Update: Temporary Relief from IRS Assessments
The Consolidated Appropriations Act that President Trump signed into law at the end of 2020 includes a temporary rule preventing partial plan termination for employers who provide defined contribution retirement plans.
Usually, an IRS assessment of plan termination is triggered whenever employee turnover exceeds 20 percent. Now, however, the IRS will defer assessments until March 2021, to give employers time to restore at least 80 percent of their workforce and avoid termination, significant costs and administrative expenses.
As businesses continue to deal with economic challenges due to the COVID-19 pandemic, many may need to permanently lay off workers. When doing so, companies that sponsor 401(k) and other qualified retirement plans should consider the IRS "partial termination rule," which can lead to unexpected costs to the company.
Partial Termination Rule
In Revenue Ruling 2007-43, the IRS held that a 20 percent or greater employee turnover rate among retirement plan participants over a single year creates a presumption of a partial plan termination. As the IRS explains on its website, terminated plan participants then "must become 100 percent vested in all employer contributions (including matching contributions) regardless of the plan's vesting schedule."
While generally the period for calculating whether turnover amounted to 20 percent of plan participants would be a single plan year, "it could be a longer period if there are a series of related events, such as a plant closing where employees are terminated in stages over a period longer than a plan year," wrote Deborah Grace, an attorney with Dickenson Wright in Troy, Mich.
Both vested and nonvested participating employees are considered when calculating the 20 percent turnover threshold, "along with employees who are eligible to make salary deferrals to the 401(k) plan but have never chosen to contribute," she noted.
Generally, voluntary terminations do not count in determining whether a partial termination has occurred, but those who left voluntarily must still be treated as vested in a partial termination, under IRS rules.
A 'Rebuttable Presumption'
"It is important for every plan sponsor to consider whether or not they experienced a partial plan termination during any year when layoffs or furloughs transpired," explained Erica K. Johnson, a qualified 401(k) administrator and an account manager with BOK Financial, an online banking and financial services company headquartered in Tulsa, Okla.
Determining whether a partial plan termination has occurred "involves a review of several facts and circumstances, including a plan sponsor's typical turnover ratio," she said, noting that "the 20 percent turnover rate established by the IRS guidance is a rebuttable presumption. Employers that traditionally have high employee turnover may be able to demonstrate that a 20 percent or greater turnover is routine."
[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]
At the end of the plan year, Grace noted, employers may be surprised to discover that "there are terminated employees to which the retirement plan owes amounts previously forfeited plus earnings since the date of distribution," due to the partial termination rule. Locating terminated employees in order to pay these distributions can be difficult and time consuming, she pointed out.
According to the IRS, an employer "must determine which participants require an acceleration of vesting due to the partial termination. Participants who improperly incurred forfeitures are owed more benefits. To the extent those forfeitures have been distributed to other participants and cannot be recovered, the employer will be responsible for making the affected participants whole."
Johnson observed, "This requires residual distributions to employees already paid out of the plan" funded by the plan sponsor.
"Restoring forfeitures is hardly something anyone wants to do during a normal economy, but it is a special hardship for plan sponsors who have already had to reduce their workforce," Johnson said. "If a plan sponsor has reduced their workforce, considering whether that reduction caused a partial plan termination to occur now may avoid an expensive surprise once the plan year has ended.
There's another consideration to keep in mind, Grace noted. If, to avoid a partial plan termination, employers subject to the Affordable Care Act (ACA) are thinking about keeping furloughed employees in a nonactive status for the year, without employer-subsidized health care, they will want to consider the ACA implications, she advised, as employers enacting layoffs without termination could inadvertently trigger ACA penalties.
CARES Act Relief
The IRS, in FAQ 15 of its July guidance on the Coronavirus Aid, Relief, and Economic Security (CARES) Act, held that an employee who was terminated because of COVID-19 and is rehired before the end of 2020 will not be treated as having an employer-initiated severance from employment, and thus would not be counted under the partial termination rule.
Johnson called the guidance "fantastic news for many plan sponsors desperate for any bright spot in an otherwise battering year."
Unfortunately, she continued, extended furloughs or layoffs may still have to be considered, even if participants are rehired by the end of the 2020 plan year, if the plan requires an employee to work a set number of hours before being granted vesting credit for a given year.
"If a layoff or furlough could reasonably prevent an employee from achieving the requisite minimum hours of service to receive vesting credit, the IRS is likely to consider that an employer-initiated termination for purposes of determining if a partial plan termination occurred," Johnson said.
For example, if a plan sponsor that requires 1,000 hours of service in a plan year to achieve vesting credit had furloughed more than 20 percent of its workforce in April and is unable to rehire any employees until November, "it will likely have a partial plan termination because its furloughed employees were not able to complete the 1,000 hours of service required to achieve vesting credit," Johnson explained. "These considerations become even more complex for organizations with multiple furloughs and rehires throughout 2020, which is why the IRS includes the caveat that partial plan terminations are determined using a facts and circumstances review of each plan."
On the related issue of furloughed employees and 401(k) vesting in general, Michael Bindner, an attorney with Frost Brown Todd in Indianapolis, advised that "employers may consider amending retirement plans to count a certain amount of furlough time due to COVID-19 as hours of service" for plan-vesting purposes. He observed, "This likely will not cost much to the employer, can go a long way in fostering goodwill with employees, and will not result in lost vesting service for employees who return from furlough."
Related SHRM Article:
Layoffs, Furloughs and the ACA's Employer Mandate, SHRM Online, April 2020
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