As a result of the recent nation-wide economic downturn, many employers have experienced reductions in their workforce (or "RIFs"). One potential unintended and costly consequence of a RIF is that an employer's tax-qualified retirement plan may have incurred a so-called "partial plan termination" as a result of such RIF (i.e., a significant reduction in plan participation that would cause the immediate vesting of affected participants). This article summarizes the applicable law regarding "partial plan terminations" under the Internal Revenue Code of 1986, as amended (the "Code"), and also discusses the adverse consequences that could result from the failure to treat a 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 had occurred. This article also explains the methodology for determining whether a partial plan termination has occurred, depending on the exact nature of participant turnover within an employer's tax-qualified retirement plan, and, if such determination remains in doubt, the process available to seek a determination from the Internal Revenue Service as to whether a partial plan termination has occurred.
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 if 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 not 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.
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 shall 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 for making a partial termination determination.
Absent any statutory or regulatory guidance on the matter, in addressing the issue of the meaning of the term "partial termination," the cases and IRS rulings have developed and utilized a so-called "significant percentage test." Such test was first announced by the IRS in a 1972 Revenue Ruling, in which the IRS held that a 70 percent reduction in plan participation resulted in a partial termination of the plan. Although this 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 has been generally accepted by courts as the key factor in making a ruling on the partial termination issue.
The Applicable Percentage
Prior to guidance issued by the Internal Revenue Service in 2007, there was no magical figure at which a partial termination was deemed to occur and the exact level at which it became determinative of the issue was historically still somewhat ill defined. Notably, several cases have held that the percentage drop in plan participation standing alone may be sufficiently large (i.e., generally greater than 50 percent) or small (i.e., generally less than five 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 have been considered in conjunction with the percentage drop in order to decide whether the percentage drop is significant, the primary focus of the determination had been on the percentage drop in plan participants. In this regard, a "semi-bright line" test had developed that (a) a drop of less than 20 percent is considered significant only if accompanied by egregious abuse on the part of the employer, such as discrimination in favor of the highly compensated, manipulation of the pension rules to obtain tax benefits, creation of a reversion of plan assets to the employer, or an attempt to prevent employees from becoming vested in accrued benefits, and (b) a percentage drop of at least 20 percent is sufficient, if coupled with other circumstances, such as the closing of a plant or division, to suggest that a partial termination has occurred.
In Revenue Ruling 2007-43, the IRS adopted a 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 noted that whether or not a partial termination occurs on account of participant turnover is 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.
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. Revenue Ruling 2007-43 uses the term "employer-initiated severance" to describe the class of affected participants to be used in the applicable test. For these purposes, 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 or after normal retirement age. In addition, the IRS indicated that the employer may be able to verify than 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.
Revenue Ruling 2007-43 also 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 is applied with respect to "all" participants or only to participants who are "actively employed" as of the dates being analyzed under the test. 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").
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 in determining whether a partial plan termination has occurred. 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 decision. 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.
The cases that have used a facts and circumstances analysis to hold that employee terminations during consecutive plan years should be taken into account have stated that the applicable time period runs 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 two and a half 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 work force resulted in a single corporate event throughout this two and a half year period for purposes of applying the significant percentage test to the partial termination analysis.
IRS Determination Letter Process
As discussed above, neither the Code nor the regulations promulgated thereunder explicitly define what constitutes a partial termination. However, the IRS will, upon request for a determination through the filing of an IRS determination letter application on IRS Form 5300, rule on the issue of whether or not a partial termination has occurred with respect to a particular plan. In this regard, the IRS has taken the position that a plan sponsor who requests a partial termination determination before fully vesting affected participants may rely on the qualified status of its plan if the IRS determines that a partial termination has occurred and the sponsor thereupon retroactively vests all affected participants as of the date of the partial termination. Hence, the plan will retain its qualified status if the employer vests affected participants after the occurrence of the partial termination so long as the vesting occurs within a fairly short period of time after the IRS' determination of the occurrence of a partial termination.
The benefit of obtaining such a determination letter is two-fold: (1) it protects the plan sponsor from a later challenge by the IRS; and (2) a court will likely give the IRS determination deference in rendering its decision in an action brought by a plan participant alleging that a partial termination has occurred entitling him or her to full vesting. (Of course, such benefits of an IRS determination are only available to the extent that all relevant information regarding the applicable participant terminations is adequately and completely disclosed to the IRS, and that the plan sponsor complies with all requirements with respect to the form of the determination letter request (e.g., participant disclosures)). Of course, the disadvantage in seeking a determination letter is that an IRS determination that a partial plan termination has occurred will require the employer to fully vest all affected participants and foreclose the ability of the employer to take a good faith position that a partial plan termination has not occurred.
Because of the uncertainty in 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." To the extent that the results of such analysis are not 100 percent clear in this regard, such an employer should consider utilizing the IRS' determination letter program discussed above and seek a ruling from the IRS as to whether or not the applicable plan has incurred a partial termination.