Plan sponsors are aware that their qualified plan can be terminated, and that such action has consequences that must be administered, because the plan sponsor generally intentionally initiates termination of a qualified plan. What they may not be aware of is that it is possible for a plan to experience a “partial termination” even if the plan sponsor did not intentionally initiate a termination. Because this can occur over a period of time, partial terminations frequently sneak up on plan sponsors. Partial terminations often present an unpleasant surprise as they also have consequences that must be administered. The fact that a partial termination may be discovered long after it occurs can complicate taking necessary measures and require correction to maintain the plan’s tax-qualified status.¹
Partial termination generally occurs when there is “significant turnover,” i.e., a (1) significant and (2) employer-initiated,reduction in the number of plan participants. That deceptively simple statement has many moving parts;based on several different sets of specific facts and circumstances, such as:
What is a “significant” turnover rate? A “significant” turnover rate is presumed where there is a reduction in participants of 20% or more,² but that presumption can be rebutted based upon facts and circumstances. For example, a significant turn over may be higher than 20% for plans maintained by employers with a high routine turnover rate.All participating employees are included in the analysis, including fully vested participants. Note that a partial termination can also be triggered by a plan amendment that adversely affects participants’ right to vesting(called “horizontal partial termination) or that reduces the number of employees eligible to participate in the plan.³ For example, if a plan is amended to exclude all employees in a division who were previously eligible to participate in the plan, and if the number of participants in the plan results in a significant reduction in plan participants, a partial termination results, triggering the special vesting requirements discussed below.
What does “employer-initiated” mean? Clearly a termination is employer-initiated if the employer fires or lays off the employee(e.g., termination other than due to death,disability or retirement),including, more relevantly in the current economy, in the context of mergers and acquisitions, where all or a group of employees ceases to be employed by the sponsor of the plan and so are no longer eligible to participate in the plan. It would see mintuitive that a termination is not employer-initiated if the employee voluntarily quits. However, the IRS’s position is that there is a presumption that all terminations in the relevant period were employer-initiated for purposes of determining whether a partial termination has occurred,even where a termination is categorized by the employer as voluntary. While the employee is the one who quit, the IRS is concerned that it could actually have been a constructive discharge, not truly voluntary, and therefore was effectively employer-initiated. This presumption is rebuttable, but this requires evidence of the reason for the termination to rebut the presumption.The presumption applies even where the reasons for the terminations were due to a circumstance beyond the employer’s control, such as depressed economic conditions.⁴
Which employer-initiated terminations are included in determining if a partial termination has occurred? A significant turnover can occur as the result of a single corporate event, such as the sale of a division, or it can occur over the course of a plan year,with a series of related lay-offs. Generally, partial terminations are determined on a plan-year-by-plan-year basis, looking at two plan years prior to the one identified as having a potential partial termination and the year following (if applicable). However, if the facts indicate that a series of related employer-initiated turnovers started in one plan year and continued into the next plan year, depending on all of the relevant facts and circumstances;it is possible that there has been a partial termination even though there was less than a 20% turnover rate in either plan year. ⁵
What are the consequences of a partial termination?If it is determined that a partial termination has occurred, all affected participants must be fully vested. That may involve a simple administrative adjustment in record keeping when the affected participant has not taken a distribution, or, if the affected participant has taken a distribution,it may involve re-opening the participant’s account to reallocate funds from a forfeiture suspense account. While the restoration of forfeited amounts can generally be paid out of a plan’s forfeiture account, if there are no forfeitures available to restore forfeited amounts, the employer may need to make a contribution sufficient to cover these amounts.
Who are “affected participants”?Since full vesting must be provided to all affected participants, it is important to carefully identify affected participants.The IRS position, as described in Revenue Ruling 2007-43, is that all participants who had a severance from employment during the period must be fully vested. This means that, under the IRS’s interpretation, if it is determined that a partial termination did occur, even participants who terminated voluntarily, or were terminated for cause, the IRS believes that they should also receive full vesting, even though they were not directly “affected.”This interpretation appears to conflict with the statute which only requires that affected participants receive full vesting,and possibly with certain case law⁶ but to date there have been no challenges to this position in court.
What does the employer need to do to implement or correct a partial termination?Once a partial termination has been determined to have occurred, and affected participants have been identified, the employer will need to work with the plan’s record keeper to determine the administrative steps that must be taken to provide the full vesting, restore any forfeited amounts, and make any necessary employer contributions.
What should the employer do if it isn’t sure a partial termination has occurred?Working with legal counsel is always recommended in these situations, particularly due to the facts-and-circumstances-reliant analysis that must be done. In addition, legal counsel can assist in drafting and filing a Form 5300 submission with the IRS for a determination on whether a partial termination occurred, which might be desirable where the facts could support no partial termination and the cost of full vesting is prohibitive.
What are other consequences of a partial termination?While ERISA does not have a similar requirement regarding partial terminations, ERISA does require that plans follow the terms of the governing documents unless they are contrary to other ERISA requirements⁷. Since a requirement for qualification under Code Section 401(a) is that the vesting terms for a partial termination be in the governing plan document⁸, affected participants may have a cause of action under ERISA for a denial of benefits if they did not receive full vesting that they were entitled to under the plan. In addition, in rare cases, if a restoration payment is made as a result of a Department of Labor investigation due to a fiduciary breach, they can assess a penalty equal to 20% of the amount restored.⁹
Ultimately, any set of terminations that may be significant should be a red flag to both the employer and the IRS. In fact, the IRS does look at the participant numbers in Form 5500s (and Form 5310) to see if a potential partial termination has occurred. Employers should consult their TPA and legal counsel as soon as any increased termination activity is detected so a partial termination doesn’t catch them unawares.
© Boutwell Fay LLP 2018, All Rights Reserved.This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create anattorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us.The information contained in this article is effective as of July 31, 2018.
¹ See IRS Retirement Plan FAQs Regarding Partial Termination at https://www.irs.gov/retirement-plans/retirement-plan-faqs-regarding-partial-plan-termination visited on July 28, 2018, Issue Snapshot -Partial Termination of Plan at https://www.irs.gov/retirement-plans/partial-termination-of-plan.
² See Revenue Ruling 2007-43 and 26 CFR 1.411(d)-2, and Matz v. Household International Tax Reduction Investment Plan, 388 F.3d 570 (7thCir. 2004)
³ See Revenue Ruling 2007-43 and In re Gulf Litigation, 764 F.Supp. 1149 (S.D.Tex. 1991).
⁴ See IRS Retirement Plan FAQs Regarding Partial Termination.
⁵ See Revenue Ruling 2007-43and Matz v. Household International Tax Reduction Investment Plan, 388 F.3d 570 (7thCir. 2004).
⁶ See, e.g., Borst v. Chevron Corp., 36 F.3d 1308, 1314, n. 9 (5thCir. 1994), Bordav. Hardy, Lewis, Pollard & Page, P.C., 138 F.3d 1062, 1068-69 (6thCir. 1998), Artz v. Fairbanks Co., 112 F.R.D. 59, 61-62 (N.D.N.Y. 1986)
⁷ ERISA §404(a)(1)(D)
⁸ 26 CFR 1.411(d)-2(i)
⁹ ERISA §502(i)