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Guest jeffschnepper@hotmail.com

Please help - plan disqualification

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Guest jeffschnepper@hotmail.com

I'd appreciate help here.

I have a 100% vested qualified plan with a proposed revocation of tax exempt status.

The reason for the revocation is that even though the plan terminated and received a 2008 termination letter from the IRS, full distribution was not made soon enough. The IRS deemed the plan to be "ongoing" rather than terminated, and now wants revocation based on failure to update.

No contributions were made since 2008.

If tax exempt status is revoked as of 2010, are the employees taxed on 100% of the plan value or just the contributions made after the date (none)? The client was highly compensated but the plan was in full compliance when terminated in 2008.

I have seen articles with both answers.

THANKS!

Jeff

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If it is disqualifed then 100% is taxable income and if amounts were rolled to IRA you might have penalties there as well.

Were the assets distributed in 2010?

If so can you argue that it's a closed tax year?

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Guest jeffschnepper@hotmail.com

What is the meaning of "(to the same extent as if the trust had not been so exempt in all prior years)" in Section 402(b)(1)?

THANKS!

Jeff

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Guest jeffschnepper@hotmail.com

Lou,

Then why the word "only" in 402(b)(1) regs?

THANKS!

All assets were distributed in 2008 to everyone but the client. His account had qualified loans and the position was taken that it was not "administratively feasible" to distribute the loans.

Jeff

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Participant loan? The fact that he didn't want taxable income doesn't make it administratively unfeasible to distribute as you are probably finding out now. Did this come up because of IRS audit?

I'm not sure I follow your other questions. Plan disqualification results in disallowance of deductions (though there are none since no contributions were made), inculsion of vested balance as income for HCEs, inability to roll balance to IRA and a few other things I'm probably forgetting like possible tax implications for the trust earnings in disqualified years.

Is it possible to amend now under EPRCS for reduced sanctions? Not ideal but may be better than full disqualification.

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I strongly encourage that an attorney specializing in ERISA and qualified plans be retained (I am not an attorney, I do not play one on TV). You need someone with the specific technical expertise who can fully understand the specific circumstances of this situation and give targeted advice to mitigate adverse income tax consequences.

If very much money is at stake, the tax and penalty can add up, so hiring the proper professional is a small price to pay.

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Nice, concise little blurb


Tax Consequences of Plan Disqualification When an Internal Revenue Code section 401(a) retirement plan is disqualified, the plan’s trust loses its tax-exempt status and becomes a nonexempt trust. Plan disqualification affects three groups:
1. Employees
2. Employer
3. The plan’s trust

Example: Pat is a participant in the XYZ Profit-Sharing Plan. The plan has immediate vesting of all employer contributions. In calendar year 1, the employer makes a $3,000 contribution to the trust under the plan for Pat’s benefit. In calendar year 2, the employer contributes $4,000 to the trust for Pat’s benefit. In calendar year 2, the IRS disqualifies the
plan retroactively to the beginning of calendar year 1.
Consequence 1: General Rule - Employees Include Contributions in Gross Income
Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions.
In our example, Pat would have to include $3,000 in her income in calendar year 1 and $4,000 in her income in calendar year 2 to reflect the employer contributions paid to the trust for her benefit in each of those calendar years. If Pat was only 20% vested in her employer contributions in calendar year 1, then she would only include $600 in her calendar year 1
income.
Exceptions: There are exceptions to the general rule (see IRC section 402(b)(4)):
• If one of the reasons the plan is disqualified is for failure to meet either the additional participation or minimum coverage requirements (see IRC sections 401(a)(26) and 410(b)) and Pat is a highly compensated employee (see IRC section 414(q)), then Pat would include all of her vested account balance (any amount that wasn’t
already taxed) in her income. A non-highly compensated employee would only include employer contributions
made to his or her account in the years that the plan is not qualified to the extent the employee is vested in those
contributions.
• If the sole reason the plan is disqualified is that it fails either the additional participation or minimum coverage
requirements, and Pat is a highly compensated employee, then Pat still would include any previously untaxed amount of her entire vested account balance in her income. Non-highly compensated employees, however, don’t
include in income any employer contributions made to their accounts in the disqualified years in that case until the
amounts are paid to them.
Note: Any failure to satisfy the nondiscrimination requirements (see IRC section 401(a)(4)) is considered a failure to meet the minimum coverage requirements.
Consequence 2: Employer Deductions are Limited
Once the plan is disqualified, different rules apply to the timing and amount of the employer’s deduction for amounts it contributes to the trust. Unlike the rules for contributions to a trust under a qualified plan, if an employer contributes to a
nonexempt employees’ trust, it cannot deduct the contribution until the contribution is includible in the employee’s gross income.
• If both the employer and employee are calendar year taxpayers, the employer’s deduction is delayed until the calendar year in which the contribution amount is includible in the employee’s gross income.
• If the employer has a different taxable year than the employee (a non-calendar fiscal year), the employer cannot take a deduction for its contribution until its first taxable year that ends after the last day of the employee’s taxable

