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Plan Disqualification

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8 replies to this topic

#1 Gary


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Posted 31 July 2008 - 12:01 PM

Say a one participant plan sponsor contributes a total of $1,000,000 to a pension plan over a 5 year period.

Then the IRS disqualifies the plan retroactive to its inception.

While it is clear that the participant must pay taxes on his pension and the trust is taxed on its earnings, should there be a 10% 4972 excise tax for non deductible contributions (i.e. all $1,000,000 of contributions)?


#2 Guest_named_Sieve_*

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Posted 31 July 2008 - 12:49 PM

That excise tax only applies with regard to contributions to a qualified plan, so how could it come into play if the plan is disqualified form its inception? What will happen, however, is that the employer (individual, corp.?) will lose the deductions taken in prior years and therefore will be subject to increased income taxes, penalties and interest.

Edited by Sieve, 31 July 2008 - 12:50 PM.

#3 Gary


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Posted 31 July 2008 - 03:31 PM

I am surprised that the IRS proposes 10% excise taxes on a disqualified plan also.

Yes, where the individual is to receive income based on the increase in PVAB, the corporation is to receive corresponding deductions.

And where the corporation does not get the deduction in the year of contribution (when the statue of limitations does not apply and all subsequent years are "open") the participants are taxed the entire pension upon distribution (less amount that was previously taxesd and is basis) and then the corporation can recevie their corresponding large deduction that will probably never be offset or utilized.


#4 david rigby

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Posted 31 July 2008 - 08:21 PM

I am surprised that the IRS proposes 10% excise taxes on a disqualified plan also.

Are saying that the IRS did propose a 10% excise tax? If so, perhaps the IRS agent is misinterpreting sec. 4972. The answer from Sieve looks pretty good.

I'm a retirement actuary. Nothing about my comments or advice is intended or should be construed as investment, tax, legal or accounting advice. Occasionally, but not all the time, it might be reasonable to interpret my comments as actuarial advice.

#5 Gary


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Posted 01 August 2008 - 07:46 PM

Yes, the IRS proposes a 10% penalty on all plan contributions, even though the plan is disqualified retroactively from inception. Although the 10% penalty is a relatively small portion of the eventual total damages to this plan sponsor.


#6 Gary


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Posted 05 August 2008 - 07:21 PM

Adding to the 4972 excise tax issue.

The plan sponsor has a 412i plan and the plan is disqualified for not covering NHCEs and the tax deductions were in excess of the 404 limits if the plan had been qualified.

So for example the client made a contribution to the plan of 100k for a plan year, but the IRS computes the maximum deduction allowable under the 412i plan for that year to be 20k.

The plan is disqualified and the IRS states that the 100k deduction is subject to 10% excise tax.

One thought was that if the plan were disqualified, why should any portion be subject to excise taxes.

I was reading a Benefits Practice Center - Tax Management article on Plan Disqualification - Effects of Plan Disqualification

In that article if I am understanding it correctly the situation I note above would be handled as follows:

The 20k can be treated as compensation (instead of a deductible plan contribution) to the 100% vested HCE, and deducted to the corporation.

However, the amount above the 404 limit, namely the 100k less 20k or 80k would be a non deductible carryover and not included in the HCEs compensation for that year. So the IRS may be on to something in their desire to apply an excise tax on the amount, but perhaps it should not reflect the entire amount, but only the amount that is above the 404 limit.

The article footnotes 404(a)(5) and 1.404(a)-12(b)(1).

Can anyone elaborate on my interpretation of this matter?


#7 Gary


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Posted 18 August 2008 - 08:13 PM

In trying to make progress with the interpretation of deductible contributions to a disqualified plan read on.

The basic concept I am wrestling with is:

If a plan is retroactively disqualified and all contributions are to be considered includible compensation to the employee (immediate vesting) for each prior year, is there a limit to the amount of compensation? That is, is the contribution subject to the 404 DB plan limits?

1.404(a)-1(a)(2) states that section 404(a) does not apply to a plan which does not defer the receipt of compensation. Based on that statement, it seems that the position that since the plan is disqualified all contributions can be immedaitely taxable compensation and thus not considered a deferral of the receipt of compensation and thus not subject to the limits under 404(a).

Alternatively, 1.404(a)-7(b) indicates that contributions to a non exempt trust (presumably a disqualified plan) are subject to the 404 limitations and carryover rules. This gives me the impression that 404 applies even if the plan is disqualifed.

Any comments to support or refute the relevance and application of 404(a) limits to a retroactively disqualified plan from its inception due to coverage?


#8 Guest_named_Sieve_*

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Posted 18 August 2008 - 10:20 PM

I have to admit that, in my practice, I have never come across a disqualified plan (thank the Lord!!), so I've never carefully learned the rather convoluted tax consequences resulting from plan disqualification. That being said, it has always been my undertstanding that the Section 4972 excise tax is intended to penalize the employer for the tax-free build-up in a qualified plan to the extent that the contribution is not deductible. Here, however, if the plan is disqualified from the get-go, that build-up--and the entire contribution--will be retroactively taxable at some point in time, with penalties & interest. That's good for the IRS, bad for your client. So, I still don't get it--and, since it relates to a disqualified plan, I hope I never have to get it.

But, here's what I can glean. First of all, IRC Section 404(a)(5) relates to the deduction for non-qualified plans, and that deduction is limited to amounts "includible in the gross income of employees participating in the plan". Clearly, in your example, there was only 1 participant, and just 20K was deductible in the first year. The rest of the contribution is not deductible at that time, because there was no one else in the Plan to take that contribution as compensation. That remaining $80K of contributions thus is, in fact, deferred compensation, to be included in income as compenstion (and thus deductible) at some time later, and that $80K is thus subject to the deduction rules of IRC Section 404(a) at some future time. Still, however, I don't see why there is an excise tax because the earnings on that 80K is not in a qualified trust and therefore is not excludable from income.

I certainly have not answered your question, just offered some random thoughts using some reasonable logic. Perhaps it will spark some follow-up logic from you or others. Someone who has more experience with the dark side (i.e., disqualified plans) will have to chime in to assist further.

Edited by Sieve, 18 August 2008 - 11:59 PM.

#9 Guest_named_Sieve_*

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Posted 19 August 2008 - 11:55 AM

Gary - I came across something that might explain the IRS insistence that a Section 4972 penalty is owed on a disqualified plan. Apparently, it is not unusual for the IRS to take inconsistent positions in situations of plan disqualification, so the IRS says: (1) the plan is disqualified form the get-go, with all the tax consequences that result from that, and (2) what we've really done is disallowed a deduction for a contribution to a qualified plan (because we say it's not qualified), and, therefore, you (the taxpayer) have made a non-deductible contribution to that qualified plan (which we just happened to disallow) and you therefore owe the Section 4972 excise tax. That may be what's happening here. I'd fight it--they should not be allowed to have it both ways by arguing, in the same case, inconsistent positions.

Edited by Sieve, 19 August 2008 - 12:17 PM.