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Measure of Damages From Loss of Tax Qualification


Guest johncpa
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Guest johncpa

I have a profit sharing plan that terminated and paid a participant a lump sum, without allowing him to elect to roll over his account to an IRA. This would seem to be a very common issue, where a plan loses its tax qualified status and the participant's benefits are no longer tax deferred, but taxed immediately. Obviously the whole point of society spending trillions of dollars on qualified retirement plans is to defer taxes on the income. When that benefit is lost, the participant suffers substantial damages.

My question is: Is there any authority as to how the claim for damages would be calculated? Since the amount of damages is not fixed because the benefits will still be subject to tax at some later time, what variables and estimates are used to calculate the monetary damages resulting from immediate taxation of benefits, rather than deferral? Can someone provide an authority of this issue?

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Guest johncpa

Thank you for your comment. But the issue is not for the plan but for the participant. The participant has a substantial economic loss from the error made by the administrator.

The question is: How should the participant calculate his damages to try and collect them from the plan administrator?

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When was the distribution done? Could the participant apply for a 60-day waiver for rollover?

I'm not sure how long that process takes, but I would think "Let's get this into an IRA ASAP." The problem then becomes, who makes up the missing 20%? Perhaps a "loan" from the ER tot he participant, because if the ER simply makes up the lost withholding, the PP will get a windfall come tax time.

Then, you'd just figure out lost earnings somehow. Does the PP have another IRA? Perhaps mimic the returns from there.

If the waiver gets denied, then you start looking at long-term ramifications.

QKA, QPA, CPC, ERPA

Two wrongs don't make a right, but three rights make a left.

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Guest johncpa

The only issue relevant to me here is: How are damages calculated?

If anyone has any authority or reference that is relevant to my question, I would appreciate your comments.

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It is a good question. One I don't have an authoritative answer too. However I assume the "damages" would be based on the acceleration of taxes on the entire balance in the year of disqualification and loss of tax deferred growth on amount disqualified.

I image you could do an after tax present value of the lump sum less taxes against an after tax present value of the stream of payments in retirement if you make some assumptions about growth of the assets before disqualification and assumptions about future tax rates and take the difference as the "damages".

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The present value approach may be more complex than needed.

BTW, from the original post, it's not clear there are any "damages", but that may not be relevant to anyone else.

I'm a retirement actuary. Nothing about my comments 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 or consulting advice.

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Guest johncpa

So David, if present value is too complex, what is your authority for a simpler approach?

As to damages, if you were to retire and instead of the plan administrator rolling over your benefit to an IRA (where I assume you know that you could pay out the benefit over maybe 20 years, when you are in a lower tax bracket and accumulate tax free income over that time) and instead had to pay a higher tax all at once at the time on the distribution, wouldn't you feel you were "damaged"?

If you think about it, if there were no tax benefits for retirement plans (e.g., the contributions were immediately taxable to the participant) probably 90% of the plans would be terminated and benefit consultants would be out of business. So not getting the tax benefits would seem to be an obvious cause of action for damages.

BTW I hope this answers your concerns.

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john,

Your concern might be valid, but I'm skeptical since the benefit paid was a lump sum.

It seems to me that the actual damages have not been defined, nor is it clear who is culpable. While I'm not asking for the details, it seems that you might need to be specific in your definitions (not here, obviously).

I'm a retirement actuary. Nothing about my comments 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 or consulting advice.

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I have some questions/comments:

1. Has the plan actually been disqualified? When? Why? If the plan had been disqualified (for any reason) before the payment was made, the distribution would truly not have been eligible to be rolled over. Remember that merely failing to follow the rules does not automatically disqualify a plan - the IRS must impose that penalty, and they have in place a number of correction methods intended to give sponsors a way out short of outright disqualification.

2. Assuming that the distribution itself was not ineligible to be rolled over, the participant could certainly have taken action to roll over the proceeds within 60 days of payment (recognizing that this could mean that any amounts withheld for taxes would either have to be replaced from other participant funds or some of the distribution would have remained taxable). If the distribution was relatively large, the participant could well have availed him or herself of professional guidance to optimize the tax consequences of the distribution (assuming, again, that the distribution did not have to be treated as ineligible for rollover).

3. Not to deny that there are many plans whose primary reason for existence is to minimize the impact of taxes, the tax-favored treatment is being provided to encourage retirement savings and to encourage companies to provide an element of retirement security to their employees, to reduce poverty and dependence after the working years (not to minimize taxes). What incentive would the government have to provide tax-favored treatment for retirement plans if all that would be accomplished would be to reduce taxes?

4. It is by no means a certainty that future taxes on amounts rolled over to IRAs and subsequently distributed from there will be more favorable than those that would apply if the proceeds were taxed currently, even if the level of annual income at the time the IRA balances are distributed is lower. What if tax rates are raised some day to reduce government deficits? It could happen.

Always check with your actuary first!

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Guest johncpa

So, My 2 Cents....

Nothing included in your long posting was relevant to my question.

If you have any authoritative opinion on this set of facts, please share it. If not, thank you for your interest.

The question is: How should a participant calculate damages when his large retirement distribution is paid directly to him (and immediately taxable), rather than as a direct roll over to an IRA? (The question is a calculation (e.g., quantitative)). Assume the plan made a mistake that can not be corrected, since this issue is beyond the scope of this simple posting.

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I don't have any authoritative opinion. So I would do what Lou S. said above. To estimate the impact of tax deferral I may start with comparing the following 2 scenarios, using the assumptions of: 1) current income tax rate; 2) future income tax rate; 3) future capital gain tax rate; 4) interest rate; 5) year of full taxation

Scenario1 - IRA Rollover - Accumulate the amount to the year of full taxation with interest rate and apply the future income tax rate to come up with net amount after taxes.

