During times of economic or business decline, many employers will experience significant reductions in their workforce (or RIFs). One potential unintended and costly consequence of a significant RIF is that an employer's tax-qualified retirement plan may incur a so-called "partial plan termination." This article summarizes the applicable law regarding "partial plan terminations" under the Internal Revenue Code of 1986, as amended (the "Code"), including a discussion of the potential adverse consequences that could result from the failure to treat a significant reduction in plan participation as a partial plan termination in the event that the IRS and/or a court of law ultimately determines that a partial plan termination has occurred. In addition, this article discusses the newly issued Internal Revenue Service (IRS) Revenue Ruling 2007-43, which sets forth a new and highly publicized standard for the determination of whether a tax-qualified retirement plan has incurred a partial plan termination.
I. Potential Consequences of Failing to Treat a Plan as Having Incurred a Partial Termination
The Code specifically provides that a plan will not qualify as a tax-qualified retirement plan unless, upon a partial termination of the plan, the rights of all affected employees to benefits accrued as of the date of such partial termination, to the extent funded as of such date, are nonforfeitable. Thus, if a partial termination occurs with respect to a tax-qualified plan and the plan sponsor does not vest affected employees in their accrued benefits to the extent such benefits are funded, the plan will cease to be qualified under the Code. The consequences of the disqualification of a retirement plan are as follows: (1) for open tax years, the employer loses its deduction for nonvested contributions made to the plan for such years (2) for open tax years, participants recognize income with respect to their vested accrued benefits (3) for open tax years, the plan's trust recognizes income on its earnings (4) distributions from the disqualified plan are not eligible for rollover into another tax-qualified vehicle and (5) the plan sponsor and/or the plan fiduciaries responsible for failing to maintain the plan's tax-qualified status face the risk of lawsuits by participants who are forced to prematurely recognize income under (2) and (4) above.
II. General Discussion of the Partial Plan Termination Rule
The Code provides, in relevant part, that, in the event of a termination or "partial termination" of a tax-qualified retirement plan, the rights of affected participants to benefits accrued to the date of such termination or partial termination will be non-forfeitable, to the extent the plan is funded, as of the date of such termination or partial termination. The regulations promulgated under the Code provide that the question of whether a partial termination has occurred is to be resolved on the basis of "all the facts and circumstances" of the particular case. The regulations go on to provide, in relevant part, that such facts and circumstances include 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.
Unfortunately, neither the Code nor the regulations thereunder explicitly define the term "partial termination." Thus, the determination of whether a particular reduction in a tax-qualified retirement plan sponsor's workforce results in a partial termination of the sponsor's tax-qualified retirement plan is often problematic for such sponsor. Thus, in the absence of clarification in the statute or regulations, we must look to the IRS rulings and case law for the parameters of a partial termination.
Absent any statutory or regulatory guidance on the matter, in addressing the issue of the meaning of the term "partial termination," the courts and IRS rulings have historically developed and utilized a so-called "significant percentage test." Such test was first announced by the IRS in a 1973 Revenue Ruling in which the IRS held that an 80 percent reduction in plan participation resulted in a partial termination of the plan. Although this 1973 Revenue Ruling did not set forth a specific percentage for which a reduction in plan participation would be deemed to be "significant," the focus on the percentage of such reduction was thereafter generally accepted by courts as the key factor in making a ruling on the partial termination issue.
A. The Applicable Percentage
There is no magical figure at which a partial termination is deemed to occur and, prior to the release of IRS Revenue Ruling 2007-43, the exact level at which it becomes determinative of the issue was somewhat ill defined. Notably, several cases had held that a percentage drop in plan participation standing alone may be sufficiently large (i.e., generally greater than 40 percent) or small (i.e., generally less than ten percent) to determine the partial termination question without the need for any further inquiry into the facts. Between these two extremes, although the surrounding facts and circumstances had been considered in conjunction with the percentage drop in order to decide whether the percentage drop was significant, the primary focus of the determination still had been on the percentage drop in plan participants. In this regard, the IRS, in an amicus curiae brief filed in connection with a court case addressing the partial termination issue, suggested that a tax-qualified retirement plan will generally be deemed partially terminated if at least 20 percent of the plan's participants lose coverage. From this brief and the preceding and subsequent case law, a "semi-bright line" test had developed that a percentage drop of at least 20 percent was sufficient to result in a partial plan termination.
