The COVID-19 pandemic has led to “shelter-at-home” proclamations from state and local governments, causing many nonessential businesses to shut down temporarily. Employers have handled the crisis in varying ways, some by temporarily paying employees to stay home, others by laying off or furloughing workers. In such instances, employers need to be aware of the qualified retirement plan partial termination rules, which require immediate 100% vesting of accounts if a partial plan termination is deemed to have occurred.
Qualified retirement plans meet IRS requirements and offer certain tax benefits. Examples include 401(k), 403(b), and profit-sharing plans. Stocks, mutual funds, real estate, and money market funds are the types of investments sometimes held in the plans.
Employee contributions to an employer’s qualified retirement plan are fully vested when contributed, which means employees will be entitled to a distribution of all their contributions plus earnings when they are eligible for and elect a distribution from the plan.
Employer contributions to a qualified retirement plan can be fully vested when contributed, but many times they’re subject to a vesting schedule that requires employees to complete a certain number of years of service before being fully vested.
The laws governing qualified retirement plans require (1) all employees to be 100% vested in their retirement plan account balance upon the termination of a plan and (2) certain employees to be 100% vested in their retirement plan account balance upon a “partial termination” of the plan, regardless of the vesting schedule or the number of years of service they have with the employer.
According to the IRS regulations, whether or not a partial termination has occurred will be based on “all the facts and circumstances” in a particular case, which include (1) the exclusion, by reason of a plan amendment or severance by the employer, of a group of employees who have previously been covered by the plan and (2) plan amendments that adversely affect their rights to vest in the benefits.
If a partial termination has occurred, all participants who terminated employment during the “applicable period” (referred to as “affected employees”) must be 100% vested in the amounts credited to their accounts as of their discharge date, including those who left work voluntarily. The applicable period is generally a single plan year, but it can span more than one plan year if the termination events are related, such as a series of related severances from employment because of business sales or closures or other events occurring over a period of years.
The IRS generally considers a partial termination to have occurred when (1) a group of participants is involuntarily eliminated from a retirement plan and (2) the reduction in the number of participants in the plan is significant. The agency has prescribed a “turnover rate” formula to determine whether the reduction is significant.
If the turnover rate is higher than 20%, the IRS presumes a partial termination has occurred. The presumption can be rebutted with evidence of extenuating facts and circumstances (e.g., a showing that the rate is routine for the employer). The higher the turnover rate, however, the more difficult it is to rebut the presumption.
Federal Court Perspective
Sometimes the issue of whether a partial termination has occurred ends up in court either because plan participants dispute an employer’s initial determination that a partial termination hasn’t occurred, or an employer disputes an IRS determination that a partial termination did occur. In 2004, the U.S. 7th Circuit Court of Appeals (in Matz v. Household Int’l Tax Reduction Inv. Plan) somewhat expanded on the IRS’s 20% presumption by outlining the following turnover rate categories:
- Under 10%—conclusively, no partial termination;
- 10% to 20%—rebuttable presumption of no partial termination;
- 20% to 40%—rebuttable presumption that a partial termination has occurred; and
- More than 40%—conclusively, a partial termination has occurred.
Factors that can rebut a presumption include whether employees are replaced, whether the employer had a bad motive (e.g., obtained a reversion from the plan or realized a tax benefit for prefunding it), and whether the terminations were related to a major corporate event (e.g., plant closing) or increased the possibility of prohibited discrimination. An employer can be proactive and ask the IRS for a determination of whether a partial termination has occurred (using IRS Form 5300).
COVID-19 Furloughs Raise Issues
Businesses that discharge retirement plan participants can cause a partial termination to occur, depending on the percent of participants affected by the action. In some cases, instead of laying off or discharging employees, employers (for the time being) have used furloughs, which are generally the equivalent of an unpaid leave of absence.
Initially, furloughed employees aren’t seen as being discharged and therefore aren’t factored into the partial termination analysis. If they aren’t brought back to work within a reasonable period of time, however, you’ll likely need consider them to be terminated and counted for purposes of whether a partial termination has occurred. The analysis will include other employees who have been laid off or terminated and can extend over more than one year (for example, in 2020 and 2021) if the circumstances that led to the layoffs and furloughs are the same.
Employers may consider amending the retirement plans to count a certain amount of furlough time caused by COVID-19 as hours of service that count for plan vesting purposes. The action likely won’t cost much or result in lost vesting service for employees returning from furlough. It also can go a long way toward fostering good will with the workforce.
In a recent retirement plan Q&A about COVID-19-related issues, the IRS addressed how to treat employees laid off in 2020 because of the virus but rehired by the end of the year for purposes of determining whether a partial termination has occurred. The agency said such participating employees generally wouldn’t be treated as having an employer-initiated severance from employment for purposes of determining whether a partial termination of the retirement plan occurred during the 2020 plan year.
The IRS’s position is consistent with its general rule that participating employees generally aren’t treated as having an employer-initiated severance from employment for purposes of calculating the turnover rate used to help determine whether a partial termination has occurred during an applicable period if they’re rehired by the end of that period.
When furloughing employees, you should consider other employment law and employee benefit issues that may arise under federal and state laws.