- To Vest or Not to Vest?
- October 18, 2007 | Authors: Sally Doubet King; Larry R. Goldstein; Angela M. Miller
- Law Firm: McGuireWoods LLP - Chicago Office
That is the question plan sponsors must answer when faced with a significant reduction in active participants in their qualified retirement plans. Plan sponsors must determine whether the reduction results in a “partial termination,” under Section 411(d)(3) of the Internal Revenue Code of 1986, as amended (the “Code”). If the reduction results in a partial termination, Code Section 411(d)(3) provides that the plan sponsor must, to the extent the plan is funded, fully vest all affected participants in the plan.
In the past, the guidance for plan sponsors has been a patchwork of case law and Internal Revenue Service (“IRS”) rulings. Recently, however, the IRS issued Revenue Ruling 2007-43 to provide plan sponsors with more focused guidance on this issue. In this ruling, the IRS clarified that when there is a 20% or greater reduction in active participation, taking into consideration all employees who lose coverage (whether or not they are fully vested), there is a rebuttable presumption that a partial termination has occurred.
Prior to Revenue Ruling 2007-43, the basis for determining that a partial termination had or had not occurred (as discussed in Treasury Reg. § 1.411(d)-2(b)(1)) was a “facts-and-circumstances” test. Under this test, the following scenarios could result in a partial termination:
Excluding eligible employees from participation in the plan through a plan amendment or by termination of employment (such as a reduction in force); or
Amending the plan to adversely affect the rights of participants to vest in benefits under the plan.
When plan sponsors experienced a reduction in participation in their qualified retirement plans due to business events -- such as a large lay-off, business location closing, or a sale of a division -- the subjective “facts-and-circumstances” test presented the uncomfortable task of determining whether the reduction was significant enough to result in a partial termination. Plan sponsors then had two choices. First, vest all affected participants (a potentially expensive endeavor), assuming that under the plan sponsor’s specific facts the IRS would determine a partial termination had occurred. Or, second, not vest all affected participants, assuming the IRS would determine that under the plan sponsor’s specific facts a partial termination had not occurred. Under the second option, the plan sponsor risked the qualified status of the plan if the plan sponsor’s assumption was incorrect.
As expected, due to the ambiguity in the facts-and-circumstances approach, a number of lawsuits have been brought by participants who believed that due to a partial termination they were entitled to additional vesting under their qualified retirement plans. The courts considering these cases reached differing conclusions on (i) what percentage of participant reduction triggered a partial termination and (ii) whether non-vested participants should be considered in the calculation of the percentage. For example:
What Percentage Reduction is Determinative
Test – Rebuttable presumption that a 20% or greater reduction in plan participation is a partial termination and a smaller percentage is not a partial termination.
Matz v. Household Int’l Tax Reduction Inv. Plan, 388 F.3d 570, 577-78 (7th Cir. 2004).
Test – Declines to “accord talismanic significance to the 20-percent rule of thumb, but will regard the percentage drop in the light of the other facts and circumstances.”
Halliburton Co. v. Comm’r, 100 T.C. 216, 237 (1993).
Which Terminated Participants Should be Counted
Test –The ratio of:
Terminated Participants (vested & non-vested)
All Participants (vested & non-vested)
Weil v. Ret. Plan Admin. Comm. of the Terson Co., 933 F.2d 106, 110 (2nd Cir. 1991).
Test –The ratio of:
Terminated Participants (non-vested)
All Participants (non-vested)
In re: Gulf Pension Litig., 764 F. Supp. 1149, 1168 (S.D. Tex. 1991), aff’d, Borst v. Chevron Corp., 36 F.3d 1308 (5th Cir. 1994).
IRS Standard Under Revenue Ruling 2007-43
In Revenue Ruling 2007-43, the IRS adopted the Weil and Matz approaches outlined above. According to the IRS, the basis for determining whether a partial termination has occurred still depends on the facts and circumstances, but a turnover rate of 20% or more, determined by dividing terminated participants (both vested and non-vested) by all participants (both vested and non-vested), is presumed to be a partial termination. The IRS further explained that the “applicable period” for determining whether a partial termination has occurred is generally the plan year. However, the applicable period may be a longer period in instances when the plan year is less than 12 months (in which case the previous plan year is also included) or when there is a series of related events which result in a reduction of participation -- for instance, when an employer engages in a series of sales of its business divisions.
Revenue Ruling 2007-43 provides much-needed guidance to plan sponsors faced with a decrease in plan participation. However, plan sponsors should be cautious: a reduction in participation that results in less than a 20% decrease does not create an automatic presumption that a partial termination has not occurred. Any involuntary reduction in the number of participants in a plan must still be analyzed in terms of that plan and the circumstances resulting in the reduction.