Mr Friedman works in our Miami and New York offices
Mr Segal works in our Miami office
During the current economic recession, many companies are laying
off hundreds, if not thousands, of employees. One consequence of
these layoffs that is often overlooked is whether the company's
qualified plan (e.g., 401(k) plan) has experienced a partial
termination.
Under Section 411 of the Internal Revenue Code of 1986, as amended
(the "Code"), if there is a partial termination of a
qualified plan, the plan sponsor must fully vest all affected
participants in the benefits they have accrued under the plan.
Failure to vest these participants could result in a
disqualification of the plan. Plan disqualification can result in
significant costs to the employer, both from the loss of deductions
and recognition of certain income from the trust, as well as from
possible lawsuits against the employer and the plan fiduciaries by
plan participants who are forced to prematurely recognize income
due to the disqualification of the plan.
Clarification of Partial Termination
Until recently, there was not a lot of guidance as to what
exactly constituted a partial termination. The regulations under
Code Section 411 provide that whether or not a partial termination
occurs is determined with regard to all facts and circumstances,
including the exclusion of a group of employees who have been
previously covered by the plan, as well as plan amendments that
adversely affect the rights of employees to vest in benefits under
the plan. Due to the lack of guidance in the Code and the
regulations thereunder, there was a great deal of disparity in how
the courts and the IRS analyzed whether a partial termination of a
qualified plan occurred. The unresolved issues included the total
percentage of participants that had to be affected in order for a
contraction in the plan to constitute a partial termination, the
identification of the participants who had to be included in
calculating the percentage of affected participants, and the time
period over which an employer had to base the previous calculation
and identification.
The IRS addressed and provided guidance on many of the open issues
in Rev. Proc. 2007-43 (the "Ruling"). Employers can now
use the guidance in the Ruling to effectively gauge whether there
has been a partial termination of their qualified plan.
The following questions and answers explain the Ruling in
detail:
1. What is the applicable percentage of terminated participants that would result in a partial termination of the plan?
Under the Ruling, the IRS stated that it will presume that a partial termination of the plan has occurred if the "turnover rate" is at least 20 percent. Notwithstanding the presumption, if there are facts and circumstances indicating that the turnover rate for an applicable period is routine, there can be a finding that a partial termination did not occur for that period even if the turnover rate is greater than 20 percent. Factors such as the turnover rate in other periods and the extent to which terminated employees were actually replaced, whether the new employees performed the same job function, had the same job classification or title and received comparable compensation are all relevant in determining whether such turnover is routine. However, it is important to note that the 20 percent standard is not a bright line. In appropriate cases, the IRS may take the position that a partial termination has occurred even if the turnover rate is less than 20 percent.
2. How is the turnover rate calculated?
The turnover rate is determined by dividing the number of
actively participating employees who had an employer-initiated
severance from employment during the applicable period (the
numerator) by the sum of all of the participating employees at the
start of the applicable period and the employees who became
participants during the applicable period (the denominator).
3. Which participants can be excluded from the
numerator?
Any participant who terminated employment voluntarily, or on
account of death, disability or retirement on or after normal
retirement age can be properly excluded from the numerator. An
employer can support the claim that a participant's severance
from employment was voluntary through information in the
participant's personnel file, employee statements and other
corporate records. All other participants who experienced a
termination of employment generally are treated as having an
employer-initiated severance and are included in calculating the
numerator. This is true even if the termination of employment was
outside of the employer's control (e.g., layoffs due to
economic factors beyond the control of the employer).
4. Are employees that were transferred to a different
employer in a transaction included in the numerator when
calculating the turnover rate?
The answer depends upon how the affected participants'
accounts are treated as a result of the transaction. Under the
Ruling, employees who have had a severance of employment from the
employer maintaining the plan on account of a transfer to a
different employer are not considered as having a severance from
employment for purposes of calculating the turnover rate if those
employees continue to be covered by a plan that is a continuation
of the plan under which they were previously covered (i.e., a
spin-off of the plan).
5. Can the employer exclude vested
participants?
No. Before the Ruling, there was some debate as to whether fully
vested participants could be excluded in calculating the turnover
rate. As the finding of a partial termination of a qualified plan
results in the full vesting of benefits of the affected
participants, some courts found that since no benefit was to be
provided to a fully vested participant, those participants could be
excluded in the calculation of the turnover rate. However, the
Ruling resolved all questions about these participants and made
clear that all participants, whether vested or unvested, are to be
included in both the numerator and the denominator when calculating
the turnover rate.
6. What is the applicable period in which the employer
must make a determination of whether a partial termination has
occurred?
The Ruling holds that the applicable period is generally the
plan year. In the case of a short plan year, the applicable period
is the short plan year plus the previous plan year. Notwithstanding
the foregoing, the applicable period may also be longer if there
are a series of related severances from employment.
7. Are there any options for an employer to determine
whether a partial termination has definitively occurred?
Yes. An employer can seek a formal determination from the IRS in
order to resolve any question as to whether a partial termination
of a qualified plan has occurred. With the release of the Ruling,
this determination could be considered more routine than in the
past and can provide the employer with reassurance that a partial
termination of the plan has (or has not) occurred during an
applicable period.
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Despite the issuance of the Ruling, there are still some legal issues that arise when making a determination as to whether a partial termination has occurred. Holland & Knight attorneys have extensive experience in this area and can assist you in analyzing and advising you on your particular situation with respect to the IRS Ruling.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.