While employers are actively reviewing the nature of employee terminations for COBRA, they should also be carefully considering the number of participants who may have been terminated from qualified retirement plans, and whether or not a partial termination has occurred.
What employers frequently overlook when conducting layoffs is the “hidden costs” of triggering a “partial termination” of a qualified retirement plan.
A partial termination occurs, in part, when an employer terminates the plan for a certain group of employees and continues it for others. If a partial termination takes place, an employer is required to 100% vest the employees who are involuntarily terminated.
Reduction in force
Employers that conduct layoffs without considering the impact of a partial termination are more likely to have used forfeited benefits to pay for future employer contributions. If a restoration of benefits is required, debilitating costs may be incurred.
Layoffs may occur in connection with a plant closure or a companywide reorganization to save money. Section 411 (d) (3) of the Internal Revenue Code states that a retirement plan will not be qualified unless the rights of all affected employees become fully vested upon a partial termination of the plan. This is the same result that would occur if an entire plan were terminated.
The issue of whether or not a partial termination has occurred is subject to a “facts and circumstances” test. In 2007, the Internal Revenue Service issued Rev. Rul. 2007-43 , codifying many of the court cases and providing the IRS’s interpretation on partial terminations.
The IRS rule of thumb has traditionally been that no partial termination will occur unless there is a 20% decline in the number of participants in a plan on an involuntary basis. All participants in a plan who have their positions eliminated involuntarily are required to become 100% vested in their benefits under the plan. Employees who remain employed do not benefit from immediate vesting.
Turnover rate
The IRS also confirms that certain events are not considered to be involuntary terminations, such as a severance on account of death, and disability or retirement on or after normal retirement age. Another important factor is the normal turnover rate for an employer.
If an employer can document that its normal turnover rate is 15% to 20%, and layoffs create an additional 10% or 15%, the 20% threshold may not be exceeded in a particular industry or for a specific employer.
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 the participating employees at the start of the period, and employees who become participants during the period.
For example, a plan with 100 participants on Jan. 1 that lays off 22 workers and adds 10 new employees, would have a 20% reduction in participants. All terminated employees are considered when performing the above calculation, whether or not they are already vested.
Audits
If an employer does not declare a partial termination, and the issue is raised by the IRS in an audit or by a plaintiff attorney in connection with the review of a severance package, employers should be prepared to respond to questions.
Assume that an employer lays off 100 employees and does not treat the event as a partial termination. Further assume the forfeitures in connection with the termination are $100,000. If it is ultimately determined three years later that employees should have been 100% vested, and the employer used the forfeitures to offset employer contributions for remaining participants, the employer will be required to restore the $100,000 forfeiture, as well as earnings for participants.
The employer will also incur significant expenses in communicating with former employers, reallocating the benefits to employees and in effectuating additional distributions.
Being proactive, documenting the reasons for termination and conducting committee meetings to confirm whether or not a partial termination has occurred will be important to defend your side on this issue.
Frank Palmieri can be reached at fpalmieri@p-ebenefitslaw.com.
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