Article – The Elusive IRC Section 410(b)(6) Transition Rule

Publication:      401(k) Advisor

Volume/Issue:  Volume 24, No. 7, July 2017

The Elusive IRC Section 410(b)(6) Transition Rule

Ilene H. Ferenczy, Esq.

One of the most confusing parts of working with retirement plans occurs when the plan sponsor buys another company.  The issues that arise in this context can (and do) provide grist for entire textbooks and treatises.  This article will review one aspect of the rules relating to transactions, which is commonly the key to a successful handling of benefits matters in M&A, and is also commonly misunderstood:  the IRC §410(b)(6) Transition Rule (“T-Rule”).  If this rule is not applied correctly, terrible things can result that can cost the buyer significantly.  So, let’s demystify the rule.

The Set-Up

 When one company acquires another or a company owner acquires another company, the two companies generally will become a controlled group.  This means that, for coverage and nondiscrimination purposes, the two companies are treated as one entity that employs everyone who works within the group.

Not all plans cover all employees of a controlled group.  The plan may be written to provide that only companies that affirmatively adopt the plan will participate.  In that case, the employees of the entity or division or location or whatever the uncovered group represents will be considered to be “nonbenefitting employees” for the IRC §410(b) coverage testing.  Under this test, you determine a coverage fraction equal to the number of highly compensated employees (HCEs) who are allowed to participate in the plan, divided by total HCEs in the company; a coverage fraction for the nonhighly compensated employees (NHCEs); and compare the two fractions.  The NHCE coverage fraction cannot be less than 70 percent of the HCE coverage fraction.  Because the uncovered group does not benefit under the plan, the fraction for at least the NHCEs will be less than 100 percent.  If it is less than 70 percent, a coverage problem may arise.

The day after the acquisition, therefore, the coverage issue raises its head.  If the Buyer’s plan does not cover the acquired group, there is some chance that the acquisition in and of itself can disqualify the plan.

To avoid this result, Congress gave us the T-Rule.  Under this rule, if the plan’s terms are such that the plan would not pass coverage testing as a result of the acquisition, the plan is given a transition period.  During that period, the plan does not need to test coverage; it is deemed to pass. This gives the Buyer time to assimilate the acquired entity into its organization and decide what it needs to do to keep the plan operating properly.

The transition period runs from the date of the transaction until the last day of the plan year following the year of the transaction.  For example, if an employer with a calendar year plan acquires another entity in June 2017, the transition period would run through December 31, 2018.  The Buyer would need to do whatever was necessary before the end of that period to make sure that the plan would comply with the coverage rules in 2019.  In the meantime, the plan can be administered as it is written, even though it would normally fail coverage.

Everything is Fine Until Someone Loses an Eye … or Wants to Amend the Plan

Easy Peasy?  Apparently so, but there are, of course, complications.  This is ERISA, after all!

Probably the most common issue arises when the plan does not treat the acquired group the way the plan sponsor wants it to.  Remember, the plan must operate according to its terms.  So, if the plan does not exclude the acquired group, the employees of the new subsidiary or sister company must enter the plan when they become eligible.  Remember:  the T-Rule does not allow you to ignore the plan’s terms; it simply allows the plan to operate as it is written during the transition period, even if those operations normally fail coverage.

So, the Buyer hears that its plan includes the acquired employees.  “No problema,” says the HR Director, who is clearly channeling Arnold Schwarzenegger.  “We will just amend the plan to exclude the acquired company’s employees.”  Ah, not so fast, Kemosabe.

There is another part to the T-Rule that provides that, if you amend the plan during the transition period, you terminate the transition period early and must comply with IRC §410(b) as of the amendment.

So, suppose the Buyer wanted to exclude the acquired subsidiary’s (Sub) employees through the transition period, but, realizes after the transaction that the plan has immediate eligibility and no exclusions.  Because Sub’s employees enter under the plan’s terms, the transition period does not keep them out.  If Buyer amends its plan to exclude Sub’s employees, that terminates the transition period, so the plan must meet coverage at that time.  No T-Rule for you.  Of course, if coverage testing is passed, all is fine.  But, if it doesn’t, Buyer is in a fix.

You Have to Plan For Success

The solution is simple, but it takes foresight.  Because only amendments during the transition period terminate the period, you must amend the plan before the transition period begins—that is, before the transaction occurs.  If Buyer had amended the plan the day before it acquired Sub to cover only Buyer employees, the transition period would not be disrupted with a plan amendment, and the T-Rule can carry Buyer’s plan through the end of the period without worrying about coverage.

How do you get clients to let you know that an acquisition is pending so that you can plan for success?  Remind them at the beginning of your relationship, and whenever you can after that, to contact you before buying or selling businesses.  As you can see, knowing about these things in advance opens up many more options than you have after the acquisition occurs.  If you tell your client this before it acquires a company, perhaps that little voice in your client’s ear will speak up when a transaction actually arises.

There is more to this T-Rule, which we will discuss in our next column.  But the concepts discussed above get you a good part of the way toward the goal of understanding the T-Rule and helping your clients.