February 2, 2008

When a Distribution Upon Termination Must be Halted

Recently, a client contacted us because an employee, who had recently been laid off and requested a distribution from the plan, was rehired in another department of the same company. The client requested our assistance in determining whether the employee could receive the distribution despite the fact that she been rehired.

In order to determine whether the company could proceed with the distribution, it was necessary to look at the terms of the plan document. The plan document set forth the following events that the participant must satisfy in order to receive a distribution: (i) the employee’s separation from service, death, or disability, (ii) the employee’s attainment of age 59 ½; or (iii) upon experiencing certain hardships set forth in the plan. The participant had requested the distribution on the basis of a separation of service and it was necessary to determine whether the employee’s original termination but subsequent rehiring, in fact, constituted a “separation from service.”

Internal Revenue Service (“IRS”) Information Letter 2000-0245 discussed such a situation and provides guidance on what constitutes a “separation of service.” In IRS Information Letter 2000-0245, an employee wanted to take a distribution from her account upon her retirement but wanted to be rehired as a part-time employee. The IRS Information Letter opined that:

Whether a participant has experienced a separation from service when she changes from full-time to part-time employment with one employer, such a change apparently would not qualify as a separation from service. This is because the employer/employee relationship is not completely severed, but is simply modified when the employee changes her work schedule. (emphasis added)

The IRS Information Letter also provided that “[i]f 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).”

We concluded that there was not a “separation of service” due to the following facts: (i) only a few weeks had lapsed from the date of termination to the date the employee was rehired; (ii) upon being terminated there was a discussion that the transfer to another department may occur; and (iii) essentially, the employee/employer relationship had not been severed. In light of the qualification issues when an improper distribution is made to a participant, we advised the client not to make the distribution.

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