Steep IRS penalties could await sham terminations


GuideStone provides this information on sham terminations to help our plan sponsors in administering their retirement plan for the benefit of all participants.

No specific tax regulation defines a "sham termination," a term used to describe a termination and sudden re-hire for the purposes of accessing retirement account balances. Nor does any rule provide a length of time an employee must be absent from service in order to constitute a severance from employment. Both are important because a termination is a reason that one can receive a distribution from a Code section 403(b) plan.

However, the IRS has communicated informally that a termination should be bona fide in order for a participant to receive a distribution.

The term bona fide has never been defined by the IRS. However, It seems that an understanding that the participant will return to work shortly after the termination in order to facilitate a distribution of funds not otherwise available for distribution may not be viewed as bona fide.

The adverse tax consequences for a 403(b) plan are imposed on the participant. In Information Letter 2000-0245, the IRS discusses a situation in which an employee wanted to take a distribution upon retirement but return to work on a part-time basis. Included in the Information Letter is the following text:

If a 401(k) plan makes a distribution to a participant due to a separation from service and it is determined that a separation from service did not actually occur, the 401(k) plan may be disqualified under 401(a) and 401(k). Plan disqualification results in adverse tax consequences to the employees participating in the plan and to their employer.

If the employer treats the employee as having separated from employment merely to facilitate a distribution not otherwise available (e.g., distribution of elective deferrals prior to age 59 ½), and both know in advance that the employee will be "rehired," the IRS may view such action as a sham termination.

IRS may require evidence

When an employee leaves, immediately takes a distribution and quickly returns to employment, we would expect the IRS to look for evidence that the termination was bona fide. It's important that it not be a sham termination in order to receive a distribution of salary reduction contributions or employer contributions not otherwise available for distribution while in service.

For example, the IRS may require evidence that the employer and the employee followed all of the organization's normal administrative termination of employment procedures. Whether the employee returns to substantially the same job would be another relevant factor. The shorter the time interval between termination and rehire, the more questionable the circumstances appear, and the more likely the IRS would require some independent evidence of a bona fide termination.

Failure to follow plan terms

Under the Code Section 403(b) regulations, a failure to follow the terms of the plan is an operational failure. Sham terminations would constitute a failure to follow the terms of the plan because plan assets would be made available for distribution in a situation not provided for under the terms of the plan. While the adverse tax consequences of such a failure impacts only the employees involved, if it were discovered on audit, the ability to correct this error may be limited and IRS sanctions may be imposed.

Retirement plan nondiscrimination testing

Employers such as colleges, universities, and hospitals with 403(b) plans that are subject to retirement plan nondiscrimination testing may face another problem with respect to sham terminations: nondiscrimination with respect to plan benefits, rights and features. If the employee involved in the sham termination is a highly compensated employee, it is likely that this would constitute a failure with respect to this feature and corrective action would need to be taken.

Dangerous precedent

Word gets around. Even though an employer's motivation is to help a single employee on a confidential basis, other employees tend to find out what happened and may wonder why they too can't quit for a day or two and receive a distribution.

Trying to help someone may have some of the unintended consequences described in this article. To discuss this topic more fully, please contact your relationship manager.

This information should not be considered tax or legal advice. GuideStone stands ready to assist your organization as you work with your legal and tax advisers by providing resource information that you and your adviser may find beneficial.