With the current economic
conditions, many companies have been forced to downsize either by
laying off a portion of the workforce or closing a plant or line of
business. These layoffs can have an impact on a qualified plan. If
enough employees are terminated, a partial plan termination can occur
which requires that the affected workers become fully vested in their
benefits.
To avoid administrative problems, it is important to identify
whether a partial termination has occurred at the time of the event
and not several years later. The situation is particularly problematic
in a defined contribution plan once the terminated employees'
nonvested benefits have been forfeited. If, at that point, the IRS
determines that a partial termination had occurred, the employer would
be required to make additional contributions to restore the forfeited
account balances of the nonvested participants.
Unfortunately, neither the tax code nor IRS regulations explain how
plans sponsors should determine whether a partial plan termination has
occurred. Fortunately, in a 2007 revenue ruling, the IRS provided
guidance for making this determination.
This article will review the procedures for determining whether a
partial plan termination has occurred along with providing examples of
the application of these procedures.
Background
Over the years both the IRS and the courts have offered insight
into how to determine whether a partial termination has occurred.
Treasury regulations provide that whether a partial termination has
occurred is determined with regard to all the facts and circumstances
in a particular case.
The regulations point out that a partial termination can arise in a
number of situations including:
- The termination of a group of employees formerly covered under
the plan;
- A plan amendment excluding a group of employees who have
previously been covered;
- A plan amendment that adversely affects the rights of employees
to vest in benefits under the plan; or
- In a defined benefit plan, the reduction or cessation of future
benefit accruals resulting in a potential reversion to the employer.
The regulations also clarify that the full vesting provisions only
apply to the employees affected by the partial plan termination.
A number of courts have also ruled on this issue. In probably the
most important case, Matz v. Household International Tax Reduction
Investment Plan, the court held that there is a rebuttable
presumption that a 20% or greater reduction in plan participants is
considered a partial termination.
Clearer Guidance from the IRS
With this background, the IRS revisited the partial termination
issue in a 2007 revenue ruling. This ruling was important because it
established much clearer standards for determining whether a partial
termination has occurred.
The case involved an employer that ceased operations at one of its
four business locations. As a result, 23% of the plan's participants
ceased active participation due to a severance from employment. Some
of those terminated participants were already fully vested at the time
of termination.
The IRS found that the facts and circumstances supported a finding
of a partial termination because the severances from employment
occurred as a result of the shutdown of one of the employer's business
locations (and not as a result of routine turnover).
The 20% Presumption
In the ruling, the IRS adopted the Matz holding that, if the
turnover rate is at least 20%, there is a presumption that a partial
termination has occurred. It also adopted another court position that
both vested and nonvested participants are counted in making this
calculation.
Calculating the Turnover Rate
The IRS specified that the turnover rate is determined by dividing
the number of participating employees who had an employer-initiated
severance from employment during the "applicable period" by the sum of
all of the participating employees at the start of the applicable
period plus the employees who became participants during the
applicable period (both vested and nonvested employees are included in
this calculation).
The IRS defined the applicable period as a plan year or a longer
period if there are a series of related severances from employment.
Example: Plan W has 300
participants at the beginning of the plan year. Due to a plant
closing, 80 participants are terminated from employment during the
year. An additional 20 employees become eligible to participate during
the plan year. The turnover rate is 80÷320 or 25%.
Defining Employer-Initiated Severance
The IRS broadly defined "employer-initiated severance" to include
any severance other than a severance that is on account of death,
disability or retirement on or after normal retirement age. A
severance is even considered employer-initiated if caused by an event
outside of the employer's control, such as severance due to depressed
economic conditions. However, the employer may be able to prove that
an employee's severance was voluntary and not employer-initiated
through documentation such as information from personnel files,
employee statements and other corporate records.
Example: Plan X has 120
participants at the beginning of the plan year. Due to economic
conditions, the company lays off 20 employees. In addition, 8
employees terminate on a voluntary basis (which can be documented). No
new employees become eligible during the plan year. The turnover rate
is 16.7% (20÷120).
