Jackson Kelly PLLC

Tax Monitor

Employer What Ifs for COVID-19

March 26, 2020

By: Robert G. Tweel


If you are considering terminating your 401(k) plan to end contribution obligations.

This could have adverse consequences since the “successor plan” rule in IRS regulations currently prohibits covering the same employees in a new plan for 12 months following the termination. A plan termination also requires full vesting of all participants and distribution of account balances to the participants, usually within 12 months. A more measured response would be to temporarily suspend or reduce employer contributions. A temporary suspension does not require full vesting of all employees as a complete termination or discontinuance of contributions would require. How a suspension or reduction of employer contributions works depends on the type of 401(k) plan currently in effect.

If you are considering suspending your 401(k) plan contribution obligations.

The IRS established a helpful rule that a plan sponsor may suspend contributions for 3 out of 5 plan years without the suspension being treated as a permanent discontinuance of contributions. While IRS rules recognize that a temporary contribution suspension is not the same as a plan termination, this rule prevents a plan sponsor from avoiding the full vesting requirement if suspensions continued indefinitely. If salary deferrals continue to the plan, and only employer contributions are suspended, this is not considered a permanent discontinuance of contributions.

If you are considering laying off employees and continue your 401(k) plan.

Employee lay-offs may trigger a partial termination of the plan, even if plan sponsors elect to continue their plans.  A partial termination is determined by assessing the facts and circumstances, but the IRS rule of thumb is that there may be a partial termination if more than 20% of their plan participants are involuntarily terminated. In the event of a partial termination, only affected participants are required to be 100% vested. A layoff is different than a termination of employment, and this affects the determination of whether or not there has been a partial termination of the plan. In basic terms, a layoff is an employee that is still on the payroll but not receiving pay and is likely to be called back to work. Termination of employment means that an employee is not on the payroll and will not be called back to work.

If your plan is in a Pooled Trust.

Some employers whose plans invest their assets in a pooled trust may have terminated employees who will be requesting distribution of their vested balance.  Most plans of this type do valuations once a year, typically the last day of the plan year, which for most plans on the calendar year is December 31. Obviously, the market has had major swings since December 31, 2019, and paying former participants out based on their December 31, 2019 balance may not be fiduciarily responsible, as their balance will not reflect the market swings while active employees bear the brunt. Most plan documents have a provision that allows the plan to be valued on any other date or dates deemed necessary or appropriate by the Trustee during the Plan Year. Judicious use of this contingency allocates any negative earnings in the plan among all participants, both terminated and active, and will allow distributions to be made based on a more current valuation of the plan.

If your plan is not a Safe Harbor plan.

It is not necessary to amend a plan with only a discretionary employer contribution. The plan sponsor can simply decide to not make a contribution for 2020. If the plan has a fixed match or non-elective contribution but does not satisfy safe harbor requirements, the plan sponsor should pass a resolution to suspend or reduce contributions, notify the participants and adopt an amendment changing the contribution formula. If the change is to a discretionary contribution, contributions can be resumed in the future without re-amending the plan, strengthening the argument that contributions have not been permanently discontinued so that full vesting of participants should not be required.

If your plan is a Safe Harbor plan.

The regulations permit contributions to be suspended mid-year if either the safe harbor notice informed employees that the plan sponsor previously reserved the right to suspend or reduce contributions during the year or the plan sponsor is suffering an economic loss, as defined in the rules governing defined benefit plan funding waivers. In either case, participants must be notified at least 30 days before the suspension can be effective and must have the opportunity to change their elections. The plan sponsor must pass a resolution suspending contributions and amend the plan.  If the amendment adopts a discretionary contribution formula, contributions can be resumed without re-amending. Of course, a further amendment would be required to convert the plan back to a safe harbor plan. IRS rules require that safe harbor contributions be made through the effective date of the suspension and that non-discrimination testing be done for the entire plan year, and not just the portion of the plan year during which the plan sponsor was not making safe harbor contributions.

One of the major benefits of the safe harbor provisions is that the plan is deemed to satisfy the top-heavy requirements if the only contributions made to the plan are salary deferrals and the safe harbor contribution. If the safe harbor contribution is suspended, the deemed satisfaction of the top-heavy rules no longer applies. Therefore, if a Key employee has deferred to the plan, and the plan is considered top- heavy for the year (60% or more of the plan assets belong to Key employees), a top-heavy minimum contribution equal to 3% of compensation will be required to be provided to all non-Key employees.

If your participants are considering borrowing against their plan.

Under IRS and Department of Labor regulations, participant loans must be repaid pursuant to payroll withholding over a five-year period (which may be for a longer period, if the loan is used to acquire a principal residence), with level amortization. If an employee fails to timely make a loan payment, the remaining balance of the loan is treated as a taxable distribution and generally will also be subject to an additional 10% tax if the employee has not attained age 59 ½  at the time that the loan default occurs. A plan is permitted to have a cure period that ends on the last day of the calendar quarter following the calendar quarter in which a loan payment is missed. What this typically means is that if an employee with a plan loan terminates employment and does not repay the loan within the cure period (or a shorter period, if the plan’s borrowing guidelines so specify), the remaining balance of the loan will be taxable.

If you are considering employee lay-offs and the employees have borrowed against their 401(k) plans.

Under IRS regulations, employees with plan loans who are placed on unpaid “bona fide leave of absence” may forego making loan payments during the leave of absence without triggering taxation of the loan if the following requirements are met:

  1. The “bona fide leave of absence” period must not exceed one year.
  2. The loan must be repaid by the end of the original term of the loan. The loan payments missed during the leave of absence period may be repaid by either continuing the original rate of repayment, with a balloon payment of the missed installments at the end of the term, or by ratably increasing the installments during the remainder of the repayment period. This requirement poses potential practical problems in the case of an employee who is laid off near the end of the original term of the loan.  Note, “bona fide leave of absence” is not defined in the regulations and leaves open an interpretation as to whether a lay-off qualifies as a bona fide leave of absence.  The only requirement as that the leave of absence be treated consistently for all purposes by the employer.  Additionally, we would expect the IRS to issue disaster relief that may also allow the same treatment, but the IRS has not yet issued this guidance.

If your plan participants are thinking about how to repay loans from severance pay.

In an effort to protect employees who have been laid off from having to fully repay a plan loan by the end of the cure period to avoid the taxable event, employers may want to consider permitting terminated employees who are receiving severance payments to continue paying their loans by withholding loan payments from their severance pay. Such an arrangement is permissible. Please note that it is not permissible to make 401(k) elective contributions from severance pay. In order to arrange to have loan payments withheld from severance pay:

  1. The plan’s borrowing guidelines need to provide that loan payments may be made from severance pay.
  2. The employer must have the administrative ability to withhold loan payments from severance pay, which is often handled in a different manner than payroll payments.
  3. Avoid an IRS nondiscrimination problem by not providing severance pay disproportionately to highly compensated employees.

We understand that business circumstances are prompting many questions. We are here to help you make an informed decision based on an understanding of the technical rules that must be followed.


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