When a buyer acquires a company — whether through a stock or asset transaction — one of the more consequential employee benefits decisions it will face is what to do with the target's 401(k) plan.
The buyer has three broad paths: terminate the plan before closing, continue it on a standalone basis post-closing, or eventually merge it into the buyer's own 401(k) plan. Buyers often ask: What is the difference, and does it matter? Depending on the facts and circumstances, it can matter a lot — one choice can cost much more in time, effort and dollars. Each path carries distinct legal, administrative, and cost implications.
Equally important: if no affirmative decision is made, the default path is continuation, which complicates any later effort to terminate the plan. The only practical path to later “terminate” the plan is a merger into the buyer’s controlled group 401(k) plan.
This article outlines the key factors buyers should evaluate early in the transaction process to arrive at the right decision with confidence.
Key Fact Patterns to Consider
Does the buyer group already have a 401(k) plan or other savings arrangement in place? If they do not, there is likely a stronger desire to continue the target plan to minimize additional set up costs and employee disruption, rather than terminate it.
Asset transactions have unique issues. The buyer is not required to continue the target 401(k) plan, and to cause the plan to be assumed by the buyer would require some additional efforts (for example, board resolutions by both parties and vendor consent as a starting point). In an asset transaction, it is often preferable for a buyer to leave the target 401(k) alone and have the selling company deal with the plan post-sale.
Does the target 401(k) plan have some identified errors and unusual features? Typically, where there are plan compliance issues, a buyer would not want to incorporate the target’s plan into its current plan. It would prefer to stop the issues and correct the errors separately from the buyer’s current plan arrangement and terminate the plan (at least one day) prior to the closing of a transaction. So in this case, a plan merger would be an undesirable path.
Path 1: Terminate the Target 401(k) Plan Before Closing
This approach is typically chosen when the buyer wants a clean break from the target plan (including any operational issues identified in diligence) and to avoid the successor plan rules. Timing is critical: to avoid successor plan treatment under the 401(k) regulations, the termination must be effective at least one day before closing.
In a stock acquisition, the main decision relating to a target’s 401(k) plan is whether the plan should be terminated pre-closing or continue post-closing. If the plan continues, it may remain standalone for a period of time and/or later be merged into the buyer’s group 401(k) plan.
In a plan termination situation, the successor plan rules under the 401(k) regulations will not apply where a plan is terminated at least one day prior to a closing. Once the plan is terminated by the board’s adoption of a resolution to terminate the plan, the annual compliance testing should be completed, participants should be fully vested in their accounts under the plan, and then participants should be allowed to take a distribution.
Distributions are often in the form of lump sum payments in cash or a rollover to an individual retirement account or another 401(k) plan the individual is a participant in. The assets should be fully distributed within 12 months of the board resolution terminating the plan. The sponsor of the 401(k) plan will remain responsible for finalizing all distributions from the plan and filing the final Form 5500.
Path 2: Continue the Target 401(k) Plan Post-Closing (Standalone)
If no affirmative decision is made, the default is that the target plan continues after closing. Continuation can be attractive where the buyer does not currently maintain a 401(k) plan, where the transaction structure makes assumption cumbersome (often in asset deals), or where the parties want to minimize immediate employee disruption while longer-term integration is evaluated.
The continuation of a target’s 401(k) plan post-closing is typically only desirable for a limited period of time when there is another plan already in the buyer’s group. There is a special transition rule that will allow the plans to be deemed to pass the minimum coverage test (until the end of the plan year following the plan year of the acquisition) – subject to certain requirements being met. This period allows time to amend the plan designs as necessary to pass the coverage test. Failing to pass a Code Section 410(b) coverage test is a qualification failure.
In addition, maintaining multiple plans within a group of companies can be costly, and may include paying for multiple plan recordkeepers, auditors and other advisors, multiple compliance tests and preparation of multiple Form 5500 filings.
Path 3: Merge the Target 401(k) Plan Into the Buyer’s 401(k) Plan
If a buyer has another 401(k) plan and the target’s plan is not terminated prior to closing, then a plan merger is the practical alternative option given the successor liability rules under the 401(k) regulations. The plans need to have separate compliance testing performed in the event of a mid-year merger - and often, when one plan is a safe harbor plan, a year-end merger is the favored approach. This can be a challenge when payroll transitions occur prior to the planned merger date.
In addition, in a merger, all assets in the target 401(k) plan trust would be moved to the buyer 401(k) plan trust after a protected benefit analysis and investment mapping analysis is performed. Blackout notices will likely be required in this situation. These actions require some careful analysis and attention, and certain steps - including mapping of investments – are fiduciary actions. But the advantages include that the assets will remain in the plans, which avoids the loan repayment issues that are often triggered in plan terminations. In addition, greater plan assets can provide access to better (lower) cost investment classes for the plan’s investment line up.
Choosing the Right Path in a Particular Transaction
Each transaction and company is different, and the facts in the specific circumstances should be considered as they may lead to a different choice in each transaction. Special additional factors to be considered in deciding which path is preferred under the relevant circumstances include:
Are there many outstanding loans in the target plan? If so, will a material amount of money be payable in a short-term post-closing for employees to be able to repay the loans or will the participants be at risk for early distribution taxes being imposed? Are there accommodations the buyer can make to address outstanding loans? Having loans outstanding does not block a plan termination, but it does require some careful consideration before proceeding to protect participants from experiencing negative tax consequences of loan defaults or offsets.
Is the target’s plan a multiple employer plan, such as one sponsored by a professional employer organization (PEO) or a pooled employer plan (PEP)? Those types of plans often limit the ability to terminate participation in the plan and leave the obligations with the entity other than the target. That is, typically a plan “spin-off” is required when a company departs a PEO or PEP, which could limit the options available to a buyer if the treatment of target participation in the multiple employer plan is not addressed sufficiently in advance of closing. For example, some PEOs would allow a “spin-off” to occur pre-close where the plan could still be terminated, but timing is key. And this would only be a practical approach if the relationship with the PEO is not continuing post-closing. It is important to review these plan documents for termination provisions - and, often, discussions with the plan’s recordkeeper and sponsor will be necessary to assess post-closing choices.
Relatedly, is the buyer’s plan a multiple employer? Would that plan accept a merger of plan assets into the buyer’s current plan trust, or will additional costs be incurred? If the plan is a PEO plan or PEP, one would expect the plan to allow a merger of additional plan assets into their plan, but the PEO or PEP sponsor is really the plan sponsor and, as a participating employer the buyer is subject to plan terms and policies and procedures of the PEO plan and PEP sponsors. Early engagement of the plan sponsor parties is important to understand choices and any timing restrictions.
There are many steps to any of the paths above, and deciding which approach is best for your organization should be undertaken with a trusted advisor familiar with the common hurdles applicable to either arrangement, only a handful of which are noted above. For example, in addition to the considerations above, buyers should focus on complying with state laws that require employers to register and to send employee contributions to state-run IRAs if the buyer is not sponsoring a plan and address other retirement plan options, such as SIMPLEs and SEPs, that may be applicable.
A 401(k) plan termination is not the only option. The facts and circumstances will guide whether it is the right approach for a specific buyer in a specific transaction.
Our team at Cohen & Buckmann can provide sellers and buyers more information on how to manage 401(k) plan integration concerns before, during or after a merger or acquisition.