In fact, in a very highly publicized decision in 2004, the Seventh Circuit Court of Appeals, in Matz v. Household International Tax Reduction Investment Plan, held that there is a "rebuttable presumption" that a 20 percent or greater reduction in a plan's participants is a partial termination and that a smaller reduction is not.
In IRS Revenue Ruling 2007-43, the IRS has adopted the Matz 20 percent presumption test. Thus, if the turnover rate is at least 20 percent, there is a "presumption" that a partial termination of the plan has occurred. However, the IRS notes that whether or not a partial termination occurs on account of participant turnover is still ultimately dependent on all of the facts and circumstances in a particular case. Facts and circumstances indicating that the turnover rate for an applicable period is "routine" for the employer, favor a finding that there is no partial termination for that period. For this purpose, information as to the turnover rate in other periods and the extent to which terminated employees were actually replaced, whether the new employees performed the same functions, had the same job classification or title and received comparable compensation, are relevant to determining whether the turnover is routine for the employer.
B. Defining the Class of Affected Employees
Notably, in applying the significant percentage test, certain classes of separated plan participants are excluded from the terminated class. Among the classes that have historically been excluded by the applicable case law, include plan participants who cease to participate in the plan as a result of death, voluntary separation from service and/or termination for cause. On the other hand, all partially vested participants who were involuntarily terminated were counted for purposes of deciding whether a partial termination of a plan had occurred. IRS Revenue Ruling 2007-43 uses the term "employer-initiated severance" to describe the class of affected participants to be used in the applicable test. In this regard, the IRS ruled that an employer-initiated severance from employment generally includes any severance from employment (even if caused by an event outside of the employer's control) other than a severance that is on account of death, disability or retirement on after normal retirement age. In addition, the IRS indicated that the employer may be able to verify that an employee's severance was not employer-initiated through supporting information as to its voluntary nature from personnel files, employee statements and other corporate records.
Regarding the issue of whether to include or exclude participants who transfer to a successor plan, the issue was historically not quite as clear. The cases that have addressed this issue have generally found that such transferred participants should not be included in the terminated class so long as the vesting rights of such transferred participants are protected under the successor plan (e.g., where the successor plan allows for vesting credit for prior service under the predecessor plan). In this regard, IRS Revenue Ruling 2007-43 provides that employees who have had a severance from employment with the employer maintaining the plan on account of a transfer to an unrelated company, 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., if a portion of the plan covering those employees was spun off from the plan in accordance with the rules of Section 414(l) of the Code and will continue to be maintained by the new employer).
Another complicating issue has historically been whether the significant percentage test was to be applied with respect to "all" participants or only to participants who are "actively employed" as of the dates being analyzed under the test. While logic would seem to dictate the test should focus only on those participants who are employed at the time of the corporate or economic event that gave rise to the applicable decrease in plan participation, the language used by the courts and the IRS in its audit guidance uses the term "participants" without distinction between active and inactive with respect to the application of this test. Notably, the sponsor of a tax-qualified retirement plan may request a determination as to whether a partial termination has occurred through the filing of an application to the IRS on Form 5300. However, unlike the courts and the IRS audit guidance, which do not distinguish between active and inactive participants in applying the significant percentage test, the calculation required by the IRS with respect to its determination of whether a partial termination has occurred, requires plan sponsors to present the information on an "active" participant basis. IRS Revenue Ruling 2007-43 clarifies the IRS' position on this issue by providing that the test is to be applied with respect to active participants (or, as the IRS refers to them in the facts section of the ruling, "participants who are employees").
