Be Aware of Triggering Partial Termination of Retirement Plans

When downsizing or laying off employees, employers need to keep in mind that a partial termination of a retirement plan may occur without any warning. This happens when a certain percentage of participants in a qualified retirement plan, whether defined contribution or defined benefit, are no longer eligible for participation because of an employer-initiated severance.

In a difficult economic environment, partial plan terminations can occur more frequently. For example, if an employer closes a plant or division that results in the termination of employment of a substantial number of plan participants, a partial plan termination might have occurred.Plan sponsors faced challenges in determining whether this had taken place until the Internal Revenue Service (IRS) issued clarification in Revenue Ruling 2007-43, which created a new standard for determining when a triggering event is deemed to have occurred.

The significance is that a partial plan termination requires immediate 100 percent vesting, to the extent funded, for affected employees. Regardless of the time remaining to become vested fully in the employer-matching contributions of a 401(k) plan, for example, the participants are fully vested automatically at the termination date. Full and immediate vesting does not apply to participants who are not affected by the event because they continue to follow the plan’s regular vesting schedule.

How to Measure

A general rule of thumb is that a partial plan termination may occur when plan participation decreases by 20 percent or more. However, the ultimate decision is based on a facts and circumstances analysis by the IRS, so the 20 percent figure might not always hold true. For example, if an employer can prove that its normal turnover rate every other year falls in the same range or is considered typical for the organization, then it’s possible that the partial plan termination ruling does not apply.

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A general rule of thumb is that a partial plan

termination may occur when plan participation

decreases by 20 percent or more.

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The formula for calculating the percentage of affected employees is not difficult. The number of affected participants who had an employer-initiated severance during the applicable period is divided by the total number of participating employees at the beginning of the period and new participants during the period. However, the specifics in defining the components of the formula need a little more explanation.

An affected participant is one who was terminated as a result of this event (e.g., layoff, downsizing, plant closing) and had an accrued benefit under the plan. All participants—whether vested or nonvested—are taken into account when calculating the percentage of affected employees.

Employer-initiatedseverance usually refers to all terminations other than those resulting from disability, death or retirement after normal retirement age, or any other voluntary separation by the employee. If questioned, it is the employer’s responsibility to show that a termination did not fall under one of these exceptions. In addition, participants in a plan that were spun off (perhaps as the result of the sale of a division, for example) would not be considered the result of an employer-initiated severance if the new owner continues the employees’ plan. The financial conditions of the company and/or the economy have no bearing on the determination.

Although the applicable period is usually the plan year, it can be cumulative if the terminations occurred in steps over several years. If a short plan year is involved, it would include the year prior to the current one.

Avoid the Consequences

A company that foresees a layoff or other employer-initiated downsizing that might result in a partial plan termination should perform an estimate of plan costs in advance. These costs will include calculating the fully vested benefits of all affected employees that are not already vested, paying out balances from the plan where necessary, and sometimes amending the plan. By making a timely determination and knowing what must be done—vesting and paying out all affected participants—the company can be prepared for such an event.

The identification of a partial plan termination is important because failure to recognize and act on it can cause disqualification of the entire plan. If a plan becomes disqualified it will cause significant tax consequences for employers and employees. For example, employer-nonvested contributions for the year are no longer deductible; trust earnings become taxable; participants’ vested benefits are recognized as taxable income; and there is always the risk of participants filing a lengthy class-action lawsuit.

Help Is Available

Plan sponsors that want to know but are uncomfortable relying on their own calculations can request a determination letter from the IRS to see whether there was or will be a partial plan termination. This is done by filing a Form 5300, which involves an application form and appropriate documents and statements.

A statement indicating whether a partial termination might have occurred or might occur as a result of proposed actions must be attached. In addition, a schedule of information for the plan year in which the partial or potential partial termination began must be submitted. A schedule for the next plan year, as well as for the two prior plan years, if available, must be attached. The submission must include an explanation of how the plan meets the requirements of section 411(d)(3), which provides that “a plan will not be qualified unless the plan provides that, upon its partial termination, the rights of all affected employees to benefits accrued to the date of such partial termination, to the extent funded on that date, or the amounts credited to their accounts, are nonforfeitable.”

Although the IRS will deal with each case individually, guidance has been clear as to what is expected of employers. Ignoring a situation that might qualify as a partial plan termination can cause bigger problems and greater expenses than addressing such a situation correctly when it occurs.

Patricia Look has been the editor of the BottomLine Benefits & Compensation newsletter for J.J. Keller & Associates since its inception in 2007. She has worked in benefits and compensation management, with a focus on retirement plans and executive compensation, for over 25 years. In particular, her expertise includes 401(k) plans, qualified pension plans, deferred compensation, and supplemental plans for executives.​