How to Keep Employee Benefits on Track Through a Merger or Acquisition

By Gail Reich

Mergers and acquisitions continue to be big business today. The healthy economy, changes in government regulation, technological evolution and the forces of globalization are feeding the merger and acquisition frenzy. Not surprisingly, in an effort to develop a competitive edge, mergers and acquisitions have become the favorite growth strategy for many law firms. The kinds of consolidation and economies of scale that are characteristic of current-day business mentality are finding their way into the legal professionals' vision of full-service law firms for the next generation of the practice of law.

In this era of merger mania, however, attorneys often fail to give a merger or acquisition decision the proper amount of upfront attention that it deserves, particularly with respect to employee benefits issues. It is not unusual for the law firms involved in a merger to give little or no thought to the effect that the business transaction has on the qualified and nonqualified retirement plans that the firms sponsor—until it is too late. Acquisitions and mergers involve many employee benefits issues that, if left unaddressed up front, can either ruin a deal or create untold problems after the deal is completed. Many of the unexpected and expensive complications can easily be avoided with proper planning and the appropriate preventive measures. The purpose of this article is to provide a sampling of retirement plan issues that can arise when two law firms merge, and steps that can be taken to substantially minimize or entirely eliminate the problems, paving the way for a smooth transition.

Due Diligence

Each type of employee benefit plan presents its own set of issues. The decisions whether to terminate a plan, merge two plans into one or become a successor employer/sponsor to an existing plan can be made only after sufficient information is gathered to allow your benefits professional to assess the consequences of each choice. A due diligence checklist should include the following for each plan involved: plan documents, amendments, summary plan descriptions, loan policy documents, IRS determination letters, administrative procedure documents, administration forms, IRS Form 5500 series for the last three years, the most recent participant allocation statements, the most recent summary annual report, historical plan contribution levels, actuarial valuations and Pension Benefit Guaranty Corporation (PBGC) filings for defined benefit plans, and detailed information regarding trust assets.

Plan Qualification

In most mergers or acquisitions, each firm will have one or more pension and profit-sharing plans that are intended to be qualified under Internal Revenue Code § 401(a). Regardless of the types of plans being maintained, significant tax advantages flow from the qualified status of the plans. If any of the plans that were thought to be qualified prove to have a defect, drastic tax consequences can follow. If the form of a document does not comply with extensive Code requirements, the plan is not administered according to its terms, or the plan favors highly compensated employees with respect to coverage, contributions or benefits, it is subject to disqualification. Particularly with smaller firms, which often maintain their plans without proper oversight by benefits professionals, myriad qualification issues and legal problems may be lurking in the plan documentation itself or in the manner in which the plan is being operated. Any one of these failures could cause the employees to become immediately subject to taxation on benefits not yet received, the employer to lose its tax deduction for contributions, and the trust to become subject to tax on its investment income.

Once a law firm acquires such a plan, it stands to suffer all these consequences, many of which are magnified if the defects are not discovered before the plan is merged into another plan. Identifying such defects will allow the responsible party to take appropriate action before the transaction is complete or allow the parties to take the expense of correction into account in formulating the terms of the agreement. The correction methods will vary. If an error has occurred within the last two plan years, the parties may be able to correct it without involving the IRS. Correcting a problem of longer duration may require submitting an application to the IRS under its Voluntary Compliance Resolution (VCR) Program or Walk-in Closing Agreement Program (CAP).

Defined Benefit Plans

If the firm being acquired has a defined benefit plan, you need to determine whether the plan has sufficient assets to cover accrued liabilities, whether proper actuarial assumptions were used to determine liabilities and whether assets have been assigned unrealistic value. It is important to take a close look at the actuarial assumptions that are being used, to find out whether a realistic determination has been made as to whether the plan is overfunded or underfunded. Actuarial assumptions that are too conservative or too aggressive can produce unreliable results. If plan assets are carried on the books at an unrealistic value, adjustments need to be made. While there are minimum funding standards under the Code that may have been met on a yearly basis, a defined benefit plan may not have sufficient assets to cover accrued liabilities, and the plan may very well be underfunded with respect to its termination liability, were the plan to terminate.

