Mergers, Acquisitions, Dispositions, and Spinoffs can Affect a Plan’s Minimum Coverage Obligations and Testing
By Kristoffer Aas, QKA, EdM
When a business is acquired or sold, the employer’s business structure may change (e.g., a sole proprietorship may become a corporation); the employer may join or leave a controlled or affiliated service group; or the employer may change for one or more individuals. Such business transactions could affect many aspects of the business’s qualified retirement plan—such as employee demographics and compliance testing, including the Internal Revenue Code Section (IRC Sec.) 410(b) minimum coverage test.
It’s important to note that additional IRS guidance is needed to address certain issues regarding these types of business transactions. For example, Treasury Regulation 1.401(k)-5 was historically earmarked to provide additional guidance on the special rules for these events. But for years the Treasury Regulation simply reflected “Reserved” (pending more guidance). More recently, the SECURE 2.0 Act amended this Treasury Regulation in order to reflect rules for long-term, part-time employees. Following that amendment, it is unknown if or when the IRS will provide more guidance on the special rules relating to mergers, acquisitions, and similar events.
What is the minimum coverage test?
The minimum coverage test ensures that highly compensated employees (HCEs) do not disproportionately benefit from the plan in relation to non-highly compensated employees (nonHCEs). If the plan is a 401(k) plan, the employer is required to disaggregate the 401(k) elective deferrals, 401(m) matching and after-tax contributions, and 401(a) nonmatching employer contributions for purposes of testing coverage. Therefore, a 401(k) plan may consist of up to three plans for coverage testing. To satisfy the coverage test for a plan year, the plan sponsor must pass either the ratio percentage test or the average benefit test.
The plan will pass the ratio percentage test if at least 70 percent of the nonHCEs are covered by the plan compared to the percentage of HCEs that are covered. The average benefits test is more complex than the ratio percentage test. The average benefits test is satisfied if the plan passes the nondiscrimination classification test and the average benefit percentage test (which is beyond the scope of this article).
Does the plan’s definition of employer need to be amended?
Amendments to the plan’s definition of employer may need to be made before the business transaction takes place in order to ensure that employees are properly included or excluded. Many document providers also offer a class exclusion of employees resulting from a transaction described in IRC Sec. 410(b)(6)(C) that applies during a special transition period (discussed later). If an elective provision is not available in the plan’s adoption agreement, a default provision may be referenced in the plan’s basic plan document (BPD). IRC Sec. 410(b) minimum coverage testing is generally deemed to pass while excluding these employees during the special transition period.
What kind of relief does IRC Sec. 410(b)(6)(C) provide?
IRC Sec. 410(b)(6)(C) provides plan sponsors additional time to evaluate employee demographic changes and weigh critical plan design options by deeming to satisfy coverage without altering the employees or employee groups included in coverage testing for any plan affected by the business transaction during a special transition period, if certain criteria are met.
A plan must have satisfied the minimum coverage test immediately before the change in employer or related group.
There must be no significant changes in the plan’s coverage or plan design during the special transition period, other than the change in employer or related group as a result of the business transaction.
While limited guidance defines “significant change,” the conservative approach is to amend the plan document before the transaction date. Otherwise, an amendment during the special transition period may need to be accompanied by a proactive strategy to pass coverage.
NOTE: If a plan sponsor needs to restate its document during a special transition period, the IRS has informally stated that it should keep all active provisions the same and simply move the plan to the new document.
Example: Amending to exclude a bona fide business classification during the special transition period may violate the “no significant change” rule because it is not directly related to the business transaction potentially resulting in the plan being amended to no longer be able to rely on the transitional relief. But, amending to add an age and service waiver for acquired employees is generally accepted because it is directly related to the business transaction and is only affecting the acquired employees.
What is the special transition period?
The special transition period begins on the date that there is a change in employer or in members of the group and ends on the last day of the first plan year beginning after the date of the change. This special transition period is optional: if elected, the plan sponsor is not required to use the entire period. Any changes to plan benefits during the period might be interpreted as making a significant change which, as of the date of the later change, may curtail the special transition period for that plan. That said, it will not retroactively invalidate the reliance on the special transition period up until that point.
