Major corporate events (such as mergers, acquisitions, reductions-in-force, and plant closings) have long presented a special problem for retirement plan sponsors. Under the Tax Code, if employee turnover results in a “partial termination” of a qualified plan, the sponsor must fully vest all affected participants in the benefits they have accrued under the plan. Unfortunately, vague and anecdotal guidance on precisely when such a partial termination occurs has left sponsors unsure of when they must take the costly step of fully vesting terminated participants.
This uncertainty has also discouraged many plan sponsors from seeking the protection offered by a formal IRS determination that a partial termination has not occurred. This can be a costly omission, however, because it increases the sponsor’s vulnerability to lawsuits filed by terminated employees seeking full vesting of their benefits. Fortunately, recent IRS guidance should make such filings a routine step in any corporate event that results in significant employee turnover.
THE NEW IRS RULING
In Revenue Ruling 2007-43 (the “Ruling”), the IRS has finally provided detailed guidance on when a partial termination occurs. Plan sponsors can now more confidently gauge the effects of employee turnover on their plans, thereby reducing the risk of unnecessarily vesting participants, on the one hand, or plan disqualification (through a failure to vest), on the other.
The 20% Rule of Thumb.The Ruling begins by formally restating the IRS’s longstanding informal rule: if the “turnover rate” of participants in the plan is at least 20%, the IRS will presume that the plan has partially terminated. The turnover rate is determined by dividing the number of participants who had an “employer-initiated” severance from employment during the “applicable period” by the sum of (i) the plan’s participants at the start of that period and (ii) the employees who became participants during that period. The Ruling then fleshes out this general rule with specific guidance on how to calculate the turnover rate. In many cases, these details resolve longstanding questions.
All Aboard. Finally resolving a question that has plagued sponsors, their advisers, and the courts for decades, the Ruling makes clear that both vested and nonvested participants are counted in both the numerator and the denominator of the turnover fraction.
Applicable Period. In general, the applicable period is the plan year. In the case of a short plan year, however, the applicable period is that short year plus the preceding plan year. And, in the case of a series of related severances from employment, the applicable period can stretch to include the entire series.
Employer-Initiated Severance. In computing the turnover rate, only employer-initiated severances are relevant. Instances in which the IRS will disregard a participant’s termination of employment include severances caused by death, disability, or retirement on or after the plan’s normal retirement age. The Ruling generally presumes that other severances are “employer-initiated” – even if they result from events completely outside the sponsor’s control (such as an economic downturn).
Although an employee’s purely voluntary severance will also be disregarded, the Ruling warns employers to substantiate such claims, and it suggests personnel files, employee statements, and other corporate records as means of proving “voluntariness.” The Ruling is vague on this point, but the IRS apparently means that it would ignore an unsubstantiated claim that an employee terminated voluntarily.
Employees who transfer out of the sponsor’s controlled group are also disregarded in calculating the turnover rate, provided they continue to be covered by a plan that is a continuation of the plan they left. Thus, if a portion of the sponsor’s plan is spun off as a part of a corporate transaction, the participants covered by the spun-off plan may be excluded from the calculation of the turnover rate.
Other Issues. Although primarily concerned with participant turnover, the Ruling also lists other events that can result in the partial termination of a qualified plan. These include plan amendments adversely affecting participants’ right to vest in their benefits, amendments that exclude employees who have previously been covered, or a reduction or cessation of future benefit accruals that results in (or increases) a potential reversion to the sponsor.
Rebutting the Presumption. As with any presumption, the Ruling’s 20% rule of thumb is rebuttable, under a facts-and-circumstances test. For example, if the sponsor can demonstrate that the turnover was routine for its business, the IRS will be less likely to conclude that a partial termination has occurred. Factors relevant to determining whether turnover was routine include the employer’s turnover rate in other periods, the extent to which terminated employees were actually replaced, whether new employees perform the same functions as the terminated employees (and whether they have the same job classifications or titles), and whether they receive comparable compensation.
DETERMINATION NOW A MORE ATTRACTIVE OPTION
Because the Ruling significantly clarifies the IRS position, it will eliminate much of the guesswork from the partial termination analysis, thereby allowing plan sponsors to prepare for – and document – corporate events that might result in the partial termination of their retirement plans. This is welcome relief because, as sponsors know, these events are stressful enough already.
As noted at the beginning of this article, plan sponsors may request a formal determination that employee turnover has not resulted in a partial termination. Though not conclusive, such a favorable determination should offer significant protection against lawsuits brought by terminated employees. Because the Ruling makes the outcome of such a filing more predicable, sponsors should now consider requesting an determination in connection with any corporate event that results in significant employee turnover