Guest Article

(From the November 15, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Seventh Circuit Changes Mind on Vertical Partial Termination Standard

More than three years after specifically rejecting the IRS's formula for determining whether a vertical partial termination of a qualified plan has occurred, the Seventh Circuit Court of Appeals has decided it is the "best available" alternative after all. Matz v. Household International Tax Reduction Investment Plan, Nos. 03-4344, 03-4345 (7th Cir. 2004). The IRS formula, which calculates the percentage of plan participants terminated in connection with one or more related events, is one of at least three approaches the Seventh Circuit considered in this case.

According to IRC section 411(d)(3), plan participants affected by a full or partial plan termination must become 100 percent vested in all their accrued benefits as of the termination date. The purpose of the full termination rule, according to the Seventh Circuit, is "to prevent plan terminations motivated by the prospect of a tax windfall." The partial termination rule is a backstop to the full termination rule, designed to prevent plan sponsors from evading the consequences (i.e., immediate vesting) of a full plan termination by terminating their plans incrementally.

There are two types of partial terminations. A vertical partial termination may occur when a plan sponsor drops a group of participants from the plan, either by terminating their employment or some other means. A horizontal partial termination can occur if a defined benefit plan sponsor ceases or reduces future accruals. See Treas. Reg. Sec. 1.411(d)-2(b).

The question in Matz is whether Household caused a vertical partial termination of its 401(k) plan by terminating a number of employees in connection with a purported corporate reorganization. The issue before the Seventh Circuit Court of Appeals was how to determine whether a partial termination occurred.

Case Facts

Robert Matz was an employee of Hamilton Investments, Inc., a subsidiary of Household. Household terminated Matz's employment on September 1, 1994, when Household sold Hamilton investments. Between 1994 and 1996, Household sold a number of other subsidiaries.

During his tenure with Hamilton, Matz participated in Household's 401(k) plan. At the time of his termination he was 60 percent vested in Household's matching contributions. As a result, he forfeited $7,289.92-- 40 percent of the matching contributions-- when his employment ended.

Matz sued the plan to recover the forfeited matching contributions. He claimed that, taken together, the sell-off of various Household subsidiaries between 1994 and 1996-- and the resulting reduction in the number of participants in the Household 401(k) plan-- constituted a "partial termination" of the plan. Matz also sued on behalf of all other plan participants who were not totally vested at the time their employment was terminated as the result of these transactions.

What Constitutes a Vertical Partial Termination?

Unfortunately, the Code provides little guidance as to what constitutes a vertical partial termination and how to determine when and if a vertical partial termination has occurred. Neither the Code nor ERISA define "partial termination." Treasury regulations explain that "whether or not a partial termination of a qualified plan occurs (and the time of such event) shall be determined ... with regard to all the facts and circumstances in a particular case." Treas. Reg. Sec. 1.411(d)-2(b)(1).

The body of case law that has examined this issue generally holds that a vertical partial termination occurs only when there is a "significant reduction" in plan participants. Courts generally use a "significant percentage" test first developed by the IRS to determine if there has been a "significant reduction" in the number of plan participants.

Basically, the significant percentage test is a ratio of terminated plan participants over total plan participants: whether the resulting percentage is more (or less) than 20 percent often is the deciding factor in partial termination cases. But which participants to include in the ratio's numerator and denominator, and which to exclude, are among the key questions in the Matz case.

Matz I

In 2000, the Seventh Circuit Court of Appeals ruled vested participants must be included in both the numerator and denominator-- the same position the IRS (and the Second Circuit Court of Appeals) took in a previous partial termination case (the "IRS approach"). However, the Court at that time indicated that, were it not "constrained" to defer to the IRS's "reasonable" construction of the statute, it probably would have reached a different conclusion. The better approach, according to the Court, would be to exclude vested participants from both the numerator and the denominator-- an approach yet another court had taken (the "Gulf Approach").