NOTE: IRC Sec. 410(b)(6)(C) does not provide relief from other applicable nondiscrimination tests, including the 401(a)(4) general nondiscrimination test and the ADP/ACP tests, so these tests must be satisfied during the special transition period.
Example: On April 1, 2024, employer A purchases employer B, making employer B a wholly-owned subsidiary of employer A. Employer A’s calendar-year 401(k) plan satisfies coverage on the transaction date.
Can employer A’s plan receive coverage relief by taking advantage of the special transition period?
Yes, the special transition period starts April 1, 2024, and ends December 31, 2025. Assuming that employer A’s plan does not make any significant changes in its coverage or plan design unrelated to the transaction, the plan may receive coverage relief during the entire special transition period. During this period there will be no requirement to perform coverage testing reflecting changes in employee demographics.
NOTE: If employer B’s employees are not eligible for employer A’s plan in the first plan year after the special transition period, employer A’s plan can fail coverage testing because the two employers are in the same controlled group, meaning employer B’s employees are included as not benefitting in employer A’s plan’s coverage testing.
Following the same fact-pattern as above, what if employer B also has a calendar-year plan that existed before, and will be separately maintained after the special transition period?
Employer B can also take advantage of the special transition period as long as it also follows the aforementioned rules, and each plan properly excludes the employees of the other employer. The two plans will have to include the other plan’s employees for coverage testing in the 2026 plan year.
Employer A’s plan must include employer B’s employees as not benefiting.
Employer B’s plan must include employer A’s employees as not benefiting.
Following the special transition period, if the plans pass separately, each employer can continue to test nondiscrimination separately. If the plans don’t pass, employer A and employer B must permissively aggregate for nondiscrimination testing (though this requires that both plans have the same plan year because two plans with different plan years have different special transition periods). Also, if the plans are subject to ADP/ACP testing, in addition to having the same plan year-end, the plans
must elect the same testing method (prior vs. current year); and
may not permissively aggregate a nonsafe harbor cash or deferred arrangement (CODA) with a plan that has adopted safe harbor CODA.
If both plans are permissively aggregated and have adopted a safe harbor CODA, the plans must generally satisfy the mandatory safe harbor contribution the same way. If they don’t satisfy it in the same way, no HCE may receive a more favorable safe harbor contribution than any other nonHCE when combined as a permissively aggregated plan.
What if employer B’s plan fails coverage immediately before the transaction date or as a result of a significant change in coverage during the special transition period?
IRC Sec. 410(b)(6)(C) applies to each plan separately, so if employer B’s plan fails to qualify, employer A’s plan is not affected as long as it remains compliant. But this means that employer B’s plan does not have a special transition period following the transaction date nor can it retain transitional relief following the date of the significant change. Therefore, employer B must pass coverage testing while including employer A’s employees.
How do the child attribution rules affect controlled groups and affiliated service groups?
IRC Sec. 1563 and Treas. Reg. 1.414(c)-4 set the rules for ownership attribution: this includes child attribution in controlled groups and affiliated service groups and the determination of HCEs and key employees. Before Section 315 of SECURE 2.0 became effective, two applications of these regulations could result in a controlled group or affiliated service group, even if a spousal exception applied: (i) when a married couple, each with their own business, lived in a community property state; and (ii) when a married couple, each with their own business, shared a minor child (younger than age 21).
Typically, community property state law required a spouse (with few exceptions) to be treated as having ownership in the other spouse's business; thereby, creating a controlled group relationship. Beginning with the 2024 plan year, the community property state laws are disregarded if a spousal exception exists.
If a married couple (not living in a community property state) shared a minor child (again, younger than age 21), that child would receive ownership attribution from each of her parents; thereby, creating a controlled group relationship. Beginning with the 2024 plan year, where the spousal exception is applicable, the minor child attribution no longer applies.
If applying these rules results in having two or more entities being treated 1) as part of a controlled group, or 2) as no longer being part of a controlled group or affiliated service group, then the change would be treated as a transaction that is eligible for IRC Sec. 410(b)(6)(C) transitional relief. As before, the plans would generally be deemed to have satisfied IRC Sec. 410(b) coverage testing during the special transition period, which may end as late as the plan year following the year in which the change in the related employer relationship occurs (i.e., the end of the 2025 plan year).
