If you’re a small business 401(k) plan sponsor considering the purchase of another company, the last aspect of the deal you’re probably considering is the seller’s 401(k) plan. However, it’s important for you to have a strategy for that plan in place before your deal is closed. Otherwise, you could be stuck with a 401(k) plan that includes costly protected benefits or uncorrected defects.
The good news? Developing a strategy is simple. There are only a handful of considerations.
Will your purchase be an asset or stock sale?
When you are planning to buy a company, your options for their 401(k) plan will depend upon whether the purchase is an asset or stock sale. Under an asset sale, you purchase the seller’s assets and liabilities, but the seller retains possession of the legal entity. Under a stock sale, you purchase the seller’s stock - thereby taking possession of the seller's legal entity (in addition to their assets and liabilities).
Why is this distinction important to your 401(k) plan? If your purchase is a stock sale, you have just two options for handling the seller’s 401(k) plan – merge it into your plan or retain it on a stand-alone basis (the latter being very rare due to IRS nondiscrimination rules). Your options are limited because you and the seller are considered the same employer for 401(k) purposes in a stock sale. However, you’re considered different employers in an asset sale, which gives you a third option – have the seller terminate their 401(k) plan before the acquisition.
Why terminate the seller’s 401(k) plan prior to acquisition?
In my experience, when a 401(k) plan sponsor buys another company with a 401(k) plan, they most often merge the seller’s plan into their own to grow plan assets and/or reduce the disruption to new employees. However, there are reasons why you might be better off terminating the seller’s 401(k) plan when possible. These reasons include:
- The seller’s 401(k) plan includes “protected benefits” you don’t want to assume. While some protected benefits can be eliminated after a period of time (e.g., safe harbor contributions), others must be retained forever (e.g., liberal vesting terms or in-service distribution options).
- The seller’s 401(k) plan includes uncorrected defects that you don’t want corrupting your plan. These defects become your plan’s problem once a merger occurs, making your plan vulnerable to IRS disqualification.
- You want to treat the seller’s employees as new employees for purposes of your 401(k) plan. When you purchase a company in an asset sale, your plan is only required to credit employee service with the seller for eligibility and vesting purposes when a merger occurs.
Even when a seller’s 401(k) plan is terminated, your plan can still credit employee service with the seller. You just need to explicitly credit that service in your plan document.
Good news! You have time to merge a 401(k) plan post-sale
When you decide to merge an acquisition’s 401(k) plan into your own, you have time to make that happen. IRS nondiscrimination rules include special transition relief for 401(k) plan sponsors that buy another company with a 401(k) plan. They allow you to test the two 401(k) plans separately for nondiscrimination until the last day of the plan year following the year of acquisition.
This extra time is helpful when an acquisition’s 401(k) plan includes protected benefits that can’t be eliminated until some future date – like safe harbor contributions.
Simple planning is the key to staying out of trouble!
When you’re planning a company acquisition, there is a lot to consider. However, overlooking the seller’s 401(k) plan can be a costly mistake. While you’re most likely to merge it into your 401(k) plan, you may want the seller’s plan terminated instead due to costly protected benefits, plan defects or how you want the seller’s employees treated by your 401(k) plan.
The good news? Developing a strategy for an acquisition’s 401(k) plan is usually straight-forward. Need help? An experienced 401(k) provider has probably helped hundreds of 401(k) sponsors make this decision.