Since some firms are reluctant to take on the liability of a firm-funded pension plan, termination may be necessary in order to proceed with an acquisition. While some firms have already faced the necessity of dropping their pension plans to avoid nixing an acquisition, this scenario is on the rise. On the other hand, one firm's defined benefit plan may have surplus assets that, when merged into another firm's defined benefit plan that is underfunded, may result in a win-win situation. If the sum of the assets of both plans involved is not less than the sum of the present values of the accrued benefits of both plans, the assets of both the plans are combined and each participant's accrued benefits are preserved upon the combining of the two plans into one. If such a factual pattern exists, the benefits may outweigh the detriment, and the same reluctance may not be present.

Benefits, Rights and Features

No matter what types of plans are being maintained, participants in any plan that is being merged are entitled to have valuable benefits, rights and features of their plan maintained after the merger. Code § 411(d)(6) protects participants from the reduction or elimination of protected benefits upon plan mergers and transfers. Protected benefits include accrued benefits, early retirement benefits, retirement-type subsidies and optional forms of benefit. Features of distribution options that are subject to protection include payment schedules, timing of payment, commencement of benefits, type of distributions (in cash, in-kind), and election rights with respect to optional forms of distributions.

Under a special testing rule in Treasury Regulation § 1.401(a)(4)-4(d)(1)(i), if these provisions are carried over to another plan, even though they benefit only some of the employees participating in the merged plan, there will be no discrimination problem for the acquisition year and for all later plan years, if certain requirements are satisfied. Thus, for example, if a firm that maintains a defined benefit plan that permits lump-sum distributions at retirement is acquired by a firm that has a defined benefit plan that does not permit lump-sum distributions, the merged plans can continue to allow lump-sum distributions to employees from the acquired firm and not to other employees. Under the special testing rule, the merged plan is treated as satisfying the nondiscriminatory availability requirements with respect to the lump-sum distribution option for the year of the acquisition and all later years. Nevertheless, if any of the rights, benefits or features that must be preserved are greater than those being provided to the existing employees of the acquiring firm, employee relations problems often ensue. To prevent any resentment arising among the combined workforce, many firms solve this problem by providing the more generous of the conflicting provisions for each issue that arises.

401(k) Plans

The most common plan being maintained today is a 401(k) plan, and it is very likely that both firms will be sponsoring such a plan. One of the unique issues presented by 401(k) plans that needs to be addressed involves a plan fiduciary's duty with respect to the designated investment options made available to participants to invest their individual accounts. ERISA establishes a level of oversight that is required with respect to the fiduciary responsibility of the plan sponsor for selecting investment alternatives and monitoring performance. These standards, however, are not always met. A firm acquiring or merging with another firm whose plan is not in compliance subjects itself to a suit by a disgruntled participant who suffered investment losses.

To avoid this type of risk, an acquiring firm may choose to have the target firm terminate its plan prior to merger or acquisition. With respect to such a termination, participants anticipate distributions. However, this presents its own set of problems, since 401(k) plans generally can make distributions only on a participant's death, disability, hardship, attainment of age 59 or severance from service. Whether a severance from service results from a merger or acquisition depends on the particular set of circumstances. In certain instances, the application of the so-called same desk rule prevents the employees performing the same functions before and after the transaction from receiving a distribution, because they have not incurred a severance from service for plan purposes. Therefore, the plan could be terminated, but distributions could not be made.

