Has employer action caused a partial termination of their qualified retirement plan? The answer involves several technical details and is not always obvious or expected. Partial Terminations can be sneaky. A lay-off, or a plan amendment that excludes a previously eligible class of employees, could result in partial termination, with certain consequences for plan compliance. If a plan administrator is not paying attention, a partial termination can seem to arise suddenly; for example, after a series of relatively small rounds of layoffs suddenly reaches a significant threshold under the partial termination rules. The fact that a partial termination may be discovered long after it occurs can complicate taking necessary measures and may require correction to restore the plan’s tax-qualified status.
Partial termination generally occurs when there is “significant turnover,” i.e., a (1) significant and (2) employer-initiated, reduction in the number of plan participants. That deceptively simple statement has many moving parts, based on several different sets of specific facts and circumstances, such as:
What is a “significant” turnover rate?
A “significant” turnover rate is presumed where there is a reduction in participants of 20% or more, but that presumption can be rebutted based upon facts and circumstances. For example, a significant turnover may be higher than 20% for plans maintained by employers with a high routine turnover rate, or a small employer where even one terminated employee is a significant percentage. All participating employees are included in the analysis, including fully vested participants. Note that a partial termination can also be triggered by a plan amendment that adversely affects participants’ right to vesting (called “horizontal partial termination”) or that reduces the number of employees eligible to participate in the plan. For example, if a plan is amended to exclude all employees in a division who were previously eligible to participate in the plan, and if the number of participants in the plan results in a significant reduction in plan participants, a partial termination results, triggering the special vesting requirements discussed below.
What does “employer-initiated” mean?
Clearly a termination is employer-initiated if the employer fires or lays off the employee (e.g., termination other than due to death, disability or retirement), including, more relevantly in the current economy, in the context of mergers and acquisitions, where all or a group of employees ceases to be employed by the sponsor of the plan and so are no longer eligible to participate in the plan. It would seem intuitive that a termination is not employer-initiated if the employee voluntarily quits. However, the IRS’s position is that there is a presumption that all terminations in the relevant period were employer-initiated for purposes of determining whether a partial termination has occurred, even where a termination is categorized by the employer as voluntary. While the employee is the one who quit, the IRS is concerned that it could actually have been a constructive discharge, not truly voluntary, and therefore was effectively employer-initiated. This presumption is rebuttable, but this requires evidence of the reason for the termination to rebut the presumption. The presumption applies even where the reason for the terminations were due to a circumstance beyond the employer’s control, such as depressed economic conditions.
Which employer-initiated terminations are included in determining if a partial termination has occurred?
A significant turnover can occur as the result of a single corporate event, such as the sale of a division, or it can occur over the course of a plan year, with a series of related lay-offs. Generally, partial terminations are determined on a plan-year-by-plan-year basis, looking at two plan years prior to the one identified as having a potential partial termination and the year following (if applicable). However, if the facts indicate that a series of related employer-initiated turnovers started in one plan year and continued into the next plan year, depending on all of the relevant facts and circumstances, it is possible that there has been a partial termination even though there was less than a 20% turnover rate in either plan year.
What are the consequences of a partial termination?
If it is determined that a partial termination has occurred, all affected participants must be fully vested. That may involve a simple administrative adjustment in recordkeeping when the affected participant has not taken a distribution, or, if the affected participant has taken a distribution, it may involve re-opening the participant’s account to reallocate funds from a forfeiture suspense account. While the restoration of forfeited amounts can generally be paid out of a plan’s forfeiture account, if there are no forfeitures available to restore forfeited amounts, the employer may need to make a contribution sufficient to cover these amounts.
Who are “affected participants”?
Since full vesting must be provided to all affected participants, it is important to carefully identify affected participants. The IRS position is that all participants who had a severance from employment during the period must be fully vested. This means that, under the IRS’s interpretation, if it is determined that a partial termination did occur, even participants who terminated voluntarily, or were terminated for cause, the IRS believes that they should also receive full vesting, even though they were not directly “affected.” This interpretation appears to conflict with the statute which only requires that affected participants receive full vesting, but to date there have been no challenges to this position in court.
What does the employer need to do to implement (or correct an earlier failure to implement) a partial termination?
Once a partial termination has been determined to have occurred, and affected participants have been identified, the employer will need to work with the plan’s recordkeeper to determine the administrative steps that must be taken to provide the full vesting, restore any forfeited amounts, and make any necessary employer contributions.
What should the employer do if it isn’t sure a partial termination has occurred?
Working with legal counsel is always recommended in these situations, particularly due to the facts-and-circumstances analysis that must be done. In addition, legal counsel can assist in drafting and filing a Form 5300 submission with the IRS for a determination on whether a partial termination occurred, which might be desirable where the facts could support no partial termination and the cost of full vesting is prohibitive.
Ultimately, any set of terminations that may be significant should be a red flag to both the employer and the IRS. In fact, the IRS does look at the participant numbers in Form 5500s (and Form 5310) to see if a potential partial termination has occurred. Employers should consult their TPA and legal counsel as soon as any increased termination activity is detected so a partial termination doesn’t catch them unawares.