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IRS letter regarding partial termination


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A client of mine just received a letter from the IRS about their 2018 Form 5500.

Apparently the trigger for the letter was a "significant reduction in plan participants" and also showing more than zero participants who terminated with unvested benefits on the 5500. For the year in question, the total number of participants at the beginning of the year was 15, and the total at the end of the year was 10, which is a 33% reduction. However the reduction was all terminated participants who took their distributions. The 20% number for a presumed partial termination is in regards to turnover, which means active employees, right? You can't have turnover of people who left in prior years.

The number of active participants at the beginning of the year was 7 and at the end of the year it was 6. Only one person actually terminated during the year and that person was less than 100% vested under the plan's vesting schedule.

What is the IRS doing sending letters and scaring sponsors over non-issues like this? Has anyone else seen a letter like this recently?

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First things first - we have thankfully not encountered this.

I suppose the IRS could be fishing - the "applicable period" for turnover CAN be longer than one year if there is a series of related events/terminations. There has been some litigation in this arena, including Matz, but I haven't followed all the back and forth for a while. I believe there have been other cases as well.

I'm REALLY hoping your situation is an anomaly, and that the IRS hasn't started some @$**%$ "initiative" or test in this arena.

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C.B. Zeller, thank you for sharing this information with us.

Does the IRS letter demand anything?

Or does the IRS letter suggest the plan’s administrator evaluate whether there was a partial termination?

(Whichever, I recognize an employer/administrator bears frustration and expense in reacting to either kind of letter, and that some of that frustration and expense can burden a third-party administrator.)

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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The letter did not demand anything. It said specifically that it was not an audit or a compliance check, and that no reply was needed.

It did say that the sponsor "may need to take certain actions based on the information provided."

The second page, which described the rules around partial terminations, also gave info about how to make a correction using self-correction or VCP, and how to correct the 5500.

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https://www.irs.gov/retirement-plans/employee-plans-compliance-unit-epcu

This link shows a few “compliance check” initiatives that the IRS states they have in place. Partial Plan Termination is listed 3rd from the bottom (in alphabetical order).

A compliance check is when they send a letter to the employer and say something like “We’re not auditing you if you answer these questions in the right way to avoid an audit. But, if you fail to reply or answer, we will very likely audit. And, if you answer in a noncompliant way, we will ask you to prove that you fixed the problem, otherwise we will audit.”

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A memo to file saying what really happened might be helpful for future IRS inquiries. Without digging back into the cases and Code, my experience is that if several people leave voluntarily in a small plan, that does not qualify, because it is intended to cover ER actions that cut large swaths of employees from a company. Several clients have had audits, but we've kept it limited to one year with the agent and also segregated employees based on voluntary or involuntary terminations. IRS also has been known in my experience to target declining industries with large layoffs that are widely reported. 

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On 8/11/2021 at 10:26 AM, John Feldt ERPA CPC QPA said:

This link shows a few “compliance check” initiatives that the IRS states they have in place. Partial Plan Termination is listed 3rd from the bottom (in alphabetical order).

A compliance check is when they send a letter to the employer and say something like “We’re not auditing you if you answer these questions in the right way to avoid an audit. But, if you fail to reply or answer, we will very likely audit. And, if you answer in a noncompliant way, we will ask you to prove that you fixed the problem, otherwise we will audit.”

Not to argue but note that C. B. Zeller said...

On 8/10/2021 at 4:22 PM, C. B. Zeller said:

The letter did not demand anything. It said specifically that it was not an audit or a compliance check, and that no reply was needed.

...so it seems not to be a compliance check.   I don't think I'd do anything except as suggested by Bob the Swimmer, make a note to the file.

Ed Snyder

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On 8/10/2021 at 8:37 AM, C. B. Zeller said:

The number of active participants at the beginning of the year was 7 and at the end of the year it was 6. Only one person actually terminated during the year and that person was less than 100% vested under the plan's vesting schedule.

As you suggest, I think the Partial Termination analysis is supposed to look at the reduction in ACTIVE participant counts.    Going from 7 to 6 is only a 14% reduction, which is less than the threshold (20%?) that is supposed to trigger a Partial termination.

....  Jeff

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Having concurred that the IRS’s suggestion didn’t fit the circumstances of C.B. Zeller’s client, let’s consider a related point.

While many of us call to mind the IRS’s subregulatory presumption, here’s the actual rule:

“Whether or not a partial termination of a qualified plan occurs (and the time of such event) shall be determined by the Commissioner with regard to all the facts and circumstances in a particular case.  Such facts and circumstances include: the exclusion, by reason of a plan amendment or severance by the employer, of a group of employees who have previously been covered by the plan; and plan amendments which adversely affect the rights of employees to vest in benefits under the plan.”

26 C.F.R. § 1.411(d)-2(b)(1) https://ecfr.federalregister.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR686e4ad80b3ad70/section-1.411(d)-2]

Have you ever argued with the IRS (or advised a client) that a situation was not a partial termination because the small number of participants made the 20% presumption inappropriate?

To pick an extreme example, if a plan has three participants, does a severance-from-employment of one of them always result in a partial termination?

Is the analysis meaningfully different if the severances are two of ten employees?

What reasoning do you use for situations like this?

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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24 minutes ago, Peter Gulia said:

To pick an extreme example, if a plan has three participants, does a severance-from-employment of one of them always result in a partial termination?

No.  For example, if the employee initiated the severance-from-employment.  

 

 

 

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7 minutes ago, RatherBeGolfing said:

No.  For example, if the employee initiated the severance-from-employment.  

