“What is a membership substitution and is it treated like an asset or stock sale for retirement plan purposes?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor is representative of a common inquiry related to mergers and acquisitions.

The advisor asked: “My client, a nonprofit healthcare facility, is in the initial stages of acquiring another nonprofit healthcare facility through a transaction called a ‘membership substitution.’ Usually, my firm deals with for-profit asset or stock acquisitions. What is a membership substitution and is it treated like an asset or stock sale for retirement plan purposes?”

Highlights of the Discussion

What follows is not legal or tax advice but is for informational purposes only. For specific tax and/or legal questions, please seek guidance from a tax or legal advisor.
Generally speaking, a membership substitution transaction is one type of nonprofit corporate transaction that resembles a stock sale more than an asset sale. (See a related Case of the Week.) In a membership substitution transaction, the parties to the transaction amend their bylaws to reflect the new governance structure resulting from the substitution of members. In addition, for most business purposes, a member substitution results in the acquiring entity stepping into the shoes of the target for the purpose of licensures, handling of charitable donations, debt, and the operation of any retirement plans.

The lack of ownership interest in the nonprofit world raises a natural question: If there is no ownership interest with nonprofits, how can the combination of two or more nonprofit entities be treated as a stock sale, with all that entails, such as the continuation of the of the entities’ operations, financial debts and obligations, missions, as well as our special focus, their retirement plans?

Although there is no shareholder equity passing hands when two nonprofits come together, under the MNCA and most state laws, the merging of nonprofit entities can have results more akin to a stock sale than an asset sale and, therefore, they are considered stock sales for retirement plan purposes. For example, will business operations be uninterrupted? Will the “buyer” acquire the debts and liabilities of the “seller” (including the pension and 401(k) plan unless it is terminated prior to the transaction)?

One of the reasons that nonprofit “mergers and acquisitions” (M&As) often seem inscrutable to those who work primarily in the for-profit sphere is that the bulk of the guiding principles governing nonprofit M&As are not in the Internal Revenue Code or Department of Labor guidance but, rather, in state laws. Fortunately, there has been a streamlining of these state laws (of sorts) due to efforts by the American Bar Association’s (ABA’s) Committee on Nonprofit Organizations of the Business Law Section. The culmination of these efforts is a uniform code that addresses corporate concerns specific to nonprofits, which is known as the Model Nonprofit Corporation Act (MNCA). At last count, 37 out of 50 states have adopted the MNCA.

The MNCA closely follows the Model Business Corporation Act (MBCA), which applies to for-profit entities, but is adapted as necessary to meet the special needs of nonprofits, because, among other things, nonprofits do not have ownership interests in their organizations and they are established under legal authorities so the guideposts for how to treat an M&A transaction are somewhat different in the nonprofit world than they are in the for-profit world.

Conclusion
When dealing with nonprofit M&As and how this activity will impact the retirement plans of the acquiring and target entities, it is important to remember that state laws will be the legal authority from which to seek guidance. Although most states have adopted the MNCA, there still are some that have not, so it is crucial to collaborate with a competent legal advisor who is well versed in the specific state laws governing any specific combination of nonprofit entities.