You know the story. The dreaded takeover case where the plan has a massive forfeiture suspense account that has been accumulating for years. Is this a problem? If so, how do you fix it?
We now have answers to these questions. On Feb. 27, 2023, the Treasury and IRS issued proposed regulations (Prop. Treas. Reg. §1.401-7) relating to forfeitures in qualified plans. The regulations provide guidance on the permissible uses of forfeitures, as well as the timing on when a plan must expend the forfeitures. While the regulations are proposed to be applicable for plan years beginning on or after Jan. 1, 2024, taxpayers may rely on them currently or another time before that date.
The regulations set forth separate rules for defined contribution plans and defined benefit plans due to the different legal requirements applicable to each of these types of plans.
DC Plans Use of Forfeitures
Sponsors of defined contribution plans have flexibility on how forfeitures may be utilized. Forfeitures may be used to: (1) pay plan expenses (see the excerpt from The ERISA Outline Book at the end of this article for more details on the use of forfeitures to pay plan expenses); (2) reduce employer contributions due to the plan; or, (3) increase benefits to other participants in the plan.
The preamble to the proposed regulations clarifes that reducing employer contributions under a plan includes the use of forfeitures to restore inadvertent benefit overpayments. This is not a new concept because one of the general correction principles of EPCRS (Section 6.02(4) Revenue Procedure 2021-30) is that if a plan provides that forfeitures may be used to reduce employer contributions, then forfeitures may be used to reduce any corrective contributions required under EPCRS. Overpayment is just one situation where corrective contributions may be required and it is not clear why overpayments were singled out in the new guidance. It may be because of the recent focus on overpayments in both EPCRS and SECURE 2.0 (although this is typically more of an issue for defined benefit plans). Nevertheless, this shouldn’t be an issue because the reference to overpayments only appears in the preamble, and not in the text of the actual regulation.
The preamble also states that using forfeitures to reduce employer contributions includes offsetting any employer contribution that is required to restore conditionally forfeited accounts. Restoration of a conditionally forfeited account occurs when a plan forfeits a participant’s nonvested account upon a distribution at termination of employment (e.g., an involuntary cash-out distribution), the participant is rehired before incurring five 1-year breaks in service, and the participant repays the amounts that were distributed (or is deemed to repay the amount when a plan provides for a deemed distribution of 0% vested accounts). While not mentioned in the preamble, some plans also include a provision allowing the forfeiture of lost participant accounts (if the account is $1,000 or less) with a restoration of the forfeitures if the individual is later located. This would also be a situation where forfeitures could be used to reduce the employer’s restorative contribution.
The preamble to the regulations also includes a helpful tip with respect to drafting plan documents. The suggestion is that the plan document include multiple options on how the plan will use forfeitures in order to avoid a violation of the timing requirement (explained below). The preamble’s example describes a plan that only uses forfeitures to reduce plan expenses, and the forfeitures exceed the expenses. The excess forfeiture cannot stay in a suspense account (beyond the permitted timing requirement) so there could be an operational error if the plan does not include another method of using forfeitures. Giving the employer discretion on how to use forfeitures would not violate the definitely determinable requirement so long as that the plan provides for a definite allocation method (if the employer decides to allocate forfeitures to participants).
The proposed regulation does not address the possibility of using the new discretionary amendment provision included in the SECURE 2.0 Act of 2022 to avoid an operational violation where a plan only includes one method of using forfeitures. Depending on the method stated in the plan, an employer could use a retroactive discretionary amendment to increase benefits (i.e., to reallocate forfeitures to participants). Nevertheless, if a plan document only includes one or two of the permitted forfeited uses, then it would be best to amend the plan to include all three uses in order to provide maximum flexibility. See “Will a plan amendment be required due to this regulation?” below.
Timing for Use of Forfeitures
Formalizing the timing for the use of forfeitures in a defined contribution plan is likely one of the primary reasons IRS issued the proposed regulations. The IRS informally, in a 2010 newsletter, addressed the timing on the use of forfeitures by generally requiring that a plan use forfeitures in the year in which the forfeitures occur, or in “appropriate circumstances,” no later than the immediately succeeding plan year. The newsletter also states that there may be appropriate situations where a plan could use non-current year forfeitures as employer contributions for the current year. The newsletter doesn’t elaborate on what those “appropriate circumstances” would be, or how long forfeitures can be held in a suspense account under these circumstances.
Despite the lack of formal guidance, the IRS has required (or depending on your perspective, has permitted) pre-approved plans to include language prohibiting the carryover of forfeitures beyond the year following the year of the forfeiture. This makes practical sense because forfeitures for a plan year may not even be determined until well after the plan year is over. Thus, it is not surprising the proposed regulations include a timing rule that in a defined contribution plan, forfeitures must be “used no later than 12 months following the close of the plan year in which the forfeitures were incurred.”
What about plans with existing forfeiture suspense accounts that have been accumulating for years? The proposed regulations include a transitional rule whereby plans with such accounts can resolve the problem without using EPCRS. The transitional rule allows a plan to treat forfeitures incurred during any plan year that begins before Jan. 1, 2024, as having been incurred in the first plan year that begins on or after Jan. 1, 2024, which allow plans to dispose of the amounts in the forfeiture suspense accounts by the end of the 2025 plan year.
The regulations do not address situations where a plan sponsor cannot dispose of the full amount of the forfeiture suspense account because it exceeds both the amount of plan expenses and would cause excess annual additions under Internal Revenue Code Section 415. The IRS might allow plans to use the same approach under EPCRS whereby the plan can continue to hold these excess amounts in a suspense account that must be exhausted in future years before the employer may make any additional employer contributions may be made to the plan.
