. Reg. § 1.411(d)-2(d)(2) a complete discontinuance becomes effective for a single employer plan on the last day of the employer’s tax year after the tax year for which the employer last made a substantial contribution to the profit-sharing plan. For a plan maintained by more than one employer, a complete discontinuance becomes effective the last day of the plan year after the plan year within which any employer last made a substantial contribution.

If a plan suffers a complete discontinuance and the plan sponsor has made partially vested distributions, the plan’s qualified status is at risk. The plan sponsor can fix the error by using the Employee Plans Compliance Resolution System. The correction will require restoring previously forfeited accounts to affected participants, adjusted for lost earnings, and correcting IRS Form 5500 filings for the plan.

For additional information, please refer to the IRS guidance No Contributions to your Profit Sharing/401(k) Plan for a While? Complete Discontinuance of Contributions and What You Need to Know.

Conclusion

While employer contributions to a profit sharing or stock bonus plan are discretionary in most cases (check the document language), the IRS still expects them to be recurring and substantial to a certain extent. For example, if the plan sponsor has failed to make substantial contributions in three out of five years, there may be a discontinuance of contributions, which triggers plan termination and complete vesting of benefits.

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