Layoffs and furloughs as a result of COVID-19 can trigger vesting obligations that may surprise plan sponsors unfamiliar with the IRS rules on partial plan terminations. Failure to treat participants correctly can jeopardize the plan’s qualified status and, if the employer has been using forfeitures to reduce its contributions, may also have a financial impact. Partial terminations can technically affect both defined contribution and defined benefit plans, but in the event of a partial termination of a defined benefit plan, benefits must be vested only “to the extent funded,” which limits the impact of the rule.
What the IRS Looks At
In simple terms, a partial termination occurs when a substantial percentage of participants is involuntarily terminated. The reduction need not be due to an identifiable event such as a plant closing. The bad news is that IRS guidance clearly says that terminations due to adverse economic conditions beyond the employer’s control are still considered to be employer-initiated and thus involuntary terminations for this purpose.
If there is a partial termination, terminated “affected participants” must be fully vested in their accounts if the plan is a defined contribution plan but, due to the “extent funded” limitation, will not necessarily become fully vested if the plan is a defined benefit plan. However, the test is a facts and circumstances test, with both the IRS and the courts weighing in on when a partial termination occurs. There may even be factual issues whether a furlough is actually a termination because there is no reasonable expectation that a furloughed employee will return to work.
In its guidance, the IRS sets out a presumption that the involuntary termination of 20% or more of plan participants in a measuring period (usually the plan year) results in a partial termination. Involuntary terminations automatically exclude deaths, ceasing to work due to disability and normal retirement on or after the plan’s normal retirement age.
The important point here is that the presumption is rebuttable and evidence may be produced that other terminations not mentioned above (such as early retirements or resigning to take a new job) were not involuntary or that high turnover is normal for the plan sponsor’s business. This factual evidence could still result in the conclusion that a partial termination has not occurred.
Calculating the Decrease in Participants
The IRS says that both nonvested and already vested employees (even fully vested participants) who are involuntarily terminated count in the numerator of the fraction, although at least one federal appeals court has counted only non-vested participants. The denominator is participants at the beginning of the plan year increased by participants added during the plan year. In certain circumstances, the measuring period may be longer than the plan year, for example, if the plan has a short plan year or if there has been a series of related terminations, but the usual measuring period is a 12 month plan year.
If plan sponsors who engaged in layoffs rehire employees who come into their plans before the end of their plan year, they might be able to avoid a partial plan termination, but every plan sponsor who has had layoffs and furloughs should keep this issue on the radar for monitoring. The IRS Manual says that once it has been determined that a partial termination has occurred, all terminated participants-including participants who terminated voluntarily- must be fully vested.
Plan Amendments and Contribution Suspensions May Also Trigger Vesting
Plan sponsors should also be aware that there are other situations that may trigger a full vesting requirement. For example, an amendment to a plan that excludes a substantial group of employees from participation, even if they are still working, or an amendment that changes the calculation of vesting service can trigger a partial termination. Primarily in the case of a defined benefit plan, in order for an amendment to cause a partial termination, the amendment must also increase the employer’s potential reversion.
401(k) and profit sharing plan sponsors who have suspended contributions should be aware that if a suspension lasts for more than 3 out of 5 plan years, these plans could be required to fully vest all participants because the plan is viewed as having a permanent discontinuance of contributions. That is an alternative vesting event for these plans.
Plan Sponsors Should Be Vigilant
While it is possible to request a determination whether a partial termination has occurred by filing Form 5300 with the IRS, many plan sponsors are reluctant to come forward. The issue of whether a partial termination has occurred often arises in the course of an IRS audit. Having to vest participants as a result of an audit long after the partial termination can be expensive and involve searches for former participants for whom there is no current contact information. These are additional reasons for plan sponsors to keep this issue on their radar screens.