VideoAs benefits managers know, it's not easy to keep a 401(k) plan in compliance with every one of the Internal Revenue Service's rules. But that difficulty is compounded when mergers and acquisitions are involved. Dealing with an acquired company's plan--preserving it, merging it with one's own plan, or terminating it--is fraught with regulatory and operational pitfalls. Like Forrest Gump's box of chocolates, you never know what you'll get with a 401(k).
Ask Maureen Phillips. As managing director at Putnam Investments, in Boston, Phillips observed a particularly ugly situation three years ago, when a large manufacturing company was acquiring a small niche player in the industry. In the small company's plan, the buyer discovered not only that a loan had been made to acquire real estate--a generally unsuitable investment for a 401(k)--but that the loan had been made to the company's outside counsel, who also happened to be the brother-in-law of the plan's trustee. Such "parties-in-interest" are strictly prohibited from benefiting from a plan. To add insult to injury, the party-in-interest was bankrupt.
This was an "illiquid, illegal, and insolvent investment," says Phillips. In order to resolve the situation, the large company had to pay back the loan out of pocket, as well as pay fines assessed by the Department of Labor. Only then was it able to merge the smaller plan into its own.
The manufacturer was fortunate to uncover the loan. A company that merges a tainted 401(k) into its own plan may pay a stiff price for the oversight. If the acquiring company doesn't detect the problem and file a Voluntary Compliance Resolution, its 401(k) could be disqualified by the IRS. Not only would the company lose the tax deduction on the contributions it had made to the plan, but all the earnings in the trust could immediately become taxable.
Unfortunately, this scenario could be in store for a lot of companies. Last year a record 10,700 mergers and acquisitions, valued at $919 billion, were made in the United States, and the M&A pace shows no sign of abating in 1998. Many of those acquired companies will have faulty 401(k) plans; no doubt more than a few will slip unnoticed through the due diligence process.
TAINTED GOODS Merging a tainted plan into an otherwise pristine plan is the most common pitfall for companies involved in mergers and acquisitions. Buying a tainted 401(k) is not hard to do and usually doesn't involve fraud or negligence on the part of the plan sponsor. Tainting can arise from many sources, such as failure to comply with antidiscrimination rules designed to insure all participants in a plan are treated fairly, failure to make proper and timely filings with the IRS or the DOL, or the inclusion of prohibited transactions and inappropriate investments.
Failure to administer a plan in accordance with the plan document--the legal foundation on which the plan is built--is another compliance problem that can result in the disqualification of a plan. Illinois Tool Works Inc., a diversified manufacturer of everything from screws to auto components, in Glen View, Illinois, brushed up against such a situation a few years ago in the process of acquiring a midsized manufacturing company. The company's plan checked out in the due diligence phase. But almost two years later, Illinois Tool Works found a discrepancy in how the plan was administered while it was reviewing the operations of the plan, in preparation for merging it with its own.
Although the plan's documents said anyone who had worked at the company 1,000 hours in a given year was entitled to a profit-sharing contribution, in practice the company was making such contributions only to people who were employed at year-end, recalls Daniel Madden, manager of retirement programs at Illinois Tool Works. "What happens [in such cases] is that the lawyers prepare the plan document, but the administrators don't read it," notes Madden.
In the end, Illinois Tool Works filed a Voluntary Compliance Resolution with the IRS. The cost of fixing the problem: $350,000.
PROTECTED BENEFITS
Another potential 401(k) pitfall for companies involved in acquisitions is failing to maintain protected benefits, rights, and features. Protected benefits include vesting schedules and distribution op-tions, such as the timing, amounts, and methods of paying out benefits. If plan ABC has a longer vesting schedule than acquired plan XYZ, the latter plan's more beneficial vesting schedule cannot be eliminated, says Phillips. By the same token, if participants have options for joint and survivor annuities (in which the annuity extends to the surviving spouse) or lump-sum distributions, those distribution options cannot be eliminated.
By contrast, loans, hardship withdrawals, and company matches are generally not protected, according to Phillips. Yet, firms often retain these features to maintain good relations with newly acquired employees.
PREMATURE DISTRIBUTIONS
Another common source of mistakes is distributions. Participants are allowed to take money out of the plan only in certain instances: retirement, separation of service, hardship (which is subject to stiff taxation and penalty), and plan termination. Many companies believe that because they are acquiring another company, they can simply terminate the other company's plan and move the assets over to their own (see "Terminate, Merge, or Preserve?" below). However, terminations are neither simple nor automatic, points out Phillips. For example, if a company sells only a division to another company, and an employee of the former company is now happily ensconced at the new company doing substantially the same job, that is not considered a separation of service, and a distribution would not be allowed.
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