When a “Termination” is Not a Termination
Employers grapple with the employee benefits consequences of employment terminations in a variety of contexts. In the retirement plan context when a vested participant's employment ends the most significant consequence typically will be the participant's right to receive a benefit distribution. In most cases – where there is a complete cessation of employment, such that no further services will be provided to the employer or any member of its controlled group – the terms of the retirement plan governing benefit distributions (and the attendant administrative procedures) should apply without complication. But what happens if the terminating employee intends and expects to continue to work for the employer or to resume employment in some capacity after a short hiatus? In such cases, one must ask whether a bona fide termination of employment has really occurred. More specifically, the question is whether the "termination" is a termination that supports the payment of retirement benefits out of the employer's tax qualified retirement plan.
The most detailed IRS guidance elucidating the standards for a bona fide termination of employment comes in the form of Private Letter Ruling 201147038. The facts presented in the PLR are somewhat unique, but the analysis and holding have broad applications. In the ruling, the IRS considered the implications of an early retirement window program designed by the trustees of a multiemployer pension plan for the purpose of mitigating extreme funding deficiencies. Under the program participants were given the opportunity to lock in a subsidized early retirement benefit that was slated for elimination by electing to "retire" within a specified period. Participants who accepted the early retirement offer were given the option to return to work immediately following their "retirement." Participants choosing to continue employment would receive their subsidized benefit after they actually retired. The IRS was asked to rule on whether the implementation of this program could jeopardize the qualification of the plan.
Relying on language from Treasury Regulations under Code Section 401(a) – which refer to the purpose of qualified retirement plans being the provision of benefits to participants "after retirement" – as well as Treasury Regulations under Code Section 409A dealing with "separation from service," federal case law, and other sources of authority, PLR 201147038 holds that "[i]f both the employer and employee know at the time of 'retirement' that the employee will, with reasonable certainty, continue to perform services for the employer, a termination of employment has not occurred upon 'retirement' and the employee has not legitimately retired." Therefore, in the view of the IRS, the implementation of the benefit design proposed by the trustees of the multiemployer plan would indeed jeopardize the tax qualified status of the plan because it would allow for the payment of retirement benefits to participants who had not experienced a bona fide termination of employment.
So what should an employer or plan administrator do to guard against an inadvertent qualification failure caused by the payment of benefits to a vested participant who has not fully retired or terminated? Some employers choose to "codify" a minimum period of separation into their employment policies or even retirement plan documents to reduce the need to make judgment calls on a case-by-case basis. For example, an employer may adopt a policy that prohibits the rehiring of a retiree within 90 days following his or her retirement date, or a retirement plan may provide that a participant will not be treated as a retiree unless he or she has a period of separation of at least 30 days. These approaches are appealing for their simplicity, but they are not perfect solutions. The shorter period will seem more like a vacation than a separation if there is a mutual understanding that the participant will return to work on day 31. The longer period, while more meaningful, could still be questioned if the participant intends and expects to resume employment. Moreover, a change in status, such as from full time to per diem, would not alter the fact that a putative retiree has resumed employment. So judgment calls are difficult to eliminate and can be very difficult to make when it comes to a senior executive, a high value professional (like doctors and nurses in a hospital setting), or a sympathetic long service employee who wants to start drawing retirement benefits but also wants or needs to keep working. (Many employers have added in-service distribution or other "phased retirement" features to their pension plans to address the third category of employees.)
Since facts and circumstances will always be part of the equation, employers and plan administrator should adhere to a few simple best practices in dealing with potentially ambiguous terminations or retirements. First, take reasonable steps to confirm that the participant requesting a benefit distribution has no current intention to resume employment with the employer or any member of its controlled group. Some employers add statements or affirmations to that effect in benefit distribution forms that must be completed by participants. Such statements, or references to pertinent employment policies, could also be added to Summary Plan Descriptions. (At the risk of stating the obvious, if the termination of employment does not trigger an immediate distribution right the concerns about the implications of a rehire should be mitigated or eliminated entirely.)
Second, make sure that managers, directors, supervisors, and others who have operational authority understand that a sham termination or phony retirement that results in a benefit distribution will be problematic for the retirement plan. Those are the front line people who are likely to be involved in making some of the nod and wink deals that spell trouble – in their view they are simply trying to construct a win-win situation for the employee and the employer.
Finally, make sure that you have systems in place that will allow you to detect the rehiring of a terminated or retired participant. This can be challenging for large controlled groups with numerous operating subsidiaries. If you do happen to rehire someone who recently retired, so long as the initial termination or retirement was on the level, a subsequent hiring should not be problematic (although any plan distribution in process must be stopped). But if you cannot confirm the circumstances surrounding a purported termination or retirement, a tricky analysis with serious consequences will be made that much harder.