Given the sharp increase in layoffs nationwide, understanding “partial plan terminations” is essential for qualified plan sponsors.
Though the rules governing partial plan terminations are complex—and their implications may depend upon the particular circumstances of each individual plan—we have compiled some core concepts and key considerations that may help you avoid triggering a partial plan termination.
When 20% or more of a plan's particpants are terminated during a given plan year—that is, a “turnover rate” of at least 20% occurs—then a partial plan termination may be triggered.
However, you should know that this “20% rule” is not absolute. While the IRS has ruled that with a turnover rate of at least 20%, a partial termination has probably occurred, layoffs of less than 20% could still be considered a partial termination, depending upon the unique facts and circumstances of the plan.
There are other situations beyond the turnover rate that may also prompt partial plan termination. For example, if a plan is amended to exclude a group of employees that were previously covered by a plan, it may also be considered a partial plan termination. And reducing or ending future benefits in a defined benefit plan may also be considered a partial plan termination.
When a partial plan termination occurs for a qualified retirement plan (whether intentional or not), current law mandates that all “affected employees”—generally those who left employment during the plan year when the partial termination took place and still have plan account balances—have to be fully vested in their account balances.
These affected employees must also become 100% vested in all employer contributions (including matching contributions) regardless of the plan’s vesting schedule. (Employee salary deferrals are always 100% vested.)
Failure to comply with these rules could result in a plan being disqualified, unless the error is corrected using the IRS Employee Plans Compliance Resolution System1.
If you are forced to cut staff, you may want to consider furloughing employees instead, which may provide a way to reduce staff while possibly steering clear of a partial plan termination.
Furloughs and layoffs are very different, although many people use the two terms interchangeably. Knowing the difference between layoffs and furloughs—and using them appropriately during this difficult economic climate—may avoid a partial plan termination.
A furlough typically applies for a limited period of time or involves a reduction in hours or compensation. A furloughed employee is still technically employed. In other words, furloughs may not add to the turnover rate and lead to partial plan termination. You should discuss the impact of furloughs on a potential partial plan termination with your legal and tax advisors.
A layoff is very different. It is a termination, or severance, of employment, without the expectation of returning to employment in the future. Layoffs increase the turnover rate—and, if 20% or more, will likely lead to partial plan terminations.
Beyond navigating the challenging current conditions, furloughs may benefit your business over the longer term. Furloughing employees may help you retain top talent while you weather the uncertainties of the current business climate. And when conditions do improve, you may be ready to benefit—and may avoid the costs of rehiring in what is likely to be a more competitive employment environment.
For more details about partial plan terminations, you can review these FAQs2 provided by the IRS.
If you think your plan may be at risk for a partial termination, you may seek an opinion from the IRS by filing an Application for Determination for Employee Benefit Plan (IRS Form 5300).3 You should also contact your Financial Advisor as well as your plan’s tax and legal advisors to conduct a comprehensive review of your plan’s specific facts and circumstances and to address any questions regarding partial plan terminations.