Part 2: Partial Plan Terminations

Workforce reductions seem to be an inescapable consequence of economic downturns. Whether this occurs through the sale of a business, layoffs or plant closures, employers too often overlook the potential impact on their employer-sponsored retirement plans. Unfortunately, failure to recognize and timely address the retirement plan implications of a reduction in force can jeopardize the plan’s tax qualified status and lead to costly and time-consuming corrections.

Earlier this month, we kicked off our blog series focused on the benefits implications of an economic downturn in Winter Is Coming: Employee Benefits Planning for the Eventual Economic Downturn. With Part 2, we now shift our focus to partial plan terminations. Fear not – as night gathers, our watch begins.

Background

Section 411(d)(3) of the Internal Revenue Code requires tax qualified retirement plans—both defined contribution plans (including 401(k) plans) and defined benefit plans—to fully vest affected participants upon the occurrence of a partial plan termination.

Failure to timely recognize and properly administer this obligation may result in the improper forfeiture of accrued benefits of terminated participants, correction of which may grow more-costly and administratively burdensome with the passage of time. For example, affected participants may include those who have terminated employment and received distribution of their account balances. Correction would likely require establishing a new account for the participant, crediting the amount improperly forfeited (with earnings), and communicating the error to the participant. That is, of course, if you can locate the former employee. In addition to potentially onerous correction, these types of failures also create a potential litigation risk from former participants related to claims for impermissibly reduced accrued vested benefits.

Has a Partial Termination Occurred?

A partial termination generally occurs when a sufficiently large number of plan participants are terminated over a specified period of time. The IRS has also indicated that a partial termination can occur for reasons other than turnover, such as plan amendments that exclude a group of employees that has historically been covered by the plan.

Whether a partial termination has occurred is generally measured over the plan year, though a longer period may apply if the reductions are in connection with a “corporate event.” Corporate events may include reduction in workforce (RIF) programs, plant closures, sales of businesses, or similar events.

To determine whether a partial termination has occurred, the following ratio must be calculated:

Plan Participants Terminated
During the Period (both Vested and Unvested)
                                                                                                               

Plan Participants at the Beginning of the Period +
New Participants Hired During the Period

If the resulting ratio for this period meets or exceeds 20%, a partial termination is presumed to have occurred.

There has been confusion in the past regarding who must be counted for purposes of calculating the turnover ratio. IRS guidance has clarified that both vested and nonvested participants are included in the calculation. The guidance has also clarified that employees who terminate employment other than those who die, become disabled, or retire at normal retirement age during the period must be included unless the employer can demonstrate that the employee would have resigned even if the corporate event had not occurred. This, of course, may be a difficult showing the make and generally leads to inclusion of all terminations other than those resulting from death, disability or retirement.

Who Must Be Fully Vested?

The IRS takes the position that all participants who terminate during the period covered by the partial termination must be vested. While it is possible to take the position that an employee who was terminated for cause or other unrelated reasons, or who voluntarily resigned during the period, should not be vested, most employers follow the IRS’s position and vest all employees who terminate during the applicable period.

Navigating a Partial Termination

While a plan termination may be “partial”, the plan sponsor should be fully engaged in planning for the event to avoid the burdensome correction previously mentioned. Advance planning will also allow the employer to anticipate future qualification issues that may increase the cost of plan compliance following the event. For example, if a plan sponsor of a 401(k) plan terminates a significant number of non-highly compensated employees, the plan may experience non-discrimination testing issues in the future, necessitating additional employer contributions to the plan or unwelcome benefit reductions among highly compensated employees.

While this blog has primarily focused on implications to 401(k) plans, partial plan terminations also may occur in defined benefit plans. We will focus on partial plan terminations in defined benefit plans—and other implications of reductions in force unique to defined benefit plans—in an upcoming blog.

The Wrap

In the event a plan sponsor proceeds with widespread layoffs, closing of a facility, reducing the pool of eligible employees, or similar action, care must be taken to comply with the resulting requirements, namely the accelerated vesting of participant retirement plan accounts. However, with a strategic plan, the risks associated with a partial plan termination can be anticipated and mitigated, resulting in the successful cost-savings that are necessary in an economic downturn.