Guest Article

(From the June 16, 2003 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

IRS Provides Guidance on Applying Vesting Rules to Un-Frozen DB Plans

The IRS has issued Revenue Ruling 2003-65 to clarify the requirements for counting years of service under the tax-qualified plan vesting rules when benefit accruals resume under a previously frozen defined benefit plan. According to IRS, all of an employee's years of service with the employer since it initially established the plan-- not just since benefit accruals resumed-- count for purposes of the vesting rules in these situations.

Facts

The plan at issue in Rev. Rul. 2003-65 is a tax-qualified defined benefit plan. The plan's sponsor, Employer M, froze the plan as of December 31, 1996, causing the plan to experience a partial termination. (In general, a partial termination occurs when a defined benefit plan sponsor reduces or freezes accruals, thereby creating or increasing the potential for reversion to the employer. A partial termination also may occur if the plan sponsor terminates a significant percentage of plan participants.) As a result of the partial termination, all of the plan's participants became fully vested in their accrued benefits at that time.

Employer M later amended the plan to resume accruals as of January 1, 2003, under a new benefit accrual formula. Each participant's accrued benefit will be the sum of his accrued benefit under the pre-freeze formula and the new formula.

Issue

The question is whether the plan must credit participants' service with Employer M since the time the frozen plan was initially established, or just the service with Employer M since accruals resumed, for purposes of applying the vesting rules to accruals under the new benefit formula. (As noted, all benefits accrued under the pre-freeze formula automatically vested due to the partial plan termination.)

Summary of Relevant Law and IRS's Holding

A tax-qualified plan must satisfy certain vesting requirements under IRC section 411(a) in order to maintain its qualified status. In general, participants must become vested in their accrued benefits attributable to employer contributions after completing no more than 5 years of service under a cliff vesting schedule or 7 years of service under a graded vesting schedule.

For purposes of the vesting requirements, "years of service" include, "all of an employee's years of service with the employer or employers maintaining the plan," subject to certain exceptions. One exception is for years during which the employer did not maintain the plan or a predecessor plan. IRC section 411(a)(4)(C). According to Treas. Reg. Sec. 1.411(a)-5(b)(3)(iii), "The period for which a plan is not maintained by an employer includes the period after the plan is terminated."

Thus, the real question is whether a "partial termination" equals a "termination" for purposes of this exception to the "years of service" rule. The answer, according to Rev. Rul. 2003-65, is that it does not. As such, the revenue ruling holds, "all years of service for the plan sponsor following the establishment of the previously frozen plan must be taken into account for purposes of vesting." The revenue ruling further holds the same result would apply if Employer M had established a new plan and merged it with the frozen plan, instead of simply amending the frozen plan.

Effect on Employers

Even though this revenue ruling does not give employers the answer they might want, it at least gives them guidance on what to do if they ever are in this situation. But there is more at stake for employers that may have faced this issue already and decided to only credit participants for service after accruals resumed. In these cases, the employers should credit participants with additional years of service as appropriate and make any necessary changes to their plans' terms.

If you have any questions or need additional information, please contact your Deloitte advisor.

The information in this Washington Bulletin is general information only and not intended to provide advice or guidance for specific situations. Contact your Deloitte advisor for information regarding your specific circumstances. If you have questions or need additional information about this article and you do not have a Deloitte advisor, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094). Human Capital Advisory Services, Deloitte LLP, 555 12th Street NW, Suite 500, Washington, DC 20004-1207. Copyright 2003, Deloitte.