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Certainly I have some factual questions about this arrangement, but it clearly doesn't pass the smell test. Although the questions about FICA/SUTA, compensations, etc., are valid, it seems that the first question is whether the individual is actually eligible to participate in a DCAP. There seems to be some doubt about that. To participate in any tax-favored benefit plan, the individual must first be an employee. Owners or partners may or may not be employees. If they are determined to be employees, they must also be eligible to participate in the plan. However, an employee must also be eligible to participate a tax-favored benefit plan, and based on the facts described, these individuals aren't eligible to contribute to a DCAP. IRC sec. 129 "Dependent care assistance programs" (DCAP) provides the rules for this program. The purpose of the DCAP is to exclude from gross income amounts for dependent care with respect to dependent care services not exceeding $5,000. IRC 129(a)(2)(A). Dependent care and dependent care services are defined in IRC sec. 21 "Expenses for household and dependent care services necessary for gainful employment." Dependent care is limited 1) to qualifying individuals; so that 2) the employee may have gainful employment. An individual who doesn't satisfy these 2 elements isn't eligible for the exclusion and, therefore, participation in a DCAP. A generic cafeteria plan doc that we use states: Dependent care expenses are defined as expenses incurred for the care of a qualifying individual. A qualifying individual is either: (i) a dependent who is under age 13, or (ii) the Participant's spouse or dependent who lives with the Participant and is physically or mentally incapable of caring for himself/herself. However, these expenses are dependent care expenses only if they allow the Participant to be gainfully employed. Next, the right to an exclusion from gross income doesn't actually accrue until expenses for dependent care are paid or incurred. IRC 129(a)(2)(A). If the individuals do not pay for dependent care services, they cannot make a claim for the exclusion. The COVID crisis illustrated this principle. Families who were at home didn't incur expenses, so, through their no fault of their own, were in danger of forfeiting amounts already contributed to their DCAP. In addition to potential forfeiture, IRC 129(a)(2)(B) requires that amounts that exceed the amounts actually used must be included in gross income in the taxable year in which the dependent care services were provided. The Code slaps the hand reaching into the cookie jar for a second (or third) cookie. The worst case scenario is that the plan appears to have intentionally allowed ineligible individuals to participate and could be disallowed because of the employer's bad faith and lack of compliance. Disqualification could be retroactive for the period that these ineligible employees contributed to the DCAP. All funds contributed would then be subject to taxation. Because these individuals weren't ever eligible to participate in the plan, it's possible that the plan could refund the amounts contributed. However, if the terms of the plan require forfeiture, it's also possible that the funds would be forfeited. Either way the amount of the contributions must be included in the employee's gross income for the tax year in which the contributions were made. Because most tax-plans don't reconcile until after the end of the tax year, the employer would have to send the employee an amended W-2 (or other applicable doc) to account for the excess. If an employee has already filed their Form 1040, they must then file an amended return. If taxes aren't paid on excess contributions for that tax year, the taxpayer and/or the plan administrator may be subject to stiff excise taxes. This type of process applies to any number of tax-favored employee benefit programs, such as HSAs, 401(k)s, IRAs, SARSEPs, etc. As for the FSA, I'd apply the same analysis. So long as the individuals are employees and eligible to participate in the FSA, they can contribute up to the maximum amount. There is a broad range of medical expenses for which their FSA funds could be used, so the blatant abuse of the statute isn't readily apparent. If they don't use their FSA contribution, it's forfeited.

https://www.irs.gov/retirement-plans/employee-plans-compliance-unit-epcu This link shows a few “compliance check” initiatives that the IRS states they have in place. Partial Plan Termination is listed 3rd from the bottom (in alphabetical order). A compliance check is when they send a letter to the employer and say something like “We’re not auditing you if you answer these questions in the right way to avoid an audit. But, if you fail to reply or answer, we will very likely audit. And, if you answer in a noncompliant way, we will ask you to prove that you fixed the problem, otherwise we will audit.”

Employers can exclude from FICA amounts where "its is reasonable to believe" that the employee will be able to exclude the payment or benefit under §129. In this case, there's a good argument the employer does not have that reasonable belief given it is clear the employees have no eligible eligible dependents (and therefore no qualifying expenses) for the dependent care FSA contributions. IRC §3121: (a) Wages. For purposes of this chapter, the term “wages” means all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash; except that such term shall not include— ... (18) any payment made, or benefit furnished, to or for the benefit of an employee if at the time of such payment or such furnishing it is reasonable to believe that the employee will be able to exclude such payment or benefit from income under section 127, 129, 134(b)(4), or 134(b)(5);

They bought the stock so Plan B is now a plan of Company A with all its history and Company A now has two 401(k) Plans at the same time. To have allowed distributions to Participants in Plan B the Plan would have needed to be terminated prior to to the sale on July 15. Typically you need to make safe harbor contribution up to 30 days after you notice participants but you may qualify for a shorter period as part of bonified business transaction.

They must merge. The successor plan rule prevents company A (which is now the sponsor of two plans) from terminating the B plan while continuing to maintain the A plan. If company B had terminated their plan before the merger, it would not have been an issue, but it is now too late.

The letter did not demand anything. It said specifically that it was not an audit or a compliance check, and that no reply was needed. It did say that the sponsor "may need to take certain actions based on the information provided." The second page, which described the rules around partial terminations, also gave info about how to make a correction using self-correction or VCP, and how to correct the 5500.

First things first - we have thankfully not encountered this. I suppose the IRS could be fishing - the "applicable period" for turnover CAN be longer than one year if there is a series of related events/terminations. There has been some litigation in this arena, including Matz, but I haven't followed all the back and forth for a while. I believe there have been other cases as well. I'm REALLY hoping your situation is an anomaly, and that the IRS hasn't started some @$**%$ "initiative" or test in this arena.

You're a very optimistic man, John.