CLOSING THE DEAL IRONING OUT PENSION PLAN ISSUES DURING A MERGER OR ACQUISITION.

MERGERS AND ACQUISITIONS represent a favorite growth strategy for many CPA firms. The consolidations and economies of scale that characterize today's business mentality are finding their way into the accounting profession's vision of full-service firms for the new century.

If your firm is contemplating an acquisition or merger, be aware that these transactions involve many employee benefit issues which, if not attended to up-front, can either ruin a deal or create untold problems after the deal is complete. When two firms merge, they need to decide whether to terminate one of the firm's benefit plans, merge two plans into one or become a successor employer/sponsor to an existing plan. Many of the unexpected and expensive complications surrounding employee benefit issues during a merger or acquisition can easily be avoided with proper planning and preventative measures.

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 IRC Sec. 401(a). If any of the plans that were thought to be qualified have a defect, drastic tax consequences can follow. For example, a plan could be disqualified if:

* the form of a document does not comply with extensive IRC requirements;

* the plan is not administered according to its terms; or

* the plan favors highly compensated employees with respect to coverage, contributions or benefits.

Smaller firms often maintain their plans without proper oversight by benefit professionals, and it is not uncommon to find myriad qualification issues and legal problems lurking in the plan documentation or in the manner in which the plan is operated. Any one of these failures could trigger a host of problems, such as: employees could become immediately subject to taxation on benefits not yet received, the firm could lose its tax deduction for contributions, or the trust could become subject to tax on its investment income.

Once a firm acquires a problematic plan, it stands to suffer all of these consequences, many of which are magnified if the plan is merged into another plan. Identifying such defects at the outset of a merger allows the responsible party to take appropriate action before the transaction is complete, or for the firms to account for the expense of correction when they formulate the agreement terms.

401(K) PLANS

The 401(k) is the most common plan maintained today. An issue unique to 401(k) plans is the fiduciary's duty with regard to the designated investment options that are available to plan participants. ERISA requires a certain level of fiduciary responsibility from the plan sponsor to select investment alternatives and monitor 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 lawsuit by a disgruntled participant who suffers investment losses.

To avoid this, the 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 only make distributions upon a participant's death, disability, hardship, attainment of age 59 or severance from service. Whether or not 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 employees who perform 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 exceptions in IRC Sec. 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 IRS exception is Revenue Ruling 2000-17, which allows an entity that sells less than 85 percent of its assets to another entity to avoid the same desk rule. If the transaction is structured to avoid the same desk rule, the plan may be terminated and distributions may be made to the participants before the merger or acquisition occurs. However, if the plan is not terminated until after the merger or acquisition, the acquiring firm will be considered the sponsor at the time of termination, making it impossible to rely on severance from service as a triggering event to justify distribution.

ROLLOVERS

If a 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 acquiring firm's existing plan. One concern is that if the terminated plan had a disqualifying defect, any plan that accepts its rollovers runs the risk of being disqualified as well. However, so long as the plan sponsor secures appropriate assurances from the distributing plan's sponsor about its qualified status, the receiving plan is protected. In any event, you should seek an IRS determination on the qualified status of the terminated plan up to the termination date.

If rollovers are permitted, a substantial increase of assets in the recipient plan can affect the plan positively or negatively with respect to top-heavy rules (rules that protect nonhighly compensated individuals when a plan unduly favors key employees) and other matters, depending on the plan's particular make-up. For example, one benefit that can result from increased plan assets is that a smaller percentage of trust assets will be charged provider fees for services rendered and there will be additional investment options available to participants.

PARTICIPANT LOANS

Many participants may have outstanding loans at the time of a 401(k) plan termination. Outstanding loans may be accepted as part of the rollover if the distribution otherwise meets the requirements for an eligible rollover, and if 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 firm will be substituted as the obligee on the loan. A transfer of a note, which is part of an eligible rollover distribution, will not be considered a loan renegotiation or revision 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 firm's payroll process without causing any tax consequences. [See Private Letter Ruling 9729042 and IRC Secs. 72(p) and 402(a).]

Rollovers of participant loans may not always be possible. Many times a loan agreement will provide that upon 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, the acquiring firm can 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.

DEFINED BENEFIT PLANS 

If the firm being acquired has a defined benefit plan, you need to determine whether or not:

* the plan has sufficient assets to cover accrued liabilities,

* proper actuarial assumptions were used to determine liabilities, and

* assets have been assigned realistic values.

Look closely at the actuarial assumptions to determine if the plan is overfunded or underfunded. Too conservative or aggressive actuarial assumptions can produce unreliable results. If plan assets are carried on the books at an unrealistic value, you need to make adjustments. For example, while a plan may have met the IRC's annual minimum funding requirements, a defined benefit plan may not have sufficient assets to cover accrued liabilities, and should the plan terminate, it may be underfunded with respect to its termination liability. Since some CPA firms are reluctant to take on the liability of a firm-funded pension plan, termination may be necessary to proceed with an acquisition.

The consequences of merger-defined benefit plans need not be detrimental. For instance, one firm's defined benefit plan may have surplus assets which, when merged into another firm's defined benefit plan that is underfunded, may result in a win-win situation. If the sum of both plans' assets is not less than the sum of the present values of the accrued benefits of both plans, the assets of both plans are combined and each participants's accrued benefits are preserved.

No matter what type of plan a firm uses, participants in any plan that is merged are entitled to have their plan's valuable benefits, rights, and features maintained post-merger. IRC Sec. 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 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.

When these protected benefits are carried over to another plan, they may benefit only some of the employees participating in the merged plan. Under a special testing rule in Treasury Regulation Sec. 1.401(a)(4)-4(d)(1)(i), 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 maintaining a defined benefit plan that permits lump-sum distributions at retirement is acquired by another 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 acquisition year and all later years.

Despite the regulatory safeguard, if any of the rights, benefits, or features that must be preserved are greater than those provided to the acquiring firm's existing employees, problems often develop. To prevent any resentment in the combined work force, many firms provide the more generous of the conflicting provisions for each issue that arises.

NON-QUALIFIED PLANS

Executive nonqualified supplemental retirement plans also 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 CPA firm mergers, unfunded retirement obligations have become a key factor in the success or demise of the transaction, especially when one firm maintains one or more such plans and the other accounting firm has none. As popular and beneficial as these types of plans may be, they can impede 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 their key employees. Once an employee performs in reliance on such a promise, a unilateral contract, upon which the employee has a right to collect, is created. However, a thorough and creative due diligence effort can uncover even those types of arrangements so that all parties are on the same page with respect to potential liabilities.

DUE DILIGENCE

In determining the outcome of each firm's benefit plan, it is necessary to gather sufficient information to assess the consequences of each choice. A due diligence checklist should include the following for each plan:

* 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,

* Most recent participant allocation statements,

* Most recent summary annual report,

* Historical plan contribution levels,

* Actuarial valuations and Pension Benefit Guarantee Corp. filings for defined benefit plans, and

* Detailed information regarding trust assets.

When employee benefit issues and sources of liability can be identified at the outset, firms can make better decisions such as whether or not 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.

Gail Surlin Reich is an associate with the Los Angeles-based law firm of Reish & Luftman, practicing exclusively in the area of employee benefits and executive compensation.