Acquisitions often occur for different reasons: Sometimes a company is looking to expand within its market sector; other times, a company is looking to expand outside of its traditional business operations for future growth and expansion.

For example, a small pharmaceutical research company might wish to purchase a manufacturing company in anticipation of eventually manufacturing a drug under development. Assume the company has a relatively rich 401(k) plan with a 6% profit-sharing contribution and a dollar-for-dollar matching contribution up to 6% (we'll call it the "research plan"), allowing it to better compete with larger companies for top talent. However, the manufacturing company might not have any profit-sharing benefits and may maintain a matching contribution equal to 25 cents for each dollar of employee savings up to 6%, providing for a maximum matching contribution of 1.5% of compensation (we'll call this the "manufacturing plan".)

In this environment, a holding company might own both the research and manufacturing entities through a recent acquisition. Thus, after the acquisition, the holding company maintains two separate legal entities with duplicative finance, sales and human resources departments and different benefit programs. In this context, the holding company must consider areas of the law in which these entities are treated as a single employer for employee benefit and other purposes.


Single-employer rule

All qualified retirement plans are subject to certain coverage, vesting, contribution and other limitations under the Internal Revenue Code. In applying these qualification requirements, Section 414 of the Code treats employees of two or more businesses under "common control" as being employed by a "single employer," regardless of whether one plan is maintained by all related entities or several different qualified retirement plans exist - unless such entities may be treated as separate lines of businesses (SLOBs). The rationale for SLOBs is to preclude employers from establishing several employee benefit plans for different companies, thereby permitting more favorable plans to be maintained for highly compensated employees.

After determining that a single-employer relationship exists, the most important rule to consider is that each qualified retirement plan satisfies Section 410(b) coverage rules. These rules generally require a qualified plan to cover 70% of all non-highly compensated employees or to satisfy a ratio percentage or benefit percentage test.

So, assume that the research company has 50 employees - 10 HCEs and 40 non-HCEs - and that the manufacturing company has 150 employees, including 10 HCEs and 140 non-HCEs. Under this structure, it would be impossible for the "research plan" to satisfy the 70% coverage test, since 70% of 150 non-HCEs is 105 employees. Therefore, the ratio percentage test is applied. The percentage of non-HCEs and HCEs who benefit under each plan is determined by dividing the number from each group who benefit under the plan by the total number of participants in each respective group. The result must equal 70% or more.

The ratio percentage test results in the following conclusions for the research plan:

40 ÷ 180 = 22.2% - non-HCE Percentage.

10 ÷ 20 = 50% - HCE Percentage.

22.2% (non-HCE) ÷ 50% (HCE) = 44.4%.

The Section 410 ratio percentage test is failed, as expected, due to the number of HCEs and non-HCEs in the manufacturing plan. For the manufacturing plan:

140 ÷ 180 = 77.8%.

10 ÷ 20 = 50%.

77.8% (non-HCE) ÷ 50% (HCE) = 155%.

Thus, the Section 410 ratio percentage test is passed. The research plan may only remain qualified if the average benefits test is satisfied, or if the research and manufacturing companies are classified as SLOBs.

Contributing Editor Frank Palmieri, CPA, JD, LL.M (Taxation), is a partner with the law firm of Palmieri & Eisenberg, with offices in Princeton, N.J. and Alexandria, Va. He is also a fellow in the American College of Employee Benefits Counsel.

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