Household appealed to the Supreme Court, which ordered the Seventh Circuit to revisit its decision to defer to the IRS on this issue. The Supreme Court's order was based on a decision in another case, in which the Supreme Court concluded courts should defer to an agency's interpretation of a statute only "when it appears that Congress delegated authority to the agency generally to make rules carrying the force of law, and that the agency interpretation claiming deference was promulgated in the exercise of that authority."

Matz II

Based on this new guidance, the Seventh Circuit determined it did not have to defer to the IRS's position on this issue. The Court then went on to rule that counting vested participants did not make sense in light of the partial termination rule's purposes to protect employees' legitimate expectations of pension benefits and to prevent employers from abusing pension plans to reap tax benefits. (Vested participants have nothing to gain from a finding of a partial termination because the remedy for a partial termination is vesting. Also, employers do not earn any potential tax benefits by terminating vested participants because they do not leave behind any assets that can revert to the employer.)

The Seventh Circuit returned the case to the district court level for purposes of applying this version of the significant percentage test to the facts in this case. But a dispute broke out over whether the Seventh Circuit meant vested participants should be excluded from just the numerator, or from both the numerator and the denominator. The Seventh Circuit's decision didn't say.

Piecing together comments the Seventh Circuit made in previous decisions, the district court decided vested participants should be excluded from both the numerator and the denominator. Once again, Household appealed.

Matz III

After reviewing Household's arguments for excluding vested participants only from the numerator (the "Household approach"), and Matz's arguments for excluding vested participants from both the numerator and denominator, the Seventh Circuit concluded both approaches are flawed. Briefly, the Court rejected Household's proposed approach because it could produce a finding of no partial termination in cases where a large percentage of plan participants were terminated. Matz's proposed approach, by comparison, could produce a partial termination finding in cases where very few plan participants were terminated.

The Court then decided the IRS's approach of counting vested participants in both the numerator and the denominator, which it had grudgingly accepted and later rejected in previous opinions, was the better alternative. The Court also stated a 20 percent or greater reduction in plan participation would give rise to a rebuttable presumption of a partial termination, and any reduction less than 20 percent would give rise to a rebuttable presumption of no partial termination. However, the Court suggested a participant reduction of more than 40 percent should be conclusively presumed to be a partial termination, and a reduction of less than 10 percent should be conclusively presumed not to be a partial termination.

Analysis

To see why the Seventh Circuit's decision matters for this (and perhaps future) vertical partial termination cases, consider the following example. Assume Employer sponsors a defined contribution plan (Plan) that has 1,000 participants, of whom 750 are fully vested. On January 1, Employer terminates 450 participants, including 270 fully vested participants and 180 nonvested participants.

Applying the Seventh Circuit's analysis to these facts results in a partial termination, because 450/1,000 is 45 percent. Likewise, the Gulf approach results in a partial termination because, when vested participants are removed from the numerator and the denominator, the ratio becomes (450-- 270)/(1,000-- 750). This represents a 72 percent reduction (180/250) which, according to the Seventh Circuit, is conclusively presumed to be a vertical partial termination.

But the Household approach leads to a very different conclusion. By removing vested participants from the numerator only, the ratio is (450-270)/1,000. The resulting 18 percent reduction, according to the Seventh Circuit, is entitled to a rebuttable presumption of no partial termination.

The Seventh Circuit adopted the IRS approach because, in the Court's words, "The natural way to decide whether a partial termination has occurred is to see how close it is to a complete termination." Thus, the Seventh Circuit has determined a vertical partial termination usually occurs when one or a series of related events results in reduction in plan participation of more than 20 percent, and always occurs when the reduction is more than 40 percent, regardless of how many of the terminated participants actually forfeited any benefits.

Outlook

This case now returns to the district court, which must resolve a variety of other issues before this case-- now in its ninth year-- can be decided. In the meantime, Household could appeal the Seventh Circuit's ruling to the Supreme Court. Clearly, the history of this case is still being written.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, or Deborah Walker 202.879.4955. Copyright 2004, Deloitte.