Calling It Quits
Given our troubled economic times, many employers have been faced with difficult business decisions including wide-sweeping financial actions such as the suspension of retirement plan contributions, the elimination of raises and bonuses, and more drastic measures such as reductions in force. This article will discuss the collateral issue of plan partial terminations following events that affect the level of overall retirement plan participation, such as a reduction in force.
A partial termination occurs when a significant percentage of employees, who previously were covered under a retirement plan, are excluded from future participation by either an employer-initiated severance from service or by a plan amendment, even if the exclusion is due to events beyond the control of the employer (e.g., the declining economy). For this purpose, an employer-initiated severance from service includes all involuntary terminations other than terminations due to death, disability, retirement on or after attainment of normal retirement age, and voluntary terminations (except possibly voluntary terminations that arose in anticipation of a future layoff).
Why should an employer analyze whether a partial termination has occurred? Under the law, if a partial termination occurs, all affected individuals (e.g., the employer-initiated terminated participants included in the calculation of the turnover rate) must become 100% vested in their accounts under the retirement plan.
Defining Partial Termination
In Revenue Ruling 2007-43, the Internal Revenue Service (IRS) indicated that there is a presumption that a partial termination has occurred when the retirement plan’s turnover rate is 20% or more. The turnover rate is calculated by dividing (i) the number of vested and nonvested participants who were terminated by the employer during the applicable period by (ii) the sum of (a) all vested and nonvested participants at the start of the applicable period plus (b) employees who became participants during the applicable period. Generally speaking, the applicable period is the plan year; however, the applicable period may include more than one plan year if there is a pattern of related severances from employment.
The following illustrates the concepts above:
Example: Assume that an employer maintains a 401(k) plan in which all employees are eligible on their dates of hire. In February 2007, the employer terminates 70 employees as part of a business reorganization where the work of a particular division will be outsourced. In November 2007, due to declining economic conditions, the employer terminates an additional 54 employees. Other participant terminations are: 20 employees terminated due to death, disability, or attainment of normal retirement age, five employees voluntarily terminated (and not in anticipation of an impending layoff), and another six employees were terminated due to poor performance. Assume that, on January 2007, the 401(k) plan had 435 participants and that 30 employees became eligible to participate during 2007.
Analysis: The total number of vested and nonvested participants who were terminated by the employer is 130. The sum of the participants at the beginning of the plan year (435) plus the employees who became eligible during the plan year (30) equals 465. The turnover rate is 130 divided by 465, which equals 28%. Since the turnover rate is more than 20%, there is a presumption, under IRS rules, that a partial termination has occurred.
Given the potentially high cost of full vesting and recognizing that the ultimate determination of whether a partial termination actually has occurred is based on all the facts and circumstances, an employer wishing certitude as to whether a partial termination has occurred may choose to submit a Form 5300 determination letter request to the IRS. Among the facts that the IRS may examine is whether the turnover rate for an applicable period is routine (which may argue against partial termination); whether the layoffs used to calculate the turnover rate are, in fact, related; and the overall impact of involuntary terminations that are performance-related on the partial termination determination. Whatever avenue is chosen, employers (and their advisers) would be well-served to review routinely their retirement plans’ participant turnover rates, especially where employer-initiated events are involved.
Quana C. Jew is a partner at the law firm of Arent Fox LLP, focusing on ERISA, employee benefits, and executive compensation. Quana frequently serves as a guest lecturer in these areas for various law schools, bar seminars, and employee benefits-related organizations. Washingtonian magazine has repeatedly named Quana as one of Washington’s best tax lawyers.