October 27, 2021

Volume XI, Number 300

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October 27, 2021

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Layoffs can trigger vesting requirements for retirement plans

If a qualified defined contribution retirement plan (e.g., 401(k), ESOP) experiences a "partial termination," then "affected employees" generally must be fully vested in their plan accounts. The Internal Revenue Code does not provide extensive detail regarding what constitutes a partial termination, and whether a partial termination occurs depends upon the facts and circumstances. However, a general rule is that a plan is presumed to have partially terminated if at least 20 percent of participating employees experience an employer-initiated severance from employment during the applicable period. This presumption can be rebutted in some situations, though. Also, in the federal Seventh Circuit Court of Appeals (which includes Wisconsin), a partial termination can occur when the turnover rate is as low as 10 percent.

According to Internal Revenue Service (IRS) guidance, an "employer-initiated severance from employment" for this purpose generally includes any severance from employment other than a severance that is on account of death, disability or retirement on or after normal retirement age. This appears to include employees who are fired, even for cause or if due to adverse business conditions. However, the IRS guidance indicates that an employee who voluntarily terminates is not an “affected employee.” The "applicable period" over which the calculations must be made varies depending upon the given fact pattern, and can span across multiple plan years if there are a series of related severances from employment.

Many employers are not aware of the partial termination requirements. This lack of knowledge is dangerous because failure to fully vest affected employees when required can disqualify the plan. In that case, the plan’s tax advantages are jeopardized.

Regardless, employers that are considering layoffs due to the 2019 novel coronavirus (COVID-19) pandemic should consider whether a partial termination may occur. Partial termination analysis can be nuanced and complicated.

Copyright © 2021 Godfrey & Kahn S.C.National Law Review, Volume X, Number 81
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About this Author

Todd Cleary Employee Benefits Attorney
Shareholder

Todd Cleary is a shareholder in the firm’s Employee Benefits Practice Group. Todd works extensively with retirement plans, such as ESOPs, pension, profit sharing, 401(k), 403(b), 457, cash balance, SIMPLE and SEP plans. Todd’s experience with welfare plans includes the design and compliance of medical plans (including issues related to ERISA, COBRA and HIPAA), wellness programs, cafeteria plans, disability plans (short-term and long-term), and group term life insurance plans. Todd has also worked with nonqualified deferred compensation plans, multiple employer welfare arrangements (MEWAs...

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