Sham Employment Terminations and Plan Distributions

Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Nebraska is representative of a common question on rehiring after separation from service with an employer.

"Is a plan distribution legitimate if the employee left employment, took a withdrawal and went back to work for the same employer shortly thereafter? If not, what could happen?"

Highlights of the discussion

Whether the participant had a legitimate distribution triggering event in the form of a severance of employment depends on the facts and circumstances. The IRS could view the severance of employment (1) as either a “sham” or “bona fide.”

Qualified retirement plan assets, typically, are not distributable until the participant incurs a distribution triggering event as outlined in the governing plan document. Severance of employment (see Revenue Ruling 56-214) is a common plan-approved distribution triggering event.

In the case of a sham severance or termination, the processing of an impermissible distribution without a legitimate distribution triggering event is an operational failure that, potentially, could put the plan at risk of disqualification, resulting in possible adverse tax consequences to the participant and the employer (see Private Letter Ruling 2000-0245).

There is no definitive rule prohibiting the rehiring of an employee who has received a plan distribution because of leaving employment. For example, at least one court ruled that a participant had a true termination, even though he returned to employment with his former employer just five months after he retired, because at the time of his retirement he had no intention of returning to work and was only able to return to employment following an unforeseen change in circumstances (see Barrus v. United States, 23 AFTR 2d 990 (DC NC 1969)). And in Revenue Ruling 69-647, the IRS ruled that a senior executive who retired from full-time employment and continued to render services to the same company, but on a part-time basis as an independent contractor, was considered to have terminated employment.

Now, if the IRS investigates and determines the severance or termination is a ruse merely to facilitate a distribution not otherwise available, and both the plan sponsor and participant knew in advance that the individual would be rehired, the IRS may view such action as a sham termination.

The basic rule is that, to receive a distribution from a 401(k) plan on account of a severance of employment, the participant must have experienced a bona fide termination of employment in which the employer/employee relationship is completely severed.

Facts and circumstances the IRS will consider include the following:

1. Did the plan sponsor follow the terms of the plan document? (Allowing a distribution because of a sham termination would constitute a failure to follow the terms of the plan document because plan assets were distributable in a situation not provided for under the terms of the plan).

2. Did the termination of employment and processing of the distribution follow all the established administrative procedures?

3. How long was the time interval between termination and rehire?

4. What documentation exists to substantiate the termination and distribution?

5. Did the alleged sham termination involve a highly compensated employee?

Conclusion

A plan sponsor and participant(s) who collude to stage a firing/re-hiring scenario to facilitate a qualified plan distribution are potentially putting the qualified status of the plan at risk. Under investigation, the IRS could conclude the termination is a sham and impose sanctions.

(1) Prior to January 1, 2002, most plans used the term “separation from service” rather than “severance of employment.” Separation of service carried the “same desk rule,” which prevented many401(k) plans from making distributions to former employees who continued working at the samejob but for a different employer as the result of a merger, acquisition or similar transaction. The Economic Growth and Tax Relief Reconciliation Act of 2001 allowed plan sponsors to replace the separation from service/same desk requirement to allow for distribution upon a participant’s severance from employment with the employer sponsoring the plan.