Art by Joseph CiardielloPlan sponsors often impose vesting requirements on employer contributions to a defined contribution (DC) plan. If an employee terminates employment before becoming fully vested and takes a distribution, this generally results in a forfeiture of some or all of the employer contributions. These forfeitures are generally held in an account within the plan until used.
Unfortunately, plan sponsors routinely fail to do anything with such forfeitures.
Forfeiture assets can be used for eligible plan purposes such as plan administrative expenses or to offset employer contributions. However, all too often, the money is allowed to just sit in a plan indefinitely. This is a problem under the Internal Revenue Code (IRC). As a general rule, forfeitures must be used as soon as possible and should not be held beyond the plan year in which they arise. Plan sponsors and third-party administrators (TPAs) need to monitor plan forfeitures. If a suspense account is used, then they must ensure that all forfeitures for a plan yar are promptly used according to the plan’s terms.
While the Internal Revenue Service (IRS) has indicated there may be situations in which forfeitures may be applied in the following plan year, it has provided no examples of those situations. Specifically, in informal guidance, the IRS has stated the following:
- No forfeitures in a suspense account should remain unallocated beyond the end of the plan year in which they occurred.
- No forfeiture should be carried into a subsequent plan year.
- For those plans that use forfeitures to reduce plan expenses or employer contributions, there should be plan language and administrative procedures to ensure that forfeitures will be used up promptly in the year in which they occurred or, in appropriate situations, no later than the immediately succeeding plan year.
In order to address the IRS’ position with respect to forfeitures, defined contribution plan documents should address how forfeitures will be applied and the necessity to use them in the current plan year. If the money is spent as soon as practicable but in the following year to pay administrative expenses, this may not be an issue, the IRS has suggested.
However, as, again, it has provided no clear guidance on how this works, use in the current year is preferable.
The failure to use forfeitures in accordance with the timing rules described above could be viewed as a plan qualification issue, either as an operational error—i.e., failure to comply with the terms of the plan—or a failure to comply with a qualification requirement. This is an issue the IRS may raise on audit.
Plan sponsors that realize they are sitting on unused forfeitures can, and should, take corrective action. Failure to use the forfeitures in a timely manner may be corrected via the Employee Plans Compliance Resolution System (EPCRS). If the error is not significant or is corrected by the end of the second plan year following the year in which it occurred, it can generally be remedied through self-correction without having to file with the IRS.
Otherwise, the failure would have to be addressed by submitting an application to the IRS under its Voluntary Correction Program (VCP).
IRS guidance provides that the failure can generally “be corrected by reallocating all forfeitures in the plan’s forfeiture suspense account to all plan participants who should have received them, had the forfeitures been allocated on time.”
Alternatively, depending on the facts, it may be possible to use the prior years’ forfeitures to reduce employer contributions in the current year. The exact approach depends on various factors, including the size of the forfeiture balance, the number of participants, and whether the forfeitures were used after the end of the applicable plan year or whether they have been accumulating in a suspense account over a number of years.
Plan sponsors should make sure their plan documents reflect how forfeitures may be used and implement a process for guaranteeing they are applied in their prescribed manner.
Summer Conley is a partner in Drinker Biddle’s Los Angeles office where she assists clients in a variety of employee benefit areas, including qualified plan work, executive compensation, and health and welfare issues addressed by HIPAA, COBRA, Internal Revenue Code Section 125, the Patient Protection and Affordable Care Act, and similar legislation.