The IRS has issued proposed regulations on the treatment of forfeitures under defined benefit and defined contribution plans. The proposed guidance, which would amend Treasury Regulation 1.401-7, synthesizes (and updates the existing regulation to reflect) guidance previously found in Revenue Rulings, an IRS newsletter, and certain changes to the Internal Revenue Code (the “Code”), made during the last 35 years or so. The proposed regulation would also generally clarify and extend what had been previously understood to be the deadline for “zeroing out” forfeiture accounts under defined contribution plans.
Defined Benefit Plans. Prior to the Tax Reform Act of 1986, Code Section 401(a)(8) provided that a “pension plan” (which term includes both defined benefit and money purchase pension plans) will not be qualified unless the plan provides that forfeitures may not be applied to increase the benefits that any employee would otherwise receive under the plan. Treasury Regulation Section 1.401-7(a), issued pursuant to Code Section 401(a)(8) in 1963, has long provided that in the case of a qualified “pension plan” forfeitures may not be applied to increase participant benefits, prior to the termination of the plan or the complete discontinuance of contributions to the plan. (Treasury Regulation Section 1.401-1(b)(1)(i), which requires that a pension plan provide for the payment of definitely determinable benefits, is generally to the same effect.) Treasury Regulation Section 1.401-7(a) has also required that forfeitures must be used as soon possible to reduce the employer’s required contributions to a pension plan.
Section 401(a)(8) was long ago revised (by the Tax Reform Act of 1986) to provide that the prohibition on the use of forfeitures to increase participant benefits applies only to defined benefit plans, not money purchase plans. Further, changes over the years in the minimum funding rules contained in the Code preclude the use of forfeitures to offset minimum required contributions. Instead, the funding rules require that reasonable actuarial assumptions be used to determine the effect of expected forfeitures on plan liabilities. Any difference between actual and expected forfeitures is reflected in future required contributions.
Proposed Treasury Regulation 1.401-7(a) would update the existing regulation to reflect these changes in law, (i) by limiting to defined benefit plans (as opposed to “pension plans”) the prohibition on the use of forfeitures to increase benefits, and (ii) by deleting the requirement that forfeitures be offset against required contributions, but (iii) by retaining the provision that the effect of forfeitures may be anticipated in determining the costs of the plan. (The proposed regulation would make conforming changes to Treas. Reg. Section 1.401-1(b)(i).)
Defined Contribution Plans. Rev. Rul. 80-155 provides that amounts distributed to participants under defined contribution plans must be ascertainable, and they will be treated as ascertainable only if such plans provide for a valuation at least annually and adjust participant accounts in accordance with the valuation. In 2010, the IRS issued a Newsletter (Retirement News for Employers, Volume 7, Spring 2010 available at https://www.irs.gov/pub/irs-pdf/p4278.pdf) noting that many plan administrators of defined contribution plans were placing forfeitures in suspense accounts and allowing them to accumulate over a number of years, which the IRS maintained was inconsistent with Rev. Rul. 80-155. The Newsletter explained that no forfeiture in a suspense account should remain unused or unallocated beyond the end of the year in which it arose, and that no forfeiture should be carried into a subsequent plan year; the Newsletter also states, however, that where forfeitures are used to defray expenses or reduce employer contributions, plan procedures should ensure that they are used up in the year in which they occurred or “in appropriate situations” no later than the immediately succeeding year.
Final regulations issued by the IRS in 2018 modified certain provisions to permit the use of forfeitures to fund corrective contributions, qualified nonelective contributions (QNECs) and qualified matching contributions (QMACs).
Consistent with the changes to Section 401(a)(8) discussed above, the proposed regulations would clarify and enumerate the permissible use of forfeitures under all defined contribution plans, including money purchase plans, and would establish clear deadlines for the use or allocation of forfeitures. A plan may provide for the use of forfeitures in one or more of the following ways: (1) to pay the plan’s administrative expenses, (2) to reduce employer contributions to the plan, and/or (3) to increase the benefits otherwise payable to other plan participants. According to the preamble, reducing employer contributions includes the restoration of inadvertent benefit overpayments and the restoration of conditionally forfeited amounts (e.g., in the case of a terminated and rehired participant), and, based on the 2018 final regulations, it would also include the use of forfeitures to fund QNECs and QMACs. The preamble notes that the proposed regulation would permit a plan to limit the use of forfeitures to one of the enumerated purposes, but that a plan may fail operationally if forfeitures in a given year exceed the amount that can be absorbed for that purpose.
The proposed regulations would require that plan administrators use forfeitures no later than 12 months after the close of the plan year in which the forfeitures occur. The proposed regulations would become effective January 1, 2024, but plan administrators may rely on the proposed rule for periods preceding the effective date. Further, under a special transition rule, forfeitures incurred during any year that begins before January 1, 2024, would be treated as having been incurred in the first plan year that begins on or after January 1, 2024. The salutary effect of the transition rule is that plan administrators will have until December 31, 2025 to “zero out” any pre-existing forfeiture accounts that have built up over multiple years. Note, however, that application of the transition rule with respect to a plan that has provided for allocation of forfeitures arising in a given year among the accounts of participants who satisfied specified allocation conditions for that year, is not without issues/complexities. Further guidance on this point in the final regulations would be helpful.
Given the apparent focus of the IRS on the treatment of forfeitures (as well as possible heightened interest by participants), plan administrators should review current plan terms and practices with respect to (i) when forfeitures are treated as arising under the plan, (ii) permissible purposes for which they may be used, (iii) the frequency with which they are used or allocated, and (iv) whether current practices comply with the proposed regulations or require modification.