401(k) Plans in Stock Purchase M&A Transactions: A Buyer’s Guide to Choosing Termination or Merger

Morgan Lewis - ML Benefits
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Morgan Lewis - ML Benefits

One of the most common questions we receive from buy-side clients in mergers and acquisitions (M&A) is how to handle the 401(k) plan of the target company in the context of a stock purchase acquisition: Should they require the target to terminate the 401(k) plan prior to closing? Or should they keep the 401(k) plan in place for a short period of time following closing and then merge it into their own existing 401(k) plan?

While many of these decisions may be driven by the administration and payroll processes in place, what are the pros and cons and other considerations to keep in mind with terminating versus merging a target’s 401(k) plan? In this ML BeneBits post, we outline some important considerations that buy-side companies should keep in mind when making this decision.

Plan Termination

In our experience, terminating a target’s 401(k) plan prior to closing (which is typical in scenarios where the buyer will be covering the target’s employees with the buyer’s 401(k) plan postclosing) is often the preferred approach for several reasons:

  • Terminating the target’s 401(k) plan prior to closing generally sidesteps the successor plan rule’s prohibition on distributions of elective deferrals and certain employer contributions and gives the target’s employees the flexibility to choose whether to take a lump-sum cash distribution of their accounts under the target’s terminated 401(k) plan or roll over their accounts to the buyer’s 401(k) plan, an individual retirement account, or another eligible retirement plan.
  • There is no need to preserve protected benefits from the target’s 401(k) plan.
  • While certain administrative tasks may remain to be completed postclosing in connection with winding down the target’s terminated 401(k) plan and making distributions, because the target’s 401(k) plan was terminated by the target prior to closing, the buyer generally is not assuming ongoing operational risk with respect to the terminated 401(k) plan going forward.
  • By terminating the target’s 401(k) plan instead of merging it into the buyer’s 401(k) plan, the buyer’s 401(k) plan avoids being tainted by any existing compliance issues with the target’s 401(k) plan.
  • Terminating the target’s 401(k) plan prior to closing avoids potential postclosing testing issues as well as the increased administrative complexity and expenses associated with maintaining more than one plan postclosing (which arise even if the buyer only maintains more than one plan for a short period postclosing and later terminates the target’s 401(k) plan or merges it into an existing buyer plan).

The “successor plan rule” is an Internal Revenue Code provision that comes into play when the target’s 401(k) plan is not terminated prior to closing and the buyer already has an existing 401(k) plan (or any alternative defined contribution plan other than an ESOP).

In that scenario, if the target’s 401(k) plan is later terminated by the buyer after closing, then unless fewer than 2% of the target’s employees are eligible for another plan at all times during the 24-month period beginning 12 months before the target 401(k) plan’s termination, the successor plan rule will generally prohibit the distribution of any elective deferral contributions made by participants under the target’s 401(k) plan (and any QNECs, QMACs, and employer safe harbor contributions) until the participants eventually have a valid distributable event other than the termination of the target’s 401(k) plan (e.g., termination of employment, attainment of age 59½, hardship, death, disability).

For this reason, terminating the target’s 401(k) plan prior to closing is generally preferred if the buyer wishes to avoid the successor plan rule.

On the flip side, there may also be reasons why a buyer may not want the target to terminate its 401(k) plan prior to closing. It can often be administratively challenging for the buyer to move the target’s employees onto the buyer’s payroll and buyer’s plans immediately following closing. As a result, if the target’s 401(k) plan was terminated prior to closing, then the target’s employees may experience a gap in 401(k) plan coverage for a period of time following closing.

In addition, if the target’s 401(k) plan has outstanding participant loans at the time of the target 401(k) plan’s termination, there may be employee-relations issues to consider as well as administrative challenges with addressing the treatment of those loans, especially if the buyer’s 401(k) plan will not accept the rollover of loans from the target’s 401(k) plan.

Finally, it may potentially be cheaper to maintain the target’s 401(k) plan for a period of time postclosing if the employer contribution obligations are less than those under the buyer’s plan—however, this perceived economy on the front end may well be eclipsed by increased costs on the back end associated with maintaining more than one plan and the increased administrative complexity and potential testing issues noted above if the buyer continues to maintain the target’s 401(k) plan for any significant amount of time postclosing.

Plan Merger

Due to the administrative challenges noted above with postclosing transitions, some buyers opt to maintain the target’s 401(k) plan for a period following closing and later merge that plan into the buyer’s plan. Some reasons that buyers may choose a plan merger include

  • merging the target’s 401(k) plan with the buyer’s 401(k) plan following closing provides continued 401(k) plan coverage with reduced disruption to employees where the buyer’s 401(k) plan offers similar or mirrored benefits to those under the target’s 401(k) plan;
  • distributions from the target’s 401(k) plans and rollovers of account balances and outstanding participant loans are not necessary, as neither the stock purchase M&A transaction on its own nor the plan merger are distributable events;
  • full vesting of employer contributions under the target’s 401(k) plan is not triggered by the plan merger;
  • the administrative costs and complexities involved with continuing to maintain the target’s 401(k) plan will be eliminated;
  • more assets in the buyer’s 401(k) plan due to the plan merger may potentially translate to lower investment fees, if the additional assets enable the buyer’s 401(k) plan to qualify for more favorable share classes; and
  • “leakage” from the plan termination scenario will be reduced (i.e., preventing target employees from taking a distribution from the target plan and spending it rather than continuing to save it for retirement).

However, there are also several reasons why we see buyers opt not to choose a plan merger. First, the buyer’s 401(k) plan must preserve any protected benefits associated with the assets merged into the buyer’s 401(k) plan from the target’s 401(k) plan, which requires a thorough analysis of the target’s 401(k) plan prior to effecting the merger (commonly called the protected benefits or “anti-cutback” analysis). This increases administrative complexity and costs for the buyer’s 401(k) plan (and also increases the potential for compliance failures under the buyer’s 401(k) plan).

Second, any compliance issues under the target’s 401(k) plan will taint the buyer’s 401(k) plan and will continue to present and accumulate risk following closing until otherwise corrected (and corrections may incur additional expense).

Finally, there are additional administrative costs and expenses generally borne by the buyer to complete the merger of the plans and effect a transfer of plan assets from the target’s 401(k) plan to the buyer’s 401(k) plan.

This often requires significant lead time to complete the anti-cutback analysis and the mapping of investment options from the target’s 401(k) plan to the buyer’s 401(k) plan, as well as providing the notices to participants required by statutes and navigating required blackout periods.

Further, advance notice requirements may be necessary with respect to the target 401(k) plan’s service providers, such as the recordkeeper and trust company/trustee. Mergers can be complex and require effective communication between service providers to ensure that the plan assets are transferred correctly.

There are other alternatives for buyers when dealing with a 401(k) plan of a target company in a stock purchase acquisition, including freezing or even continuing the plan, which have their own complexities.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Attorney Advertising.

© Morgan Lewis - ML Benefits

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