For plans with large forfeiture suspense accounts, the transition rule (i.e., allow a plan to dispose of the account by the last day of the 2025 plan year) provides a much better approach than using EPCRS to either self-correct (by retroactively allocating the forfeitures) or using VCP and hoping the IRS will permit a current year allocation of the forfeitures. And, because these regulations change the qualification requirements, this transition rule would presumably be available even if a plan document already contains language that complies with the timing requirement and the employer has an existing operational error for not following the plan terms.
For plans with large forfeiture suspense accounts, Suppose an employer has a 401(k) plan which includes all three permitted uses of forfeitures. The plan provides for elective deferrals and discretionary contributions (match or nonelective). What happens if the forfeitures exceed the amount of plan expenses and the employer does not want to make a discretionary contribution for the year? The employer would need to declare a contribution equal to the amount of the forfeitures by the forfeiture timing deadline. An employer would not be able to declare a contribution of $0 so that the amounts could be held in the suspense account in a way that would violate the timing requirement for the use of forfeitures.
Defined Benefit Plans
The proposed regulation reiterates the requirement in existing regulations that a defined benefit plan must expressly provide that forfeitures cannot be used to provide additional benefits to participants. The proposed regulation, however, removes the statement in the existing regulations that forfeitures must be used as soon as possible to reduce employer contributions to the plan. That statement is inconsistent with changes in the law that have been made with respect to the minimum funding requirements since the initial regulations were released. The proposed regulations reflect that, under the funding requirements, a plan must use reasonable assumptions in determining the amount of contributions an employer is required to make to a plan, and the effect of forfeitures may be anticipated in determining these costs. Differences between actual forfeitures and expected forfeitures will increase or decrease the plan’s minimum funding requirement for future years pursuant to the plan’s funding method.
One item not addressed in the proposed regulations is when a forfeiture occurs in a defined benefit plan. This is relevant not only for funding, but also on plan termination when determining which employees are “affected employees” who must become fully vested. This issues is addressed in The ERISA Outline Book, the relevant portion of which is reflected at the end of this article.
Will a Plan Amendment be Required Due to this Regulation?
A plan amendment isn’t needed if a plan’s terms already conform to the new rules and the plan (if a defined contribution plan) includes all three permissible uses of forfeitures and doesn’t, in operation, have an existing forfeiture suspense account that violates these rules. Because pre-approved plan providers may not know if an adopting employer needs to use the transitional rule, an interim amendment for that purpose may be necessary. Under current guidance, an interim amendment to a pre-approved plan generally needs to be adopted by the last day of the second calendar year following the calendar year in which the amendment is effective. Thus, the interim amendment deadline would be Dec. 31, 2026, for a calendar year plan.
Parting Thoughts
The proposed regulation will not impact the operation of most plans. This is because the regulation formalizes practices that most providers have already been following (whether in operation or pursuant to written plan documents). Even if not required, it would be prudent to ensure defined contribution plans include the use of all three permitted uses of forfeitures, regardless of how unlikely it is that all three will be utilized or that the plan will have forfeitures. There’s no downside to including all three, and the benefit is having flexibility should the need arise. In addition, the transitional rule may be needed for some plans in order to avoid a plan qualification violation once the rules become effective.
Excerpts from The ERISA Outline Book:
Timing of expenses
The IRS, at the Q&A session at the 2012 ASPPA Annual Conference in National Harbor, MD, noted that the IRS does not have a position with respect to the “matching” of forfeitures with expenses. The IRS panelists were presented with the following fact pattern (the years have been updated). For the 2023 plan year, forfeitures are incurred that, under the terms of the plan, are allocated as additional employer contributions to the extent not used to pay expenses. The IRS was asked whether the 2023 plan year forfeitures could be used to pay the following expenses: (1) expenses billed in 2024 incurred for services performed by a TPA firm in 2023, (2) expenses billed in 2023 for services to be performed in the 2024 plan year, and (3) expenses billed in 2024 for services to be performed in the 2024 plan year. In the case of (1) and (3), it is assumed that the plan is billed before the 2023 forfeitures are actually allocated. The IRS’ responses that, barring language in the plan that would preclude such an approach, the 2023 forfeitures probably could be used to pay for all of these expenses.
“Affected employees” in a defined benefit plan termination
The IRS has not issued formal guidance on identifying "affected employees" in a defined benefit plan termination. A defined benefit plan cannot use the 5-year break in service rule to forfeit nonvested benefits unless it is a fully insured plan. See IRC §411(a)(6)(C). Arguably then, all employees and former employees with accrued benefits under the plan are "affected employees" for plan termination purposes, without regard to whether they have incurred a 5-year break in service before the plan’s termination date. For that reason, a cash-out forfeiture provision is especially recommended in a defined benefit plan so that any former employee whose vested benefit is cashed-out will forfeit the nonvested benefit at that time. In such case, a subsequent plan termination will not result in any additional vesting for the former employee.
IRS has applied 5-year break in service rule. Although the 5-year break in service rule does not apply to a defined benefit plan, the IRS seems to have informally adopted the rule to determine who vests upon plan termination, so that defined contribution plans and defined benefit plans are treated the same. It should be noted, however, that no formal guidance exists and the IRS' application of this rule in the field has been inconsistent.
Robert Richter is Retirement Education Counsel, American Retirement Association, and also is the editor and author of the ERISA Outline Book.
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