What if the person was fired (ER action), but the position was not eliminated, but restaffed.  Depending on the timing of the hire, it could be nearly 18 months until that person becomes a participant.  (Think someone hired July 5, 2021.  With 1 YOS and semi-annual entry, they aren't in the plan until 1/1/23!)

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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I haven't had any occasion to do so, but probably would under the right circumstances. Even if you agree the 20% presumption is an appropriate starting point, the very small participant count should, I think, at least make the presumption easier to rebut absent some other bad factors.

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RatherBeGolfing, BG5150, and EBECatty, thank you for your further points.

Would your outlook about the one-of-three example be different if the severance is involuntary (employer-initiated) and the employer has no intent to hire another employee?

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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16 minutes ago, Peter Gulia said:

Would your outlook about the one-of-three example be different if the severance is involuntary (employer-initiated) and the employer has no intent to hire another employee?

Yes.  It is an employer-initiated reduction in staff, and it's significant.  50% of the staff (if the owner is the 3rd participant) is now no longer in the plan.

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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If the facts are there, and it was important to the sponsor, I would still try to make a case it's not a partial termination. If the only variable is one person, I think by definition it depends on the individual facts and circumstances. If you have an owner, a spouse, and one employee, and fire the employee just short of becoming vested and reallocate the forfeitures to the owner and spouse, then the argument would be harder to make whether you replace them or not.

Changing the facts slightly, what if you had 5 participants in total (an owner and four unrelated, similarly paid, non-HCE employees all with similar employer-source account balances). Of the four unrelated employees, two are 80% vested and two are 100% vested. One of the employees who is 80% vested is terminated for poor performance, and the owner realizes the other three employees can handle the workload so doesn't replace the terminated employee. 

Whatever theory you subscribe to regarding the underlying purpose of the partial termination rules, I would have no problem taking the position (again, if it was important to the client) that a partial termination has not occurred even though the numerical turnover rate was 20% or higher. 

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2 hours ago, Peter Gulia said:

Would your outlook about the one-of-three example be different if the severance is involuntary (employer-initiated) and the employer has no intent to hire another employee?

I wouldn't rule any argument out, but I don't see an exception to employer intent in the rule. It is an employer initiated action which adversely affect the rights of employees to vest in benefits under the plan.  Seems pretty textbook when you look at the rule.

From practical point of view, I have had this conversation with clients before, and it usually goes like this:

"I know its unfair, but the amounts are pretty small.  Is it really worth it?  The IRS will probably take the opposite position, and if we have to fight it you will pay me more in fees just to argue it than it will "cost" you to vest contributions you have already made?"

They usually say something about being screwed by the government and agree it is better to just vest the benefits and be done with it.

On the other hand, I work with some government contractors.  Sometimes, a contract expire or don't get renewed while you are still waiting on other bids.  In those situations, it is not always possible to retain contract employees in between contracts.  You can have a reduction of 50%  in one year only to win a bid early next year and have to rehire the 50% and then some.  The amounts here can get pretty sizeable.

 

 

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Thank you, all, for the further observations.

Among many challenges in interpreting the rule, we lack a statement of the rule’s purpose.  It is not stated in the rule.  And neither the August 23, 1977 final rulemaking nor the November 5, 1975 notice of proposed rulemaking states an explanation.

Peter Gulia PC

Fiduciary Guidance Counsel

Philadelphia, Pennsylvania

215-732-1552

Peter@FiduciaryGuidanceCounsel.com

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  • 2 weeks later...

We just had a client receive one of these. Like C.B.'s, it doesn't ask for a reply or require any action. Different from the compliance check situation on the IRS website, which follows:

Why did I receive an EPCU Compliance Check Letter?

You filed a Form 5500 series return indicating that the plan had a significant decrease in plan participants. Employers who have a decrease of 20% or more in participation may have experienced a partial termination.

Background

The Partial Termination strategy focuses on information from employers' Form 5500 (Annual Return/Report of Employee Benefit Plan) filings which indicate that their plans have had a significant decrease in plan participants. The strategy will determine:

  • if the plans have experienced a partial termination and whether the plan sponsors are following the requirements of the plan document and related law pertaining to partial terminations, and
  • if the information reported on the Form 5500 is accurate.

When a group of participants is involuntarily terminated from the plan due to employer-initiated severance or a plan amendment, a partial termination occurs if the reduction of plan participants is deemed "significant." A percentage test is used in determining what is significant. Generally, there is a presumption that a partial termination occurs when more than 20% of the plan's participants are involuntarily terminated from the plan during the "applicable period," which is generally the plan year. When a partial termination occurs, section 411(d)(3) of the Code requires full and immediate vesting of all "affected" participants, including those participants who voluntarily terminated from the plan during the applicable period. (See Revenue Ruling 2007-43).

What is the EPCU attempting to determine?

We want to determine if the plan experienced a partial termination and if the plan administrators complied with the vesting requirements of Internal Revenue Code (IRC) section 411(d)(3). Additionally, we want to determine the accuracy of the information provided on Form 5500.

The EPCU will send contact letters, seeking data regarding the percentage of involuntary terminations from the plan and the circumstances which led to company downsizing and the reduction of plan participants to a selected group of Form 5500 filers. We will request an explanation or discussion of any special circumstances that may have an impact on whether a partial termination has occurred. The EPCU will evaluate the response and work with the plan sponsor to take appropriate action.

What actions do I need to take?

Please complete the information request. You may also furnish any other documents or clarifying material that you believe will be helpful for us to review. You should make every effort to be as complete and accurate as possible in your responses and respond by the due date. If you need additional time, make sure to contact the person whose name is listed on the letter to request an extension. Failure to provide the information could result in examination of your plan.

If You Have Questions

Please feel free to contact the person listed in the cover letter with questions about this strategy and how it relates to your situation.

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