year in which the amount is includible in the employee’s income. For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s gross income for the employee’s taxable year that ends on December 31 of year 1, the employer cannot take a deduction for its contribution until its taxable year that ends on September 30 of year 2. 9 For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s
For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s
gross income for the employee’s taxable year that ends on December 31 of year 1, the employer cannot take a deduction for its contribution until its taxable year that ends on September 30 of year 2.
Also, the amount of the employer’s deduction is limited to the amount of the contribution that is includible in the employee’s income and whether a deduction is allowed depends on whether the contribution amount is otherwise
deductible by the employer. Finally, if the plan covers more than one employee and it does not maintain separate accounts for each employee (as may be the case with a defined benefit plan), then the employer is not able to deduct any
contributions.
In our example, assuming both the employer and Pat are calendar year taxpayers, the employer’s $3,000 deduction in calendar year 1 and $4,000 in calendar year 2 would be unchanged because that is when Pat would include these amounts in her income. However, if Pat were only 20% vested, then the employer would only be able to deduct $600 in calendar year 1 (the vested part of her employer contribution) which is the amount Pat would include in her calendar year
1 income.
Consequence 3: Plan Trust Owes Income Taxes on the Trust Earnings
The XYZ Profit-Sharing plan’s tax-exempt trust is a separate legal entity. When a retirement plan is disqualified, the plan’s trust loses its tax-exempt status and must file Form 1041, U.S. Income Tax Return for Estates and Trusts (instructions), and pay income tax on trust earnings.
Revenue Ruling 74-299 as amplified by Revenue Ruling 2007-48 provides guidance on the taxation of a nonexempt trust.
Consequence 4: Rollovers are Disallowed
A distribution from a plan that has been disqualified is not an eligible rollover distribution and can’t be rolled over to either another eligible retirement plan or to an IRA rollover account. When a disqualified plan distributes benefits, they are subject to taxation.
Consequence 5: Contributions Subject to Social Security, Medicare and Federal Unemployment (FUTA) Taxes
When an employer contributes to a nonexempt employees’ trust on behalf of an employee, the FICA and FUTA taxation
of these contributions depends on whether the employee’s interest in the contribution is vested at the time of contribution.
If the contribution is vested at the time it is made, then the amount of the contribution is subject to FICA and FUTA taxes at the time of contribution. The employer is liable for the payment of FICA and FUTA taxes on them. If the contribution is not vested at the time it is made, then the amount of the contribution and its earnings are subject to FICA and FUTA taxation at the time of vesting. For contributions and their earnings that become vested after the date of contribution, the nonexempt employees’ trust is considered the employer under IRC section 3401(d)(1) who is responsible for withholding
from contributions as they become vested.
Calculating Specific Plan Disqualification Consequences
Calculating the tax consequences of plan disqualification depends on the type of retirement plan. For example, the tax consequences for a 401(k) plan differ from the consequences for a SEP or SIMPLE IRA plan.
How to Regain Your Plan’s Tax-Exempt Status
Generally, if a plan loses its tax-exempt status, the error that caused it to become disqualified must be corrected before the IRS will re-qualify the plan. You may correct plan errors through the IRS Voluntary Correction Program. However, if your plan is under examination by the IRS, you must correct the errors through the Audit Closing Agreement Program.
Note: This is a general overview of what happens when a plan becomes disqualified for failure to meet qualification requirements (see IRC section 401(a)). These examples provide general information and you should not rely on them as legal authority as they do not apply to every situation. For more information, see Rev. Rul. 74-299 and Rev. Rul. 2007-48 (and the law and regulations discussed in those rulings).

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Based on comments from several IRS representatives at conferences over the years, I suspect there is significantly more going on here than just a failure to timely distribute the assets of a terminated plan. Based on the reason listed in the OP, I would have expected an offer of Audit CAP, not a proposal of disqualification.

While under examination, the only EPCRS options available are SCP for insignificant operational failures and Audit CAP. I doubt the IRS would classify this as eligible for SCP. The sanctions under Audit CAP are a negotiated percentage of the Maximum Payment Amount. Rev. Proc. 20013-12 Sections 13 and 14 deal with Audit CAP. There are other references to it throughout the Rev. Proc. Among others, Section 4.07 says Audit CAP is available for terminated plans, 4.11 says Audit CAP is available to correct egregious failures, 4.12 says Audit CAP is not available to correct a diversion of assets and 4.13 the IRS can decide that Audit CAP is not available if the failure is related to an abusive tax avoidance transaction (listed transaction).

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Guest jeffschnepper@hotmail.com

What happened was that the plan was audited...and the IRS agent spent over 2 year claiming that the loans made by the plan were prohibited transactions....which they clearly were not.

In response to a Protest, the IRS completely changed it's position, gave up on the prohibited transaction argument, and alleged that the plan should be disqualified because it failed to distribute the one account left on a timely basis becoming an "ongoing" plan despite the fact that a termination letter was received from the IRS. That said, if the plan was not "terminated," it had to be updated...which it was not....causing the disqualification.

My issue is the word "only" in the section cited. I have seen different answers as to whether the whole account becomes taxable or "only" the amount contributed during the disqualification years.

Take Belgarath's below example from the IRS.....but what would be the tax impact if the plan was disqualified just for year 2....ie would the contributions from year 1 be taxable (when the plan was qualified) when the plan loses its qualified status or just the amount when the plan was not qualified.

THANKS!

Jeff

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My understanding is if the Plan becomes disqualified, the whole vested benefit becomes taxable but you might find an ERISA attorney who will take your position and argue on your behalf. good luck it's never fun fighting with the IRS.

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Guest jeffschnepper@hotmail.com

THANKS to all for their efforts - much appreciated!

Jeff

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I think you're worrying about the word "only" when you should be worrying about the words "made available" which are in both the Code and Reg.

Because of the plan termination, I see little room for you to argue that the entire account balance was not "made available" to the participant at the time of plan termination in accordance with the constructive receipt doctrine. Cross ref to Reg Section 1.451-2(a).

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Disqualification is supposed to be their last resort. From what you are saying, you should at least be able to correct using Audit CAP. While that isn't pleasant, it should be much better than disqualification. It does sound like you need to get an ERISA attorney involved. Sometimes the IRS lives up to their reputation.

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