Strategic mergers and acquisitions are complex deals that have many moving parts, so it is not uncommon for certain areas to be overlooked. Often, one such area is employee benefit plans.
The U.S. Department of Labor (DOL) and the Internal Revenue Service (IRS) have specific guidance regarding Form 5500 filings and the audits of financial statements for plans. The Employee Retirement Income Security Act of 1974 (ERISA) states that “large plans” (defined as having 100 or more eligible participants at the beginning of a plan year) are subject to these filings and audits.
Tracking benefit-plan participants is relatively straightforward for a private small or medium-sized business. It becomes more challenging, however, when businesses are acquired or merged. Suddenly, the number of eligible employees can increase quickly, potentially triggering the reporting and audit threshold, depending on the substance of the transaction.
Even if these consequences are anticipated, there could be issues pertaining to record keeping. Plans for small employers that were designed to avoid being classified as large plans typically do not keep the same level and quality of records as those that know they will be audited every year. Gathering the support required for an audit can be a labor-intensive task, and not being able to do so can result in a modified audit opinion or a disclaimer of opinion, both of which will raise red flags with the DOL and IRS.
When business mergers and acquisitions occur, there can be mergers and terminations of the related plans. When two companies merge, each typically has at least one benefit plan. The businesses, known as plan sponsors, can either merge plans or continue operating them separately. When plans merge, the number of eligible participants increases. Here is a simple example: Plan A and Plan B are both 401(k)s, each with 75 eligible employees. Upon the effective date of the merger, there are now 150 eligible employees. The “new” plan would now be subject to the provisions of ERISA, and thus an audit and Form 5500 filing for the plan year beginning on the date of the merger.
If the plans remain separate and distinct, but the plan sponsors share the same owner or owners, then the IRS’s controlled group rules apply. These rules consider multiple plan sponsors with the same ownership to be a single employer for 401(k) nondiscrimination testing. Simply put, these tests verify that wage deferrals, employer matching and profit-sharing contributions do not discriminate in favor of highly compensated employees, including owners. These rules often obligate all members of a controlled group to cover employees with one single 401(k) plan. Failing these tests can result in a plan disqualification by the IRS and loss of tax-exempt status. Employee benefit plans hold their assets in tax-exempt trusts for the benefit of the plan’s participants (employees).
When tax-exempt status is lost, there are negative consequences to the participants, the employer and the trust holding the assets. Any vested employer contributions become taxable income upon loss of the tax status. Participants are unable to make rollover contributions to eligible plans as any distributions from a nonqualified plan are fully taxable. The employer cannot immediately deduct its contributions to the plan while it is nonqualified. Finally, the trust holding the assets becomes a taxable entity and will be subject to income tax on any earnings.
The DOL and IRS rules exist for the protection of employees. It is often best to consult with an ERISA attorney during any planning or due diligence phase of a transaction existing plans to ensure ongoing compliance with regulators.
Brian Weldin is an assurance manager with Macias Gini and O’Connell LLP and a member of the Pennsylvania Institute of CPAs’ employee benefits plan committee.