Layoffs, Partial Termination, and Vesting Corrections

A partial termination occurs when a significant percentage of participants are terminated by employer action, and the facts and circumstances show that the plan is being terminated as to a meaningful group. The IRS has a rebuttable presumption that turnover of more than 20% of participants in a plan year due to employer-initiated terminations is a partial termination. Here, 30 of 80 participants, or 37.5%, were laid off in one year. That exceeds the 20% presumption by a wide margin, and the layoffs were involuntary and concentrated in the warehouse group. The company can try to rebut the presumption by showing that the layoffs were isolated, that the group was not a meaningful portion of the plan, or that the plan continued on a stable basis, but the facts strongly favor a partial termination.

The consequence is that affected employees become 100% vested in their accrued benefits to the extent funded. For the cash balance plan, the 18 employees with fewer than three years of service must be fully vested despite the three-year cliff. For the 401(k) plan, the laid-off employees must be fully vested in employer contributions despite the six-year graded schedule. Forfeitures already taken from affected employees must be restored. The plan does not have to terminate; the partial termination rule protects the affected group's vesting. The administrator should document the affected class, calculate the vesting correction, and restore any forfeited amounts with earnings.

A partial termination does not automatically override a valid allocation condition. The vesting rule protects accrued benefits and account balances; it does not necessarily create an allocation for a year in which the employee did not satisfy the plan's allocation conditions. The administrator should review the plan document and adoption agreement to see whether the last-day/1,000-hour condition applies to the 2024 employer contribution and whether there is an exception for termination due to layoff, plant closing, or partial termination. If the condition applies uniformly and no exception exists, the laid-off employees may not be entitled to the 2024 profit-sharing allocation solely because of the partial termination.

However, if the plan is also terminated or if the employer adopts a corrective amendment, different rules apply. The employer should also check whether the exclusion causes a coverage or nondiscrimination problem for the remaining employees. The safest approach is to calculate the allocation both ways, document the plan terms, and obtain counsel's view before denying the allocation. If the employer wants to make the laid-off employees whole, it can adopt a corrective amendment or make a discretionary contribution, but it should not retroactively cut back benefits already accrued.

A prospective amendment to reduce the vesting schedule is possible only within the IRC 411(d)(6) anti-cutback rules. The amendment cannot reduce a participant's vested percentage or eliminate an optional form of benefit. Under IRC 411(a)(10), if a plan amendment changes the vesting schedule, each participant with at least three years of service must be allowed to elect to remain under the old vesting schedule. The election period and notice requirements must be satisfied. For the cash balance plan, IRC 204(h) may also require notice if the amendment reduces future accruals, although a vesting-schedule change alone is not necessarily a 204(h) reduction.

More importantly, the partial termination has already vested the affected employees 100%. The company cannot use a later amendment to reduce that vested status. The amendment can apply prospectively to the remaining active employees, but it cannot take away the vested benefits of the laid-off group. The company should also consider whether the amendment creates a nondiscrimination issue under IRC 401(a)(4) and whether the plan's top-heavy minimum is affected.