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    Retirement Plan Partial Terminations - It's A Question Of Vesting

    Economic recovery since 2008 has meant different things to different industries and to individual businesses. For many, it means doing more with less, especially less staff. Sponsors of tax-qualified retirement plans such as the 401(k) who have had significant (and later we'll explain what the IRS considers to be "significant,") reductions in force should be aware of the special vesting rules relating to "partial plan terminations," and be prepared to act if necessary to protect plan status.

    Affected participants become fully vested as a result of a partial termination. Therefore, it is better to recognize a partial termination event when it occurs, rather than to realize that one has occurred in the past and that your plan has not paid out affected participants on a fully vested basis. Although there are technically two types of partial terminations, horizontal partial and vertical partial, this article will focus only on the vertical partial termination – that is, a situation in which an employer-initiated action results in a significant decrease in the employees covered under a retirement plan.

    If a partial termination has occurred, the tax qualification rules applicable to practically all retirement plans (with the exception of certain governmental and church plans), require that the participants affected by the partial termination become fully vested. This sounds fairly straightforward, and in many cases it is. However, as with many retirement plan rules, "the devil is in the details." Therefore, in order to be aware of the potential for a partial termination, employers need to understand a little more of what goes into the determination that a partial termination has occurred.

    First, there needs to be some employer-initiated action that decreases plan participation (for example, a plant closing or a series of layoffs). If participation levels drop solely due to normal employee turnover on a voluntary basis, then there has not been a partial termination. Of course, there are a number of instances in which it is not clear whether a decline in participation is due to employer action. In one case, participants argued that they had not voluntarily terminated employment under a severance plan offer because they were fraudulently induced to accept termination under the severance plan. Another case suggests that employees who can demonstrate that they have been "constructively terminated" may be part of a partial termination. The more typical case is where there is a significant reduction in plan participation due in part to normal turnover and in part to employer layoffs. Because employees who terminate voluntarily are not affected by a partial termination that affects laid-off employees, it is important for the employer to keep appropriate records of the reasons for each employee's termination.

    Second, even if there is employer action that decreases participation, there is no partial termination unless the reduction is permanent and significant. And although the IRS issued a revenue ruling suggesting that a significant decrease has occurred if the reduction in participation due to employer action is at least 20 percent, a number of courts have found partial terminations to have occurred based on a significant decrease in the number of participants. Some courts have placed a greater significance on the number of employees terminated, as opposed to the percentage, when the circumstances reflect the layoffs were done to increase forfeitures or reduce employer contributions.

    Under the revenue ruling, the percentage reduction in participation 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 and the employees who became participants during the applicable period.

    According to the ruling, all participating employees are taken into account in calculating the turnover rate, regardless of whether they are vested. Although this somewhat mechanical approach to the matter is helpful in many ways, it also can create problems – particularly for small employers with relatively few participating employees. For example, it would appear that a partial termination has occurred in the case where a dentist terminated one of his four employees who was not yet fully vested, even though the termination was for cause (that is, the employee did something to warrant the termination).

    Over what period of time is the percentage reduction measured? According to the ruling, the applicable period depends upon the circumstances. Generally, it would be at least the plan year in which the employer-initiated event occurred. If the current plan year is less than a 12-month period, you would tack on the preceding plan year. On the other hand, the ruling makes clear that the applicable period could extend over a longer period "if there are a series of related severances from employment." This aspect of the guidance can be particularly troublesome. For example, imagine a company that has just been purchased. In such a case, it would not be unusual for new management to lay off 5 to 10 percent of the workforce in order to trim costs. Has a partial termination occurred? Perhaps, depending upon the absolute numbers of employees affected; but most likely not, due to the relatively low percentage of employees affected. Perhaps the next year, after a more thorough review of its administrative operations, another 5 to 8 percent of the workforce is permanently laid off – this time it's mainly mid-level managers. Finally, in year three, the economy takes a nosedive and no one is buying the company's product. Once again, management evaluates its options and decides to close one of its manufacturing plants, resulting in the layoff of another 7 percent of its workforce. As you can see, each of these employer-initiated actions when viewed alone under the company's only plan probably did not constitute a partial termination. However, when you step back and look at these layoffs as part of a series of related reductions in force that have occurred over a 3-year period, the whole thing suddenly looks much more like a partial termination. This illustrates the need to examine each employer-initiated layoff to determine if it is an isolated event – or part of a series of related events giving rise to a partial termination.

    In summary, the determination of whether a partial termination has occurred is an operational determination – one best made at or about the time that an employer-initiated reduction in participation occurs. If a proper determination can be made at that time, then participants who have been affected by a partial termination can be paid out on a fully vested basis. Of course, it can be dangerous to rely too heavily on IRS guidance alone. Partial terminations have been found by the courts in instances where a significant number of participants were terminated (regardless of the percentage). One must also consider the circumstances surrounding an employee's voluntary termination of employment – appearances may be deceiving. Finally, employers can be surprised to learn that their plans have been the subject of a "creeping partial termination" – one that has evolved over a period of years. With all of this in mind, it is important for employers to remain diligent and to discuss these issues with their plan advisers where appropriate.