February 10, 2009

Partial Termination of Qualified Plans: What Employers Should Know

Holland & Knight Alert
Robert J. Friedman

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.

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.

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