The short answer is –it depends. And at this point in the pandemic, it is probably too early to conclude one way or the other.
Relevant Rule and Applicable Standard
Generally, the Internal Revenue Code (Code) requires all unvested benefits to immediately vest when the (tax-qualified) plan¹ is either terminated or the plan experiences a “partial termination.” Whether or not a partial termination occurs,and the exact point in time the partial termination occurs, is determined by the IRS based on all the facts and circumstances involved. The Code provides the following factors for employers to consider:
Any action taken by the employer, through a plan amendment or severance of employment, to purposefully exclude a group of previously covered participants from participating;and
Plan amendments that adversely affect the rights of unvested benefits.
Because the partial termination standard is based on facts and circumstances, along with all the other business uncertainties that come with COVID-19, employers are also faced with a considerable amount of gray area related to partial terminations. However, there’s one threshold that has clearly been established by the IRS in Rev. Rul. 2007 -43, and largely supported by the courts: if the number of participating employees in a plan is reduced by 20% or more in an “applicable period” (typically the plan year), there’s a rebuttable presumption that the plan has been partially terminated. Unfortunately, all other aspects of partial termination fall within the gray area of “facts and circumstances.”
Finding Your Way Through the Gray Area
Turnover Rates that are Below the 20% Threshold
Although a rebuttable presumption of partial termination is triggered when 20% of participating employees are terminated, the facts and circumstances may allow the IRS (or a court) to conclude that a partial termination occurred even if the percentage of terminations (i.e., turnover rate) did not reach the 20% threshold. Although at least one court suggested that turnover rates below 10% are presumed to not result in a partial termination, again, that is only a presumption.² If a plan’s turnover rate approaches 10%, plan administrators may need to anticipate the possibility of a partial termination.
No Percentage Establishes a Conclusive Partial Termination
While a rebuttable presumption of a partial termination is triggered after a plan’s turnover rate reaches 20%, the Code does not provide a percentage point at which a partial termination becomes conclusive. Nevertheless, the IRS has taken the position that a partial termination occurs when a "significant percentage" of employees covered by the plan are excluded from participating in the plan either by severance of employment or plan amendment. In Rev. Rul. 2007-43, the IRS held that a mere 23% turnover rate (caused by a non-routine shutdown at one business location) was sufficient to meet the significant percentage test and concluded that a partial termination occurred. The IRS further provided that its finding of a partial termination would apply “irrespective of whether the significant decrease in participation in the plan was the result of adverse economic conditions or causes within the control of the employer.”
Calculation of the Turnover Rate
According to the IRS, the turnover rate is determined by dividing the number of participating employees, that suffered an “employer-initiated” severance from employment during the applicable period, by the total number of participating employees, including all participating employees at the beginning of the applicable period and any additional employees that became participants in the applicable period. It is tempting to argue that only terminated non-vested employees participating in the plan should be included in the numerator, but the courts have disagreed with this argument. Fortunately, employers are allowed to verify (supported through personnel files, employee statements, and other corporate records) that a severance from employment was purely voluntary. In addition, the IRS will take an employer’s normal, cyclical turnover rate into consideration when they make a partial termination calculation.
The applicable period used to calculate a plan’s turnover rate depends on the facts and circumstances; it could span more than one plan year if employer-initiated reductions in employee participation are related. And in this case, a series of terminations related to the pandemic are likely to be grouped together when calculating a plan’s turnover rate (even if they occur in multiple plan years). Consequently, if non-COVID-19 severances occur beyond a plan year, it is critically important for employers to record the circumstances surrounding those severances to avoid including them in the numerator in their plan’s turnover rate calculation.Unfortunately, where the employment relationship with participating employees is officially severed through layoffs, resulting in a 20% or more turnover rate, the IRS would likely conclude that a partial termination may have occurred, even if these layoffs occur within a short period of time (e.g., 1-2 months).
Next Month: more thoughts on rebutting the presumption, so stay tuned.
Potential Risk for Getting it Wrong –Facing IRS Audit Cap or Potential Litigation
Most plans contain language regarding partial terminations. And failure to properly vest or follow the terms of the plan is a potentially disqualifying defect.³ So plans face both the risk of disqualification and the risk of participant claims (possibly even class action claims). More on how correct/mitigate these risks next month.
Immediate Action Items
Plan administrators should consider taking the following action items:
Review plan terms and conditions related to partial terminations to understand how their plan addresses partial terminations and vesting;
Ensure that the plan administrator has discretionary authority in the plan to decide on whether a partial termination has occurred;and
Meet on a regular basis with their HR team to carefully record the circumstances surrounding each employee that terminates employment so a fully-informed decision on partial termination can be made.
Given that the IRS (or a severed employee leaving an unvested balance in a plan) will only be focused on a plan’s turnover rate –which will be clearly visible in the plan’s Form 5500 –employers must take the necessary steps to account for each participating employee that incurs a severance of employment. Plan administrators should consider the action items above, and meet with the plan’s auditor to understand their applicable partial termination audit standard. Finally, employers should also be cautious with their plan’s use of its forfeiture account because they may be required to restore the forfeited portion of previously terminated participants’ accounts.
¹ Although 403(b) plans (tax-sheltered annuity plans) may in certain situations have unvested benefits, these types of plans are not subject to the partial termination requirements under the Code. The partial termination rules only impact tax-qualified plans that maintain a trust under Code section 401(a) –and 403(b) plans do not. In addition, for those 403(b) plans that are subject to ERISA, there is no corresponding partial termination vesting requirement for 403(b) plans. However, that does not necessarily mean that a partial termination will not result in the immediate vesting of affected participants under a 403(b) plan. The plan document or the investment arrangement used to fund the plan may contain provisions that incorporate the partial termination rules.
³ Code Sections 411 and 401.
© Boutwell Fay LLP 2020, 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 an attorney-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 May 2020.