Scenario2 - Cash Distribution - Apply the current income tax rate to the amount. Accumulate the remaining amount to the year of full taxation with interest rate. Apply the future capital gain tax rate to the earnings portion of the accumulated amount to come up with net amount after taxes.

Then I would take a difference between 2 net amounts and discount it back to today's date with the same interest rate.

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Its a simple economics calculation - but one based on assumptions. What's the present value of the current principal projected out to a retirement date minus the present value of the future taxes to be paid give an assumed mode of withdrawal. If I represented the participant as plaintiff, my assumptions would start at 1) deferred withdrawals till RMDs; 2) only MINIMUM RMDs over the expected life expectancy of the participant; 3) today's current (low) tax rates (as anything else would be "speculative") and 4) an appropriate DB discount and investment return assumptions.

And I doubt there is any authority on point - the people here are trying to provide you with an informed, theoretical approach to solving the problem ABSENT such authority.

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Guest johncpa

I agree with everyone who thinks a discounted, present value approach is the most logical way to go. Thank you for your interest.

However, there is another "twist" I would appreciate your comments on. As you know, no one can refund and pay you for the taxes you wrongly incurred, because the administrator made and error, but the IRS (who is not going to do that). So, if the administrator pays you "damages" representing the additional taxes you incurred, those "damages" are taxable because they are not a tax refund, but taxable income.

Therefore, in my opinion, the "damages" claimed by the participant should be grossed up and increased by the additional taxes the participant is going to pay when he is paid the "damages" in settlement, so that after taxes he actually keeps the taxes he had to wrongly pay to the IRS to begin with.

What do you guys think about grossing up the claim for damages?

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I'm not sure I follow your last post but are you proposing that the Plan Administrator pay all the taxes the participant incurred on the distribution plus grossing that up for t he additional taxes owed? That would seem to put the participant in a BETTER position than had the plan not been disqualified in the first place as you would essential convert his pre-tax retirement balance into an after tax balance with a basis that is no longer subject to taxation on that portion.

Or maybe I misunderstand your question and you are saying maybe the total taxes were to throw out a number $50,000, if the additional "taxes" because it all became taxable now at highest marginal tax rate was hypothetically determined to be $10,000 that the $10,000 "damages" should be grossed up for the additional taxes that will be due on that?

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johncpa. You insist that there are damages, but, can you provide any authority which supports your position?

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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Guest johncpa

So GBurns

If appears you do not feel the loss of the tax benefits of a retirement plan account is really an "economic loss". which you have a right to recover from the plan administrator.

I assume you have a tax qualified plan for yourself (e.g., IRA, 401k, etc.). If there is no "economic loss" from losing the tax deferred status, why don't you just terminate you plan, since apparently you feel you have nothing to lose?

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An "economic loss" does not mean that there are "damages" or that if there are "damages" the plan administrator is liable.

George D. Burns

Cost Reduction Strategies

Burns and Associates, Inc

www.costreductionstrategies.com(under construction)

www.employeebenefitsstrategies.com(under construction)

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There is a principle of law that an aggrieved party has a duty mitigate damages. Failure to mitigate damages will result in a loss of any recovery by the plaintiff. In this case the plan participant received the amount that he was entitled to receive under the plan. However plan did not offer right to make a direct rollover. Participant had an obligation to mitigate damages by rolling over the amount he received to an IRA. If he did not rollover the amount received then he has no right to claim damages for that amount. Plan participants have no rights to receive any payments or damages under the tax law.

There is a separate question of whether the participant had a duty to mitigate damages on any amount withheld as taxes but the participant must have a cause of action in equity in order to recover damages. You can make up any hypothetical number you want as how damages can be calculated but the question is how are you going to get anyone to pay it. If plan is terminated it no longer exists as a legal entity.

mjb

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There is a principle of law that an aggrieved party has a duty mitigate damages. Failure to mitigate damages will result in a loss of any recovery by the plaintiff. In this case the plan participant received the amount that he was entitled to receive under the plan. However plan did not offer right to make a direct rollover. Participant had an obligation to mitigate damages by rolling over the amount he received to an IRA. If he did not rollover the amount received then he has no right to claim damages for that amount. Plan participants have no rights to receive any payments or damages under the tax law.

There is a separate question of whether the participant had a duty to mitigate damages on any amount withheld as taxes but the participant must have a cause of action in equity in order to recover damages. You can make up any hypothetical number you want as how damages can be calculated but the question is how are you going to get anyone to pay it. If plan is terminated it no longer exists as a legal entity.

If the plan had already been disqualified, the proceeds would probably not be eligible to be rolled over.

One suspects that it would be from the employer as a fiduciary of the plan (and the employer would usually be the plan administrator) that damages would be sought, not from the plan itself.

Always check with your actuary first!

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You are presuming facts not in evidence. There is no factual evidence that plan has been disqualified. Only distributions made after plan is DQed are not eligible for rollover. Why is the employer a fiduciary? Don't see any basis for that conclusion. Also there are valid reasons for distributing amounts to a participant such as when the participant fails to respond to requests to provide information needed to make a rollover.

mjb

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Assuming that we are talking about a single employer plan, when is the employer not a fiduciary? It is my understanding that even if another entity has been designated as the plan administrator or trustee, the employer has the authority to replace them, usually at will and retains sufficient control to be considered a fiduciary.

Always check with your actuary first!

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