Question 29: I have an employer (company A) that is acquiring 100% of the stock of company B. Company A has an existing 401(k) plan. It is his intent not to cover company B under the company A 401(k) Plan, but rather to start a separate plan for company B. Is this permissable and, if so, is it logical?

Answer: I'm glad you asked this question because it is a good illustration of one of the most commonly held misconceptions about controlled groups.

A and B are a parent-subsidiary controlled group. What are the consequences of that?

Many people would answer that A is required to cover B's employees under A's plan. That answer may be true in some circumstances. For example, if A has a standardized prototype document, indeed the employees of B would be covered. Of course, A could simply amend the plan to exclude those individuals and no longer have a standardized prototype, so let's assume that the plan document does not require A to cover the employees, and look at the requirements of the law itself.

The controlled group rules do not, in and of themselves, require one controlled group member to cover the employees of another member. Rather, the controlled group rules provide that all employees of both businesses are deemed to be employed by a single employer.

What does that mean? Well, in this context, it means that when you test A's plan to see if it satisfies the IRC 410 coverage requirements, for example, that you test it based on all employees of both businesses. The same would be true with B's plan.

If the plan can pass 410 (and, in the case of a defined benefit plan, 401(a)(26)), notwithstanding the exclusion, then the exclusion is perfectly valid. On the other hand if you cannot pass 410 with the exclusion in place (and you still cannot after permissively aggregating the two plans) then the exclusion is invalid.

Consider the following examples, in which A and B are in a controlled group:

Suppose Company A has 10 young employees, all of whom are highly compensated. Company B has 100 employees, none of whom are highly compensated. Suppose further that Company A has a much more generous plan than Company B. In this situation, the exclusion of B from A's plan will be invalid because it is discriminatory, and will not satisfy 410(b), considering the entire controlled group.

On the other hand, suppose A's 10 employees included 2 highly compensated and 8 other employees. B has 20 highly compensated and 80 other employees. In this case, the B plan will satisfy 410(b)(1)(A), and the A plan will satisfy 410(b)(1)(B) and both plans will be qualified.

In other words, the controlled group rules do not say you must cover any particular group of employees. They merely say that all employees of both businesses have a single employer, and you must do your nondiscrimination testing accordingly.

Your second question was whether this arrangement was logical. It may well be, depending on the employer's business objectives.

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.