The Hidden Cost of Terminating 20% or More of Your Employees – Partial Termination of the Retirement Plan

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Dickinson Wright

With the delay in re-opening businesses, some companies are finding that they need to terminate employees who had been placed initially on furlough or a reduced-hours assignment.  When analyzing the costs that will be incurred due to these terminations, companies that sponsor 401(k) plans or other qualified retirement plans should determine if the partial termination rule will apply to the plan and, if it does, what will be the financial impact to the company.

Partial Termination Rule

To be qualified, a retirement plan must provide that upon a partial termination the accounts of all affected employees are fully vested.  In Revenue Ruling 2007-43, the IRS noted that a 20% or greater employee turnover rate during an applicable period creates a presumption of a partial termination.  Generally, the applicable period is a plan year, but it could be a longer period if there are a series of related events, such as a plant closing where employees are terminated in stages over a period longer than a plan year.  If a partial termination occurs, any employee who is terminated during the applicable period, including a voluntary termination, must be fully vested in his or her account.

Calculation of the Turnover Rate

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 all of the participating employees at the start of the applicable period plus the employees who became participants during the applicable period.  Both vested and non-vested participating employees are taken into consideration, along with employees who are eligible to make salary deferrals to the 401(k) plan but have never chosen to contribute.  An employee’s severance from employment is employer-initiated even if caused by an event outside of the employer’s control, such as severance due to the pandemic. In FAQ-15 of its  CARES Act guidance, the IRS indicated that an employee who was terminated because of COVID-19 and is rehired before the end of 2020 is not treated as having an employer-initiated severance from employment.

Planning Considerations

Since an employer may use the full plan year to determine if there has been a partial termination, it may find that after the end of the plan year there are terminated employees to which the retirement plan owes amounts previously forfeited plus earnings since the date of distribution.  Locating terminated employees to make a second distribution is time consuming.  If the plan imposes a distribution fee, the company may want to have its recordkeeper waive the fee for the second distribution.  If the company has been using forfeitures during the plan year to offset company matching contributions, the company may need to make a special contribution to reinstate these forfeitures.

The 20% turnover rate established by the IRS guidance is a rebuttable presumption.  Employers that traditionally have high employee turnover may be able to demonstrate that a 20% or greater turnover is routine.

Employers that are thinking about keeping furloughed employees in a non-active status and without employer subsidized health care so to avoid a partial termination will want to consider the Affordable Care Act implications that are discussed here.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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