Facts and Circumstances
Even though the focus is on the 20% presumption, the 2007 revenue
ruling notes that whether or not a partial termination occurs is still
ultimately dependent on all of the facts and circumstances in a
particular case.
If the employer can demonstrate that the turnover rate for an
applicable period is routine for the employer, this will favor a
finding that there is no partial termination for that applicable
period. In making the comparison, information as to the turnover rate
in other periods and the extent to which terminated employees were
actually replaced, whether the new employees performed the same
functions, had the same job classification or title, and received
comparable compensation are relevant to determining whether the
turnover is routine for the employer.
Thus, there are a number of factors that are relevant to
determining whether a partial termination has occurred as a result of
turnover, both in the case where a partial termination is presumed to
have occurred due to the turnover rate being at least 20% and in the
case where the turnover rate is less than 20%.
Applying the IRS Rules
The IRS guidelines go a long way toward creating discernable
standards. Especially helpful is the clearly defined method for
determining the turnover rate. Even though the test is still a facts
and circumstances test, the 20% presumption and the IRS's discussion
of what facts are relevant should make it easier to decide whether a
partial termination has occurred in a particular case.
Small Plans
The 20% presumption test may be most problematic for small
employers. A small employer can face the partial termination issue if
only one or two employees are laid off.
Example: Plan Y has 6 participants
at the beginning of the plan year. Due to economic conditions, the
company lays off 2 employees and no new employees become eligible to
participate during the plan year. The turnover rate is 33.3% (2÷6) and
the presumption is that a partial termination has occurred.
Note that even when the 20% threshold has been met, the employer
can rebut the presumption with facts that show that this is a normal
turnover rate--which may very well be the case with a small employer.
Also, the potential for problems demonstrates the necessity to keep
records documenting the circumstances of each employee's termination.
Series of Layoffs
If a partial termination occurs on account of turnover during an
"applicable period," all participating employees who had a severance
from employment during the period must be fully vested in their
accrued benefits. According to the IRS's definition of the "applicable
period," the IRS could look at the series as a single event. It's not
entirely clear when or how this determination would be made, which
could be problematic for the many employers facing this situation
today.
Example: Plan Z has 100
participants at the beginning of the plan year. Due to economic
conditions, the company lays off 10 employees in February. Fifteen
months later in May of the following year 15 more employees are
terminated. If the IRS considers this one "applicable period," it
appears that the employees laid off in February must be fully vested,
even though these layoffs did not result in a 20% or more turnover
rate.
Other Concerns
In addition to these issues, here are several additional concerns
under the current partial termination guidance:
- An employer should not rely entirely on the IRS guidance as
courts have sometimes come to different conclusions. For example,
some courts have focused on the number of terminated employees in
contrast to the IRS's focus on the percentage involved. This could
have an impact on larger employers.
- The 20% presumption does not preclude a finding of a partial
termination if the percentage reduction is less than 20%. What
changes is the IRS would have the burden to demonstrate that the
partial termination occurred instead of the employer having to rebut
the presumption.
- The rules not only apply to employee terminations but also can
apply when exclusion from the plan is a result of a plan amendment.
The IRS has not traditionally applied the partial termination rules
in these cases, but the IRS revenue ruling reminds us of this
possibility.
Conclusion
In these trying economic times, it is important for employers to be
aware that layoffs or plan cutbacks can result in a partial
termination of the company's qualified plan. The determination whether
a partial termination has occurred should be made at or about the time
of the employer-initiated reduction. Failure to 100% vest all affected
participants can result in plan disqualification.
Since employees who terminate voluntarily are not affected by a
partial plan termination, it is important for employers to document
the circumstances of each employee's termination.
An employer facing a situation of reducing its workforce should
review all the facts and circumstances in detail with the plan's
advisors to determine the appropriate course of action.
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