Allowing an employee to receive a benefit before a bona fide termination or separation from service with an employer can (1) jeopardize the qualified status of the plan and (2) result in an early distribution penalty to the member. The key question is whether a governmental plan member may receive a distribution when there has not been a bona fide separation from service – a true termination of employment.

This alert provides an overview of the qualification and taxation standards under the Code and related IRS guidance that should be considered in designing or implementing a retiree reemployment policy for a governmental plan.

Qualification and Taxation Issues

General Qualification Rule

In general, a qualified pension plan is defined as “a plan established and maintained by an employer primarily to provide systematically for the payment of definitely determinable benefits to his employees over a period of years, usually for life, after retirement.” ¹ Under this definition, the IRS takes the position that a member of a qualified plan may only receive a retirement benefit upon the following:

• Termination of employment;
• If the plan provides, attainment of normal retirement age; ²
• If the plan provides, attainment of age 59 ½ (or a later age); or
• Termination of the plan.³

Stating this rule in its simplest form, the requirement is that (absent a plan termination) a qualified governmental pension plan can only provide for payment of a pension benefit if a member (1) terminates employment with their employer, or (2) if the plan so provides, the member reaches normal retirement age (the age at which the member would receive an unreduced benefit), or age 59½ (or some later age).

Bona Fide Termination of Employment

If a retiree reemployment policy allows a plan member to retire and be reemployed without a bona fide “termination of employment,” that policy raises a qualification issue for the plan. A bona fide termination of employment means more than a termination of “covered employment.” Instead, a termination of employment means that the employee is no longer working for the employer, whether as a “regular” employee, a part-time employee, a seasonal employee, a contractual employee, an independent contractor, a leased employee, etc. The IRS has issued both binding and non-binding guidance on the qualification requirement that there must be a termination from employment prior to a distribution from a qualified plan. In a private letter ruling (“PLR”), the IRS exhaustively addressed how paying retirement benefits without a termination of employment may affect the qualified status of a plan. In PLR 201147038, the IRS reached the conclusion that:

Employees who “retire” on one day in order to qualify for a benefit under the Plan, with the explicit understanding between the employee and the employer that they are not separating from service with the employer, are not legitimately retired. Accordingly, because these employees would not actually separate from service and cease performing services for the employer when they “retire,” these “retirements” would not constitute a legitimate basis to allow participants to qualify for early retirement benefits (which are then immediately suspended). Such “retirements” will violate section 401(a) of the Code and result in disqualification of the Plan under section 401(a) of the Code.

PLR 201147038 (emphasis added). The IRS also noted that “because a qualified pension plan is generally not permitted to pay benefits before retirement, an employee who ‘retires’ with the explicit understanding between the employer and employee that upon retirement the employee will immediately return to service with the employer has not legitimately retired and may not qualify for an early retirement benefit under the Plan.” Finally, the IRS reviewed court cases with regard to the meaning of the word “retire” and summarized the holding as following – an employee would not legitimately retire if he did not actually leave employment upon retirement.

Taxation Concerns for Both the Plan and the Member

In addition to the plan qualification issues, the employee may incur a premature distribution tax if the member is not age 59½, and there has not been a separation of service.

Code Section 72(t) imposes an additional 10% premature distribution tax on distributions that are paid to members prior to the date the member attains age 59½ unless an exception applies. This tax is in addition to income tax that applies to the distributed amount. The recipient of the premature distribution, not the qualified plan, is liable for this tax. The member reports the early distribution tax on IRS Form 5329, which is then filed in conjunction with the member’s regular income tax return. However, a qualified plan must properly code premature distributions when preparing IRS Form 1099-R.

