Employers that sponsor qualified plans must monitor those plans for compliance with the Code’s requirements on partial plan terminations. Partial plan terminations occur when, by virtue of employer action, a plan realizes a significant decrease in the number of covered participants. In the case of a partial termination, a special 100% vesting rule applies.
Sec. 411(d)(3) provides in part that in order to be qualified, a plan must include a provision stating that in the case of a partial termination, all affected employees have a nonforfeitable right (100% vesting) to their funded accrued benefit, in the case of a defined benefit plan, or their account balance, in the case of a defined contribution plan.
The Code does not define partial termination or affected employee. However, Regs. Sec. 1.411(d)-2 does provide guidance on what is and what is not a partial plan termination. Partial terminations occur as a result of employer action to:
- Terminate employees (a reduction in force, for example);
- Exclude, by plan amendment, a group of employees from future coverage under the plan; or
- In the case of a defined benefit plan, reduce significantly or cease future benefit accruals that result in a potential reversion to the employer
Unlike most of the IRS’s qualified plan regulations, this regulation does not provide any sort of bright-line test. Instead, it requires the IRS to consider all facts and circumstances surrounding a plan and the employer sponsoring the plan in determining whether a plan has incurred a partial termination.
When Does Partial Termination Occur?
Most partial terminations occur because of employer-initiated turnover. Courts have generally held that termination of a number of employees does not constitute a partial termination unless there is a significant reduction in plan participants (see Weil v. Retirement Plan Admin. Comm. of the Terson Co., 933 F.2d 106 (2d Cir. 1991)). Historically, the IRS has used a 20% or greater turnover factor as a rebuttable presumption that a partial termination has occurred. When the turnover factor is greater than 20%, the IRS will require the employer to demonstrate why a partial termination has not occurred.
The IRS approach to determining the turnover rate is to divide the number of participating employees who had an employer-initiated severance from employment during the applicable period by the sum of all participating employees at the start of the applicable period plus the employees who became participants during the applicable period. For example, if a plan with 100 participating employees at the plan year’s beginning had 35 employees terminate and added 40 new participants, the plan’s initial turnover factor would be 25% (35 ÷ (100 + 40)). Even though there is a net growth of employment at the company, an employer with a plan in this circumstance would have to demonstrate why a partial termination has not occurred. The employer can do so by identifying how many employees in the numerator terminated voluntarily as opposed to by employer-initiated action.
The number of participating employees reflected in both the numerator and the denominator described above includes all participants, whether vested or not. The applicable period for the computation is generally the plan year. However, the IRS’s position is that it may extend the period in the case of a short plan year or other appropriate circumstances. For example, a period longer than a plan year may be part of the applicable period where there is a series of related terminations from services. The rationale supporting the IRS’s position is that a taxpayer should not be able to use the intervention of the end of a plan year in between two or more related corporate events to argue that a partial termination did not occur.
Rev. Rul. 2007-43
The courts generally have supported the IRS’s approach to:
- Using 20% as a guideline as to whether a partial termination may have occurred;
- Including vested participants in the count; and
- Expanding the applicable period beyond the plan year (see Matz v. Household Int’l Tax Reduction Inv. Plan, 265 F.3d 572 (7th Cir. 2001)).
While not a party to Matz, the IRS used the Seventh Circuit’s holding in a later appeal in the Matz case (Matz v. Household Int’l Tax Reduction Inv. Plan, 388 F.3d 570 (7th Cir. 2004)) in drafting Rev. Rul. 2007-43. This revenue ruling was an opportunity for the IRS to issue more comprehensive guidance on this subject.
Under Rev. Rul. 2007-43, the IRS’s view of an employer-initiated severance is very broad and includes any severance from employment other than severance that is on account of death, disability, or normal retirement. Even if the severance from employment is for reasons beyond the employer’s control, such as the result of bad economic times, the IRS considers the termination from employment an employer- initiated severance. In other words, even if someone just quits, the IRS will consider the termination to be employerinitiated unless the employer can demonstrate otherwise.
However, an employer can rebut this presumption of involuntary termination. One factor the IRS will consider is a showing by the employer that the turnover rate for an industry is high (as in retail or food service, for example). An employer can also provide information from its employee personnel files to demonstrate the voluntary nature of the termination. The employer can present information on the terminated employee’s prior acceptance of another job, the employer’s immediate search to replace the terminated employee, etc., as evidence.
If a partial termination occurs, the affected participants are those participants that were, during the applicable period, part of an employer-initiated severance from employment or the subject of a plan amendment that resulted in either their exclusion from the plan or a reduction in their accrued benefit (that leads to the potential for a reversion to the employer). The plan’s established vesting schedule will continue to apply to employees not affected by the partial termination.
Consequences of a Partial Termination Finding
The consequences of the IRS’s finding that a partial termination has occurred where a plan has been otherwise administered can be particularly difficult for a defined contribution plan. Affected employees may have received a distribution of their vested account balance and forfeited the unvested portion. In the course of a plan’s administration, forfeitures are often reallocated to other participants, used to reduce future employer contributions, or used for the payment of plan expenses.
If the IRS subsequently finds that a partial termination occurred, the employer must determine which plan participants would have required an acceleration of their vesting due to the partial termination. Participants who incurred the improper forfeiture of their account balance would be due additional plan benefits. Thus, to the extent the plan has reallocated these forfeitures to other participants or otherwise used them, the employer will be responsible for the “shortfall” to these participants’ accounts.
An employer may request a determination letter on the issue of whether or not the plan has a partial termination. However, because the determination letter process can be lengthy and burdensome, an employer may choose to internally assess whether a partial plan termination has occurred and take action to vest the affected employees.
When the economy moves downward, partial plan terminations tend to trend upward. The worst-case consequence of failing to identify a partial plan termination is the disqualification of the plan sponsor’s qualified plan. Plan sponsors need to carefully consider whether any plan they sponsor may have undergone a partial plan termination. Fortunately, the IRS is unlikely to propose the drastic consequence of disqualification. However, in the case of an audit and any related closing agreement process, the IRS will require the plan sponsor to pay a monetary sanction and reinstate any forfeited benefits or account balances of the affected participants. Even this bestcase scenario of correcting the error with IRS supervision would be an expensive and time-consuming process that an employer could avoid through better upfront monitoring.
Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or firstname.lastname@example.org.