As seen in our 2023 EOY Newsletter: Click Here
by: Aaron Epstein, QKA
The term “forfeiture” refers to the non-vested portion of a former employee’s account balance in the plan. For example, if a participant is 40% vested in their profit sharing account source when they terminate, the remaining 60% of his profit-sharing account balance will become a forfeiture.
Plan sponsors can use forfeitures in defined contribution plans to take any of the following three actions:
1. Reduce employer contributions Under this option, the forfeitures offset a portion of the contribution the employer would otherwise make under the plan. For example, assume a company has a forfeiture account balance of $3,000. The company decides to make a profit-sharing contribution of 10% of compensation for the year, which equals $35,000. In this case, the company could deposit $32,000 toward the contribution from employer general funds and use the $3,000 in the forfeiture account to bring the total contribution allocation to $35,000.
2. Enhance employer contributions A plan may use forfeitures to provide additional allocations for participants. Under this option, the forfeiture allocated represents an increase to the contribution the employer would otherwise make under the plan. In the example above, if the company’s target profit sharing contribution was $35,000, and they had $3,000 in the forfeiture account, the company could deposit $35,000 toward the contribution from employer general funds and use the $3,000 in the forfeiture account to provide an enhanced profit-sharing contribution of $38,000.
3. Payment of plan-related administrative expenses A plan may provide for the use of forfeitures to first pay reasonable administrative expenses. To the extent forfeitures exceed the amount required to pay expenses, the excess could be used to reduce or enhance employer contributions.
Most defined contribution plan documents include language authorizing all 3 forfeiture uses described above.
In April 2023, the IRS released proposed regulations on forfeiture accounts, including timing for the use of forfeitures. In these proposed regulations, the IRS re-emphasized the existing rule that a plan must use forfeitures no later than 12 months after the close of the plan year in which the forfeiture occurred. For example, if a forfeiture occurs in a calendar year plan in 2024, the forfeiture would have to be used to reduce employer contributions, enhance employer contributions, or pay plan expenses by 12/31/2025.
The proposed regulation has formalized this timing requirement. The proposed regulation also provides for a transition rule. Under the transition rule, any forfeitures that were incurred in any plan year beginning before 2024 are treated as having been incurred in the first plan year that begins on or after 01/01/2024, and must be used no later than 12/31/2025 for a calendar year plan.
In summary, plan sponsors should review their plan document to confirm that it provides for the 3 allowable options regarding how forfeitures may be used. If the document does not currently include all 3 options, it can be amended. Plan sponsors should make sure that the timing of forfeiture use is in compliance with regulations. They can take advantage of the transition rules to utilize any forfeitures incurred prior to 2024 by the end of the 2025 plan year.
Now that the IRS has formalized the timing requirements for forfeiture use, it stands to reason that they are less likely to be forgiving of violations of this requirement.