The same desk rule, however, has statutory in Code § 401(k)(10), one of which allows corporate entities selling at least 85 percent of their assets to another corporate entity to make lump-sum distributions upon plan termination. A new exception just issued by the IRS in Revenue Ruling 2000-17 allows any entity that sells less than 85 percent of its assets to another entity to avoid the same desk rule. If the transaction is structured adequately to avoid the same desk rule, the plan may be terminated and distributions made to the participants before the merger or acquisition occurs. If the plan termination, however, is not accomplished until after the merger or acquisition, the acquiring firm will be considered the sponsor at the time of plan termination, making it impossible to rely on severance from service as a triggering event to justify distribution.

Rollovers

If the 401(k) plan is properly terminated before the transition and distributions are made, the next issue is whether the distributions from the terminated plan should be accepted as rollovers into the existing plan of the acquiring firm. One concern is that the terminated plan might have suffered a disqualifying defect, and any plan that accepts rollovers from a plan that is not qualified runs the risk of being disqualified as well. However, so long as the plan sponsor secures appropriate assurances from the sponsor of the distributing plan as to its qualified status, it has protected the qualified status of the receiving plan. In any event, it would be prudent to seek an IRS determination with respect to the qualified status of the terminated plan up to the date of termination, to avoid any concerns.

If rollovers are permitted, substantial increase of assets in the recipient plan can affect the plan positively or negatively with respect to top-heavy rules (rules that protect non-highly compensated individuals when a plan unduly favors key employees) and other matters, depending on the particular makeup of the plan. One benefit that can result from an increase in plan assets is a smaller percentage of trust assets being charged by providers as fees for services rendered, and the availability of additional investment options.

Participant Loans

Many participants may have outstanding loans at the time of a 401(k) plan termination. Any outstanding loans that exist may be accepted as part of the rollover if the distribution otherwise meets the requirements for an eligible rollover, and the plan provisions and loan terms allow for the rollover. Each participant with a loan being rolled over should execute an acknowledgment that the acquiring law firm will be substituted as the obligee on the loans. A transfer of a note, which is part of an eligible rollover distribution, will not be considered a renegotiation or revision of the loan, since the substantive terms do not change. While the loan must be repaid within its original term, the repayment schedule can be revised to accommodate the acquiring law firm's payroll process without causing any tax consequences. (See Private Letter Ruling 9729042 and Code §§ 72(p) and 402(a)).

Rollovers of participant loans, however, may not always be possible. Many times, a loan agreement will provide that on termination of employment, a participant's outstanding loan balance becomes immediately due and payable, and, if not paid off, the participant's account balance is offset to satisfy the outstanding amount. If such a provision exists, or if the recipient plan does not allow for rollover of outstanding loans, a technique that is sometimes used is to have the acquiring law firm provide a bridge loan. The employee uses the bridge loan to pay back the outstanding balance to the terminating plan, and, upon entry into the new employer's plan, the employee takes a loan from the plan to pay back the bridge loan.

Nonqualified Plans

Finally, executive nonqualified supplemental retirement plans deserve attention. Since these plans are not qualified, they must remain "unfunded" to retain favorable tax treatment. Pared down to basics, an unfunded plan is simply an unsecured promise by the employer to pay future benefits out of its general assets. In many law firm mergers, unfunded retirement obligations have become a key factor in the success or demise of the transaction, especially where one law firm maintains one or more such plans, and the other law firm has none. As popular and beneficial as these types of plans may be, they are often viewed as an impediment to a merger. A related problem lurking in the wings is the not-so-uncommon practice of employers making informal, inadequately documented promises of deferred compensation to its key employees. Once an employee performs in reliance on such a promise, a unilateral contract, on which the employee has a right to collect, is created. Again, a thorough and creative due diligence effort can uncover even those types of arrangements so that all parties concerned are on the same page with respect to potential liabilities.

To the extent that employee benefits issues and sources of liability can be identified at the outset, better decisions can be made as whether to proceed with the transaction; whether to terminate, merge or acquire any given plan; and how to allocate responsibilities among the parties for handling potential liabilities.

© 2000 NLP IP Company. This article is reprinted with permission from the June 2000 Law Firm Partnership & Benefits Report, Volume 6, Number 5.

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