LAST REVIEWED May 19 2021 12 MIN READ
By The Human Interest Team
Selling or acquiring a small business is exciting but there’s a lot to do to get it right, both for you and for the company being acquired. Making arrangements for a company’s retirement plan may not be top of mind during the process, but if you don’t make an informed choice about what’s best for your business ahead of time, you could find yourself stuck with a situation that can result in unexpected and ongoing costs.
What happens to the retirement plan of a company that’s being acquired?
There are essentially four options for dealing with the retirement plan of a company that’s being acquired:
The retirement plans of both companies can be merged
The plan at the acquired company can be terminated
The retirement plans of both companies can be maintained
The plan at the acquired company can be frozen—or, maintained without the option of further contributions
Determining the best option
The options available, however, are partly determined by the type of sale—stock or asset.
In an asset sale, the buyer is only purchasing certain assets of the seller, like client lists, physical and/or intellectual property, equipment, and so on. Ownership of the company remains with the seller. The seller may be selling all of its assets as part of winding down the business or it may only be selling part of what it owns with the intention of the company continuing in operation. The seller's retirement plan does not pass automatically to the buyer.
In a stock sale, the buyer is acquiring ownership of the company from the seller. Ownership of the seller's company includes everything that belongs to the company, including any active retirement plans.
Plan options in an asset sale: the onus is on the seller
In an asset sale, the seller generally maintains responsibility for the retirement plan after the sale. The seller can continue to sponsor the plan or terminate it, depending on what they are trying to accomplish as a company after the sale. The seller should be aware that:
If they continue the plan but have terminated 20% (or more) of its workforce, all affected participants will be 100% vested under the IRS partial plan termination rules.
If they intend to terminate the plan, they cannot simply walk away. It is the seller's responsibility to take all required actions to terminate the plan, including formal termination, distribution of assets, and filing the final Form 5500.
Sometimes the parties agree that the buyer will assume sponsorship for all, or a portion, of the seller's retirement plan after the sale. This typically only happens when the buyer agrees to hire a substantial number of the seller's former employees. The buyer should understand that, in this situation, they are accepting all liabilities associated with the portion of the seller's plan they accept, such as any operational errors or audit issues.
If the buyer is assuming the role of plan sponsor of the seller's plan, the buyer may choose to maintain the seller's plan separately or merge it into another plan it already sponsors. If the buyer is only taking a portion of the seller's plan, that portion will "spin out" to a new plan established by the buyer or to another plan that the buyer already sponsors. If a portion of the plan remains with the seller, the seller will need to decide what to do with that part of the plan (see above).
Both buyer and seller should be aware that, if the buyer agrees to take all or part of the seller’s plan, employees who are terminated by the seller and hired by the buyer cannot take a distribution from either plan. The buyer will be treated under IRS rules as maintaining a “successor plan” for those employees and they will only be entitled to a distribution if they have a future distributable event, such as obtaining Full Retirement Age or termination of employment from the buyer.
Plan options in a stock sale: the onus is on the buyer
The buyer effectively assumes responsibility for a retirement plan, both future and past obligations, in a stock sale. Before the sale, the buyer must know whether or not the seller has a plan so that the buyer can determine whether to inherit the seller’s plan or have the seller execute a resolution to terminate the plan with an effective date prior to the transaction.
Once a buyer has inherited the seller’s plan—intentionally or otherwise—there are three options for maintaining it:
Freeze the acquired plan
Merge the acquired plan into the buyer’s plan
Separately maintain the acquired plan
Generally, plans that have been inherited via a stock sale cannot be terminated after the transaction. However, if the buyer does not maintain a similar plan that can be considered a successor plan for the newly acquired retirement plan, they may be able to terminate the acquired company’s plan.
3 options for when a company inherits a 401(k) plan in a stock sale
1. Freezing the plan
Freezing the acquired plan requires the buyer to fully maintain the plan, including the accounts, documents, annual Form 5500 filing, and so on, while prohibiting any further contributions.
2. Merging the plans
This is the most common option. Merging an acquired plan with the buyer’s existing plan requires separate accounting of the merged plans. To comply with the anti-cutback rule, a close comparison of the provisions in each plan is also required to determine if changes are needed to accommodate protected benefits. Protected benefits include accrued benefits, early retirement benefits, retirement-type subsidies, and other forms of optional benefit in a qualified retirement plan.
In a stock sale, the buyer may decide to merge plans after the transaction. However, doing so will still require a written agreement to transfer or merge the assets of one plan into the other.
Although a plan merger may result in some changes in a plan’s administrative terms (for example, the plan administrator or investment choices), it usually does not have a significant impact on a participant’s benefits.
3. Maintaining separate plans
The buyer may decide to maintain each retirement plan separately. This requires aggregation for certain compliance tests each year, and depending on demographics, amending the plans to more closely mirror one another.
New hire or vested employee?
In a stock sale…
Employees of the acquired company become the employees of the buyer. In other words, the buyer can’t treat these “new” employees as new hires when it comes to the retirement plan. The buyer must recognize the employees’ service from their original hire dates with the seller for all plan purposes such as eligibility, vesting, and allocations. There is no amendment to negate recognition for years of service, so it is essential that the buyer understands the compliance and any financial implications.
While most 401(k) plan provisions are not protected by law, vesting is one thing that can't be reduced. If an employee is vested in a 401(k) plan at the previous company, but isn't eligible under the rules of the buyer’s 401(k), they can’t lose their vesting.
Because many plans are designed so only the sponsoring organization is considered as participating in the plan, acquired employees who continue to work directly for the acquired company—whether a wholly-owned subsidiary or brother-sister organization—are generally not eligible to join the buyer’s plan until a separate joinder or participation agreement is signed. This is preferably done before the enrollment date. (Note that acquired employees who work for a subsidiary are still considered as “non-benefiting” employees during annual compliance testing.)
In an asset sale…
Employees of the seller can be, but are not automatically, hired by the acquiring entity. They are essentially new employees of the buyer, meaning service with the seller is generally not automatically recognized. If the buyer wishes to credit service with the seller for eligibility, vesting, and/or allocation purposes, their plan must be amended to include prior years of service with the company.
Due diligence before the transaction
In an ideal world, the buyer and seller have discussed the plan before the sale is complete. Note that sometimes in a stock sale, the seller terminates the plan before the transaction.
A buyer can also take the following steps to learn about the target company’s current retirement plan:
Identify the plan’s fiduciaries, and confirm that the plan is not currently subject to an IRS or DOL audit or any threatened, pending, or filed fiduciary breach lawsuits.
Multiemployer plan? Know how the plan of the target company assesses withdrawal liability and determines the extent of a buyer’s potential liability.
As a buyer, you may choose to review the plan’s process and procedures, compliance testing outcomes, plan documents and amendments, and any audit reports. In the purchase agreement, the seller should verify that a plan is qualified in operation. Determine if and when any defects should be corrected.
Determine the best post-transaction plan design for your company, based on whether the transaction is an asset or a stock sale.
Determine whether any amendments to the retirement plans are likely to cause complications during annual testing.
Good to know
Often, there is a “grace” period available through the end of the year after the year in which the transaction takes place, during which buyers can maintain two separate plans and pass certain compliance testing. This gives the buyer some time to conduct some of their due diligence before determining what to do with the plans. Keep in mind that the analysis takes time. Don’t put it off!
If you’re thinking about or in the process of merging with or acquiring a company, we support Human Interest customers (and incoming customers) to help you determine the best retirement plan option available to your business. We’ll also take care of all the plan amendment notices and filings. Learn more about the services we offer.
The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment advising, and integration with leading payroll providers.