Employers that reduce their workforce or discontinue defined contribution (DC) plan eligibility for certain employee groups may experience an inadvertent “partial plan termination.” If not properly managed, this event could result in a disqualification of the entire plan.

Background

A partial plan termination is typically triggered by a distinct event or series of events (e.g., reductions in force, sales of subsidiaries). The determination of a partial plan termination is based on the facts and circumstances of the situation.

When a partial termination occurs, all participants who left employment during the applicable period must be fully vested. This includes participants who terminated service prior to when the plan sponsor identified that the partial plan termination had taken place. In that case, plan sponsors may have to restore previously forfeited balances and locate those former participants to inform them of the restored balances. To the extent forfeited assets have been used for other purposes (e.g., reducing employer contributions or paying plan expenses), the employer will be responsible for making the affected participants whole.

Vesting does not need to be accelerated for participants not affected by the event.

Generally, if the employer’s turnover rate is at least 20% during the applicable time period, there is a presumption that a partial termination of the plan has occurred. The time period in question depends on the facts and circumstances of a situation, and legal counsel may help determine the appropriate period to be considered. According to IRS Rev. Rul. 2007-43, the turnover rate is determined by “dividing the number of participating employees who had an employer-initiated severance from employment during the applicable period 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.” Routine turnover during the year does not generally generate a partial termination. To understand what constitutes routine turnover, plan sponsors should consider how the current turnover compares to the turnover rate in other periods and if the employees were replaced.

Example:

ABC Company typically experiences 6% annual turnover. In July 2019 the company closed a division resulting in a 10% reduction in staff. In April 2020, the company experienced financial hardship due to the coronavirus pandemic and had to let go another 10% of its workforce. Although this situation spans plan years, a partial termination may have occurred. Legal counsel should weigh in and a plan sponsor can request a determination from the Internal Revenue Service (IRS). If it is determined that a partial termination occurred, the plan would need to fully vest participants who were terminated beginning in July and any forfeited account balances would need to be restored.

Definitions:

• Participating employees: active participants and eligible employees
• Applicable period: usually the plan year, although it can be cumulative if the terminations occurred over several years. If a short plan year is involved, it would include the year prior to the current one.
• Employer-initiated severance: generally includes any turnover, with the exception of death, disability, or retirement.

A partial termination of a qualified plan can also occur for reasons other than turnover. For example, it can occur if a group of employees who had been covered by the plan was later excluded.

Bottom Line

Identifying a partial plan termination is important since the failure to recognize and act on it can cause disqualification of the entire plan. Plan sponsors that are uncomfortable relying on their own calculations can request a determination letter from the IRS to see whether a partial plan termination occurred. Legal counsel should also be consulted in determining the status of a partial plan termination.

Because partial plan terminations are generally determined at or after the end of a year, plan sponsors should continue to apply the current vesting schedule to mid-year distributions, but be prepared for the possibility of a partial plan termination at year-end and continue to monitor the plan status as the economic implications of the coronavirus pandemic continue to unfold.