Many employers who implement reductions in force are unaware that their actions could also cause a “partial termination” of their qualified retirement plans. If a partial termination occurs, the Internal Revenue Code requires full vesting of benefits. Unfortunately, most employers are unaware that a partial termination has occurred until well afterward. Being able to identify a partial plan termination when it occurs will enable an employer to fully vest participants at or near the time of the event, thereby avoiding fines, additional contributions and potential lawsuits.

When Does a Partial Termination Occur?

In Revenue Ruling 2007-43, the IRS adopted a rule that a 20% reduction in the number of employees participating in a qualified retirement plan is a presumptive partial termination of the plan. The number of employees is calculated by dividing the number of participating employees who experience an employer-initiated severance during the measurement period by the sum of (i) participating employees at the start of the measurement period, plus (ii) the new participants added during the measurement period.

What is an Employer-initiated Severance from Employment?

Only employees terminated in employer-initiated severances are required to be included in the calculation. Employment terminations resulting from death, disability or retirement on or after normal retirement age are excluded. Voluntary resignations may also be excluded in calculating the turnover rate. However, some case law supports classifying as employer-initiated severance employees who resign based on fears related to their employer's financial future. In addition, IRS agents sometimes attempt to classify certain employee resignations as employer-initiated severances on this basis.

What is the Measurement Period?

The applicable measurement period is generally the plan year, but the IRS may apply a longer measurement period if it finds a series of related severances from employment. Historical case law suggests that a major corporate event or series of related layoffs is required to expand the measurement period beyond the plan year. In the current economic climate, where many employers have implemented sequential reductions in force, we anticipate the IRS taking an even more expansive view of the measurement period.

What Steps Should Your Company take to Monitor for a Partial Termination?

Documentation and regular monitoring are essential. Revenue Ruling 2007-43 provides that an employer can support a claim that an employee’s severance was voluntary with information from personnel files, employee statements, and other corporate records. Implementing a recordkeeping system that tracks the timing and reason for each employee's severance from employment will be useful both in guiding internal employer decisions as to whether a partial termination has occurred and in defending an external claim of a partial termination.

In addition, an employer with a turnover rate of more than 20% during a measurement period may be able to rebut the partial termination presumption by showing that a high turnover rate is normal in its industry. Information relevant for establishing that the employer's turnover rate is a routine rate rather than a partial termination includes: turnover rates from other periods, the extent to which terminated employees were replaced, and whether the new employees performed the same functions, had the same job classifications or titles, and received comparable compensation.