C. Counting of Vested Participants
Notably, the significant percentage test analysis has historically been further complicated by the fact that the relevant authorities were not in agreement with respect to the issue of whether to include or exclude certain other classes of employees. For instance, while most cases and rulings that apply a significant percentage test analysis to the determination of whether or not a partial termination has occurred, include fully vested participants without discussion of the merits of doing so, a few courts that have focused on the issue have excluded fully vested participants for purposes of applying the test (e.g., if a plan covered 100 participants, 40 of whom were fully vested and 60 of whom were not fully vested and the plan sponsor terminated 50 such participants, 30 of whom were fully vested and 20 of whom were not fully vested, such courts would apply the test by focusing only upon the non-fully vested participants (such that the plan sponsor would be considered to have terminated 33 percent (20/60) of the non-fully vested participants). To complicate matters even further, the few courts that have excluded fully vested participants have done so inconsistently. Specifically, some federal courts excluded fully vested participants from both the numerator and the denominator (as indicated by the example above), while one federal court has excluded fully vested terminated participants from the numerator, but included fully vested active participants in the denominator (e.g., in this court, the significant percentage test would have resulted in a 20 percent (20/100) reduction in the example above). The courts that have excluded fully vested participants in one form or another have done so in reliance on the legislative history under the relevant sections of the Code, which describes the purpose of the partial termination rule as intending to protect plan participants from forfeiting rights to accrued, but unvested, benefits. In doing so, such courts have reasoned that including fully vested participants within such analysis does not further such purpose because fully vested terminated participants forfeit no benefits.
In the Matz case cited above, in addition to establishing a new rebuttable presumption standard to the 20 percent significant percentage test, the Seventh Circuit Court of Appeals also held that vested participants should be fully represented in both the numerator and the denominator of the significant percentage test. In deciding to count all participants, the court relied on the fact that the 20 percent figure in the IRS's amicus brief that helped establish the 20 percent threshold was the total percentage of the applicable plan's participants who were terminated, irrespective of how many were fully vested. IRS Revenue Ruling 2007-43 provides clarity on this issue as well, by ruling that all vested participants are to be included in both the numerator and the denominator of the significant percentage test.
D. The Relevant Time Period/ Aggregation of Multiple Plan Years
Neither the Code, nor its legislative history, nor the applicable regulations thereunder specify whether aggregation of multiple plan years is required or permitted. Most IRS rulings and court decisions analyzing the partial termination rules have simply applied the significant percentage test on a plan year basis, without discussion of the merits of such a decision. The handful of authorities that have analyzed the issue, however, have held that employee terminations during consecutive plan years should be taken into account — stating the applicable time period as running from the start of the event, causing the employer-initiated terminations through its completion.
Some courts have bifurcated multiple corporate events where clear timing break-points could be established. For instance, one federal circuit court of appeals applied the significant percentage test with respect to two different time periods where the applicable tax-qualified retirement plan lost participants due to (a) the general economic recession in the March 1989 — June 1990 time-period and (b) the increase in the luxury tax rate which suppressed the plan sponsor's boat sales from January 1991 — June 1991. By contrast, another federal court rejected a tax-qualified retirement plan sponsor's argument that terminations over a 2½-year period occurred due to two distinct corporate events (i.e., terminations in connection with the merger of the plan sponsor with another company and terminations due to the drastic decline in oil prices) and held that the plan sponsor's business decisions to reduce its workforce resulted in a single corporate event throughout this 2½-year period for purposes of applying the significant percentage test to the partial termination analysis.
On this point, IRS Revenue Ruling 2007-43 provides that the applicable period "depends on the circumstances," and indicates that the applicable period is generally the plan year, but could be a longer period if there are a series of related severances from employment.
Because of the uncertainty of the application of the partial termination rule and the severe adverse consequences that could result from making an erroneous determination in this regard, an employer who has seen its workforce shrink in recent times should engage in a significant and careful analysis as to whether or not any tax-qualified retirement plan sponsored by it has incurred a "partial termination." Although IRS Revenue Ruling 2007-43 provides more definitive standards in this regard, there are still a number of legal judgement calls that need to be made in conducting the applicable analysis. White & Case would be pleased to assist in helping you conduct this partial termination analysis.