Employers in all industries have faced unprecedented business challenges during 2020, and responding to those challenges has often entailed adjustments to the size and composition of workforces through targeted or broader-based reductions in force. As we finally face the end of this seemingly interminable year, it is important to consider some of the less-obvious consequences of reductions in force on tax-qualified retirement plans. In particular, a frequent “gotcha” for employers that have made significant workforce reductions during a year (or, in some cases, over a period of years) is the so-called “partial plan termination.” Failing to spot a partial plan termination can lead to costly and time-consuming plan repair work, but if an employer is alert to the circumstances in which one can occur, the potential pain of a partial plan termination can be readily avoided.
The Internal Revenue Code contains detailed rules regulating when and how employer contributions to retirement plans must become vested and nonforfeitable. As a reminder, employee-funded contributions to retirement plans are always fully vested when made, so the partial plan termination rules apply only to employer-funded benefits (e.g., matching or profit-sharing contributions in a 401(k) plan or benefit accruals under most defined benefit pension plans).
Generally, participants in these plans earn a right to employer-funded benefits over the period of time specified in the plan document. However, the Code has a long-standing rule that accelerates vesting automatically when a plan is terminated. The partial plan termination requirements are essentially a specialized application of this general rule: if a sufficiently large portion of a plan’s participant group terminates during a particular year, the Internal Revenue Service (IRS) considers the plan to have been partially terminated and the affected participants become entitled to accelerated vesting of their employer-funded benefits. A partial plan termination may also occur without a mass layoff when a plan amendment intervenes to disqualify a large group of participants from further participation or vesting.
Although accelerated vesting of employer-funded benefits might sound like an expensive proposition for an employer, the financial impact may end up being less than one might expect. Once employer contributions have been made to a retirement plan, the employer cannot generally reclaim them. In most cases, when a participant terminates and forfeits the unvested portion of his or her account balance or accrued benefit, the forfeited funds are simply reallocated within the plan and used to fund benefits for other participants or pay the plan’s administrative expenses. As a result, the employer doesn’t incur an out-of-pocket expense so much as lose the opportunity to recycle amounts that would have otherwise been subject to forfeiture. Correcting a partial plan termination after the fact is not likely to be as pain-free for the employer.
Prior to 2007, neither the Code nor its related tax regulations provided much guidance for employers that were trying to identify potential partial plan terminations, reverting to one of the IRS’s most favored and vague standards: the relevant facts and circumstances determine whether a plan amendment, mass layoff, or other event has caused a partial plan termination. This standard left courts as the primary arbiters of the partial plan termination standards and, predictably, their conclusions varied a good bit from circuit to circuit, meaning that an event might be regarded as a partial plan termination in Louisiana but not in Illinois. The varying application of these rules obviously complicated life significantly for employers that did business in multiple jurisdictions.
In 2007, the IRS issued a revenue ruling (i.e., official guidance with binding effect on both taxpayers and the IRS) that meaningfully clarified how the partial plan termination rules were to be applied. This ruling adopted a numerical threshold based on a plan’s “turnover rate” during a particular year or years and clarified how employers should calculate this rate. Specifically, the ruling indicated that if a plan experienced a turnover rate of 20 percent or more during a single year (or, in some cases, over two or more years for longer-term workforce restructurings), a partial plan termination would be presumed to have occurred, subject to the employer’s ability to rebut the presumption with evidence that the turnover at issue was normal.
Calculating the turnover rate for a plan is simple enough in theory, but employers often encounter difficulties with the process. Per the IRS guidance, the turnover rate is calculated by reference to the number of participants who experience employer-initiated terminations (including both vested and non-vested participants) relative to the total number of participants in the plan during the period at issue. Historically, there has been some confusion in the employer community about whether fully vested participants who terminate should be taken into account; a few years ago, the IRS clarified that all participants who do not leave of their own volition, whether fully vested or not, must be taken into account. Generally, an “employer-initiated termination” does not include a termination resulting from a participant’s death, disability, or retirement, and purely voluntary terminations are also excluded, provided the employer can document the basis for them.
The period over which the turnover rate should be calculated is usually the “plan year” (i.e., the 12-month period over which the plan is administered, as specified in the plan document), but there have been notable instances in which courts and the IRS have extended the relevant period to include one or more subsequent years. This is primarily a risk when an employer engages in a series of related workforce reductions over an extended period of time; whether multiple reductions over two or more years must be aggregated is—you guessed it—dependent on the relevant facts and circumstances. An employer that implemented a reduction in force in 2020 and that may be facing further reductions in 2021 may want to consider carefully the entirety of its likely pandemic-related workforce reductions when assessing whether a partial plan termination may have occurred.
Although annual reporting for 2020 for retirement plans that operate on a calendar-year basis remains some time off, employers may want to remember that the annual reports they submit for their retirement plans include questions that solicit participant information that can be readily used to determine whether the 20 percent threshold may have been crossed. The IRS has been known to follow up with employers that report reductions of 20 percent or more in participant headcount to seek additional information about the circumstances, and partial plan terminations are a common topic for discussion during IRS plan audits. Failure to timely identify and respond to a partial plan termination can require restoration of forfeited amounts (plus earnings) to the affected participants, both current and former.
As we wind our way to the end of 2020, employers may want to take a close look at any personnel actions they may have taken—or expect to take—that impact employees who participate in their retirement plans to determine whether partial plan terminations may have already occurred, and if so, they may want to ensure that appropriate action is taken to fully vest any participants whose employment ended during the year.
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