There have been important developments from the Internal Revenue Service (IRS) as well as pending court cases regarding the proper use of forfeitures which arise under defined contribution plans, such as 401k plans. These developments present potential conflicts and liabilities that employers and fiduciary committees need to be aware of and review. These issues should be discussed with ERISA counsel and consideration should be given to the "next steps" and "the key decision" discussed below.
FORFEITURES
Forfeitures occur when employer contributions, e.g., profit-sharing or matching contributions, are not fully vested when a participant terminates employment. As an illustration, if a 401(k) plan applies a six-year graded vesting schedule to profit sharing contributions, and a participant terminates employment prior to achieving six years of vesting service,
Mark E. Bokert is a partner and co-chairs the Benefits + Compensation Practice Group of Davis+Gilbert LLP. His practice encompasses nearly all aspects of executive compensation and employee benefits, including matters related to equity plans, deferred compensation plans, phantom equity plans, qualified retirement plans, and welfare plans. Mr. Bokert may be contacted at mbokert@dglaw.com. Alan Hahn is a partner and co-chairs the firm's Benefits + Compensation Practice Group. His practice is devoted to advising clients of all sizes, including in the design and implementation of a wide variety of creative, unique, and tax-effective employee benefit plans and programs. Mr. Hahn may be contacted at ahahn@dglaw.com.
the non-vested portion of the participant's profit sharing account is subject to forfeiture.
The exact timing of when the non-vested portion of an account becomes a forfeiture is dictated by the plan document. Generally, the non-vested portion can be forfeited as of the earlier of (i) the date the participant incurs five consecutive one-year breaks in service (or five consecutive years of separation if the elapsed time method for calculating vesting service is used), or (ii) the date the participant takes a complete distribution of the vested portion of their account balance. If the plan allows forfeitures to arise when the participant takes a complete distribution, the plan must also allow reinstatement of the forfeited amount if the participant becomes reemployed before incurring five consecutive one-year breaks in service (or five consecutive years of separation) and repays the vested amount that was previously distributed1.
IRS GUIDANCE
There are several provisions of the Internal Revenue Code (the Code) that address forfeitures in defined contribution plans.
First, Code Section 401(a)(7) requires qualified plans to comply with the rules set forth under Code Section 411(a). Generally, Section 411(a) provides that an employee's right to employer contributions must become nonforfeitable after a specified period of service. It also provides exceptions to this general rule, conditions under which forfeitures must be restored, and other related rules.
In addition, Code Section 414(i) provides that a defined contribution plan must provide benefits that are based solely on the amount contributed to the participant's account, plus any income, expenses, gains, losses and forfeitures allocated to the account.
In February 2023, the IRS issued proposed regulations providing guidance as to how and when forfeitures arising in defined contribution plans may be used.2 Under the proposed regulations, forfeitures may be used as follows:
- To pay expenses that can be properly charged to the plan;
- To reduce employer contributions under the plan; or
- To increase benefits by being allocated to participant accounts.3
The proposed rules provide that the deadline for using forfeitures is twelve months after the close of the plan year in which they were incurred.4 For example, forfeitures incurred in 2024 must be used by December 31, 2025. If finalized, the proposed regulations will become effective on January 1, 2024, but plan fiduciaries are permitted to rely on them in the meantime. Further, it is important to note that a transition clause set forth in the proposed regulations permits a plan to use up old forfeiture balances (accumulated prior to January 1, 2024) by December 31, 2025.5
It also should be noted that the IRS proposed regulations do not prohibit a plan from specifying only one use for forfeitures or mandating that forfeitures be used in a particular order. Thus, a plan could require that forfeitures only be used to reduce employer contributions, or to reduce employer contributions and then, if any remain, to pay plan expenses.
DEPARTMENT OF LABOR (DOL) GUIDANCE
The DOL has not issued formal regulatory guidance regarding the use of forfeitures, and has not addressed whether forfeitures are plan assets under ERISA that must be used for the exclusive purpose of providing benefits to participants and defraying reasonable expenses of plan administration.6
Most practitioners assume that the DOL agrees with the IRS rules that forfeitures can be used either to pay plan expenses or reduce employer contributions. However, on September 28, 2023, the DOL issued a news alert indicating that ERISA fiduciary duties could apply to the use of forfeitures.7 In that news report, the DOL announced that it had ordered a company, Sypris Solutions Inc., to restore $575,000 to its 401(k) plan participants due to the company's improper use of forfeitures. The plan document specifically required that forfeitures be used to pay plan expenses, but the company used forfeitures to reduce employer contributions. The DOL ordered the company to restore $575,000 not only because it had failed to follow the terms of its plan document, but also apparently because it acted in a manner that benefited itself at the expense of plan participants whose account balances were charged the plan expenses. The DOL could have announced that their penalty was assessed simply because of Sypris' failure to follow plan terms in contravention of ERISA, but it chose not to do so.
LITIGATION
Recently, plaintiff attorneys have initiated several lawsuits that challenge how 401(k) plan sponsors use forfeitures. As of the writing of this column, companies that have been sued include Qualcomm, Intuit, Clorox, Thermo Fischer, Honeywell, HP, Mattel and John Muir Health. In nearly every lawsuit, the plans permitted forfeitures to be used to pay administrative expenses or reduce future employer contributions, as permitted by the IRS regulations. In nearly each case, the forfeitures were used to reduce employer contributions rather than pay plan expenses.
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