Treatment of forfeitures in DC plans – regulation and litigation
IRS recently proposed a regulation clarifying the treatment of forfeitures in defined contribution plans. Forfeitures must be reallocated within 12 months of plan year end to pay expenses, reduce employer contributions, or increase participants' benefits. Despite near-universal practice and IRS guidance allowing forfeitures to reduce employer contributions, lawsuits filed in California allege this violates ERISA fiduciary duties. Lawsuits against Intuit and Thermo Fisher Scientific claim that using forfeitures to reduce employer match rather than plan expenses is a disloyal, imprudent, and prohibited transaction. Cases face an uphill battle, given widespread acceptance of the practice. DC plan sponsors should review forfeiture policy and plan documents to conform with proposed IRS regulation.
Two recent cases have been filed in California challenging – as an ERISA fiduciary violation – the (standard) practice of using forfeitures in a defined contribution/401(k) plan to reduce the cost of employer matching contributions. In this article, we review the (February 2023) IRS proposed regulation clarifying the treatment and timing of forfeitures under a defined contribution plan. We then review the complaint in one of the California cases – Rodriguez v. Intuit, filed in the United States District Court for the Northern District of California on October 2, 2023 – challenging the use of forfeitures to reduce employer matching contributions.
IRS’s proposed forfeiture regulation
In defined contribution plans, forfeitures generally arise when a participant terminates employment before she is fully vested in employer contributions, e.g., employer matching contributions in a 401(k) plan.
On February 27, 2023, IRS proposed a regulation clarifying the treatment of these forfeitures in DC plans.
Under the proposal, a DC plan must provide that forfeited amounts in the plan (e.g., in a terminating non-vested participant’s account) will be re-allocated in one (or more) of three ways:
To pay plan administrative expenses;
To reduce employer contributions under the plan; or
To increase benefits in other participants’ accounts in accordance with plan terms.
The proposal also requires that all forfeitures be re-allocated “no later than 12 months following the close of the plan year in which the forfeitures were incurred.” The rule is applicable for plan years beginning on or after January 1, 2024, so that the first re-allocation deadline would be 12 months after the close of the 2024 plan year. Sponsors may rely on the proposed regulation until the (final) applicability date.
The proposal brings clarification to current rules and is generally regarded as workable. Sponsors will want to consider amending their plan to (at a minimum) reflect current forfeiture policy; most sponsors will want – in their plan language – to provide for maximum flexibility in the treatment of forfeitures.
Forfeiture litigation
Notwithstanding that nearly everyone, very much including the IRS, views the allocation of forfeitures to reduce employer matching contributions as standard practice, the plaintiff in Rodriguez v. Intuit is suing fiduciaries of the Intuit Inc. 401(k) Plan, alleging that in doing so they have violated ERISA fiduciary rules.
The core of plaintiff’s argument is that forfeitures under the plan – which annually run in the millions of dollars – should have been used to reduce plan expenses, which instead have been paid for out of participants’ accounts. They argue that this practice:
Violates ERISA’s duty of loyalty – the fiduciaries’ duty to act “solely in the interest of the participants and beneficiaries” and “for the exclusive purpose of: (i) providing benefits to participants and their beneficiaries; and (ii) defraying reasonable expenses of administering the plan.”
Violates ERISA’s duty of prudence – “Defendants failed to engage in a reasoned and impartial decision-making process to determine that using the forfeited funds in the Plan to reduce the Company’s own contribution expenses, as opposed to the administrative expenses charged to participant accounts, was in the best interest of the Plan’s participants or was prudent, and failed to consider whether participants would be better served by another use of these Plan assets after considering all relevant factors.”
Constitutes a prohibited transaction (as both an impermissible exchange between the plan and the sponsor and as self-dealing).
The same law firm that filed the Rodriguez complaint has filed a nearly identical complaint against Thermo Fisher Scientific Inc. – Dimou v. Thermo Fisher Scientific Inc. – in the United States District Court for the Southern District of California.
It’s hard to take a case like this seriously, given that its theory of the law is at odds with both a nearly universal practice and the IRS’s regulatory position. The only point to the contrary that could be made is that plaintiff’s claims are made under ERISA, not under the Tax Code, and it is conceivable (although unlikely) that a court might hold that a practice permissible under a qualified plan for purposes of tax qualification might nevertheless be illegal under ERISA.
With respect to IRS’s proposed regulation, we repeat – DC plan sponsors will want to review their forfeiture policy and plan documentation with a view to conforming them to IRS’s proposal.
We will continue to follow this issue.