The retirement distributions that are covered by exceptions to the 10% tax that are most relevant for governmental plans include (but are not limited to) the following:

• distributions made after the member’s death;
• distributions attributable to the member’s service-connected disability;
• substantially equal periodic payments commencing after the member separates from service and payable over the life (or life expectancy) of the member or the joint life (or joint life expectancy) of the member and member’s designated beneficiary;
• distributions made to a member who separates from service after attainment of age 55 (age 50 or 25 years of service under the plan for public safety);
• distributions to an alternate payee pursuant to a qualified domestic relations order;
• distributions made on account of a levy under Code § 6331 on the qualified retirement plan; 
• eligible terminal illness distributions; ⁴ and
• qualified disaster recovery distributions.⁵

Two of these exceptions upon which many governmental plan retirees rely to avoid the tax penalty – the substantially equal periodic payment exception and the age 55 (age 50/25 years of service) exception – require a “separation from service.”

There is no exception for normal retirement age under Code Section 72(t), so, in preparing Forms 1099-R, the governmental plan payor must focus on age and separation from service in order to determine whether a retiree will be subject to a 10% taxation penalty.

The concept of “separation from service” for taxation purposes is viewed as a more stringent test than “termination of employment” for qualification purposes. There are a series of cases that define what is a separation from service for purpose of taxation. For example, in Ridenour v. U.S., 52 AFTR 2d 83-5584 (Cl. Ct. 1983), the Claims Court held that promotion from the status of common law employee to partner at the same firm was not a separation from service. The court drew a distinction between one who continues to provide services and one who discontinues providing services, rather than upon the particular status of the person rendering the service. The Claims Court concluded that one who continues to provide services has not separated from the service within the meaning of Code Section 402(e)(4)(A)(iii).

If a reemployment policy allows a member to “retire” and commence a retirement benefit without a bona fide separation from service, and if that member is less than 59½ when they receive a benefit, the governmental plan must code the Form 1099-R with respect to those benefit payments such that the retiree will be subject to a 10% penalty on the taxable amount of the benefit.

Summary of IRS Position

No Pre-Arranged Agreement to Reemploy. It is clear from the IRS guidance that a prearranged agreement for reemployment by the same employer will not be treated by the IRS as a termination from employment. Therefore, unless the plan provides for an in-service distribution at normal retirement age (or age 59½), a member may not be permitted to receive a retirement benefit if, pre-retirement, the member and the member’s employer have entered into a prearranged agreement for employment.

No Continuation of the Employment Relationship. The IRS takes the position that the employment relationship must not continue post-retirement, even if there is a substantial modification of the hours worked. The IRS may not consider the employment relationship to have been severed if the member becomes the leased employee or independent contractor of the same employer. A reemployment policy should clarify that a termination of employment requires termination of the employment relationship and that moving to a temporary or part-time position, or becoming a leased employee or an independent contractor, is not sufficient to constitute a termination.

Period of Separation from Employment. The IRS has stated repeatedly that the determination of whether there is or is not a severance from employment is to be determined using a facts and circumstances test. In this regard, the IRS has not established a “safe harbor” period for severance from employment. However, based on the regulations under Code Sections 410 and 457, which are cited in PLR 201147038, some governmental plans have implemented a required minimum period of time (typically from 6-12 months) without performing service (and without a pre-existing arrangement for re-employment) to demonstrate reasonable compliance with the facts and circumstances standard.

Alternatively, if in-service distributions were allowed at the normal retirement age (or age 59½), a member could commence their benefits without a bona fide separation of service. However, commencing an in-service distribution prior to age 59½ will result in an early distribution penalty.

For more information about how the separation from service and reemployment rules may affect your qualified retirement plan(s), please contact your Ice Miller Workplace Solutions lawyer with whom you regularly work.

^{[1] Treas. Reg. §1.401-1(b)(1)(i). 
[2] In 2016, the IRS issued proposed regulations defining normal retirement age for qualified governmental defined benefit plans. ("2016 NRA Regulations"). The 2016 NRA Regulations place parameters on what the IRS considers a permissible normal retirement age for purposes of permitting in-service distributions. 81 FR 4599.
[3] Treas. Reg. §1.401-1(a)(2)(i); Rev. Rul. 74-254, 1974-1 C.B. 94; Code § 401(a)(36).
[4] Code § 72(t)(2)(L), added by SECURE 2.0.
[5] Code §§ 72(t)(2)(M) and 72(t)(11), added by SECURE 2.0.}

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.