When a company is considering an acquisition of an entity, the plan sponsor must scrutinize when acquired employees in that company will participate in the employee stock ownership plan (ESOP). For various reasons, the plan sponsor, i.e., the buyer, may wish to delay the entry of the acquired employees or may even consider excluding the new group of employees for a period of time. Understanding the nuances of ESOP coverage testing is crucial as companies navigate acquisitions and plan for employee participation in an ESOP.
Knowing when the acquired employees are eligible for participation is important not only for record-keeping purposes, but also for the plan’s annual ERISA coverage test, i.e., the Internal Revenue Code (IRC) Section 410(b) test. As a refresher, the coverage test compares 1) the number of highly compensated employees (HCEs) benefiting under the plan divided by the total number of HCEs in the company and 2) the number of non-highly compensated employees (NHCEs) benefiting under the plan divided by the total number of NHCEs. The NHCEs’ coverage fraction cannot be less than 70% of the HCE coverage fraction to avoid a coverage test failure.
Based on the ESOP’s plan provisions, it could be possible that the newly acquired employees cause the coverage test to fail as soon as the ink dries on the closing documents. Fortunately, the IRC provides for a transition rule, IRC 410(b)(6), to specifically address the coverage test issues that may be encountered during a merger or acquisition.
Transition Rule Guidance
During the transition period, the plan does not need to test for coverage. It is deemed to pass. This allows time for the new entity to be acclimated to the organization and for the buyer to decide how to operate the plan going forward.
The transition rule doesn’t mean the plan’s provisions can be ignored; it allows the plan to operate as written during the transition period, even if those operations would cause the coverage test to fail.
The transition period begins with the transaction date and concludes at the end of the plan year following the year the transaction occurred.
Example: An acquisition occurs on September 15, 2024. The transition period is from September 15, 2024, to December 31, 2025 (assuming a calendar year-end plan). The plan would need to be amended/changed to satisfy coverage rules for the year beginning January 1, 2026.
The qualifications to rely on IRC 410(b)(6) relief include:
- The ESOP/plan must have successfully passed the coverage test immediately prior to the acquisition/disposition.
- There can be no substantial change in the plan or the plan’s coverage other than the acquisition or disposition itself during the transition period. This would most likely mean no plan amendments.
Example: Let’s assume that ABC’s ESOP allows participation after 30 days of service. If ABC Company is considering an acquisition and would like to delay the entry for the acquired firm’s employees, then the plan document should be amended before the acquisition to exclude the employees of the acquired firm. If the ESOP document were to be amended the day after the acquisition, then the transition rule would no longer apply due to a significant change in the plan.
Following the transition period, some sort of action would be required, presumably a plan amendment, to extend plan participation to the employees of the acquired firm to the extent the plan can satisfy the annual coverage test.
Lastly, each qualified plan is treated separately. Let’s say ABC Company sponsors both a 401(k) plan and an ESOP. If, for some reason, the transition period is terminated for the 401(k) plan, such termination has no impact on the ESOP’s transition period. The ESOP can remain compliant with the transition rule even if the 401(k) plan does not.
When contemplating a merger or acquisition, it’s important to coordinate with your ERISA legal counsel and ESOP record-keeper to help enable a smooth transition. If you have any questions or need assistance, please reach out to our ESOP team at Forvis Mazars.
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