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Getting into the weeds on this one?

You will want to Internal Revenue Code Section 280E. During the '80s at the height of the drug war the made deducting the expense related to the sale and distribution non-deductible. https://www.law.cornell.edu/uscode/text/26/280E They might be able to set up a 401(k) plan but not be able to deduct any of the costs and it raises the question if you can even have pre-tax deferrals. I have never looked into Roth. I am NOT an expert on the intersection of this part of the law and 401(k) plans. I learned about 280E back in my days as an IRS agent. There are also threads on here about how some banks and other financial institutions are reluctant to do business with a company that is technically violating federal law. If anyone curious keep reading otherwise you can stop. 280E is interesting as it only applies to drug crimes. So for example a chop shop can deduct "payroll costs" of the people stealing the cars and cutting them up for parts. But a pot shop will most likely have trouble deducting the payroll costs of the employees in the shop. It all stems from a famous court case where the Feds tried to get a drug dealer like they got Al Capone. The drug dealer's clever tax lawyer managed to dramatically reduce the tax liability and thus the criminal sanctions by showing that when you deducted the costs of the operation the drug dealer's net profit wasn't very large. Hard to believe I know but the lawyer did it. Congress got mad and even by disallowing the deduction of the costs of operation for illegal drug operations.

You say you will spinoff/restate, but I don't think that is right. You will spinoff and ESTABLISH a new plan, not restate it; Plan X continues in existence with no need for restatement due to the spinoff (obviously, the appropriate spinoff language needs to be adopted). If the plan sponsor of the plan was A and that tax ID number was used to identify the plan 001, then I would set up the new plan for B as 001 (assuming that employer with that tax ID never had a plan identified with its own EIN) and it would be the first 5500 for that plan. Line 4 would be left blank.

A plan’s administrator might read carefully the governing documents’ provisions about a distribution to a beneficiary who is not yet an adult. Typical provisions permit paying a minor’s conservator or guardian, including a natural guardian (a parent). But a provision of that kind does not necessarily command paying such a fiduciary. Or if it does, there might be little or no constraint on a plan amendment. Also, a plan’s administrator might read carefully the governing documents’ provisions to check whether the plan’s termination undoes provisions that otherwise might have required a distributee’s consent to a distribution. If—after exhausting loyal, obedient, and prudent efforts to get the beneficiary’s choice about whether the beneficiary prefers money or a rollover—the beneficiary has not specified his or her choice, a plan’s administrator might obey the plan’s provisions (including recent amendments). What does the plan provide for a situation in which an adult beneficiary, after due notice, fails to specify the beneficiary’s choice between money and a rollover? Does anything in the plan’s governing document vary that provision regarding a minor beneficiary?

I would challenge them to prove this can't be forced out to an IRA like any other payment in a plan termination. I am not aware of any such rule/law. I would add the platform isn't supposed to have the power to overrule the plan sponsor and plan administrator (PA) unless they are one PA or trustee. There job it to take directions from the PA/sponsor and trustee.

So the deduction probably would be available to the employer; question then is whether the fees are taxable income for the employees. IRS Pub. 525 distinguishes between "qualified retirement planning services" and "financial counseling fees": Financial counseling fees paid for you by your employer are included in your income and must be reported as part of wages. Fees for tax or investment counseling are miscellaneous itemized deductions and are no longer deductible..... If your employer has a qualified retirement plan, qualified retirement planning services provided to you (and your spouse) by your employer aren't included in your income. Qualified services include retirement planning advice, information about your employer's retirement plan, and information about how the plan may fit into your overall individual retirement income plan. You can't exclude the value of any tax preparation, accounting, legal, or brokerage services provided by your employer. Also, see Financial Counseling Fees, earlier. Another approach might be to terminate the plan, roll to individual IRAs, pay the fees directly from the IRAs, and have the owner-employees make individual deductible contributions that (at least in this case) could cover the total aggregate investment fees. The employer could increase W-2 salaries to cover those amounts, but that triggers FICA/FUTA costs. Since it's an S-corp, the owner-employees could instead pay the fees from an S-corp distribution (or make the contributions from other assets). Depending on the amounts involved, the 199A deduction could in fact make the S-corp distribution approach significantly less costly than W-2/FICA.

IMHO, I think Revenue Ruling 86-142 covers this, and no, you can't do it. It would be considered a plan contribution for 404 purposes. Stretching far into the dim and distant past, I have a hazy memory that this might have been allowed for a while under some old PLR's (we never had anyone attempt to do this for plans where we were the TPA) but then the IRS reversed course anyway. Whether or not such an arrangement might raise Prohibited Transaction issues, I'll leave to one of the PT experts here - I certainly don't know off the top of my head - but I think the PT issue is moot since they can't successfully utilize the arrangement you mention. P.S. Here's an interesting piece by Groom Law Group on paying "wrap fees" - https://www.groom.com/wp-content/uploads/2017/09/1000_Dold-Levine_MAG_05-11.pdf

Dave, although I have not undertaken extensive research on this, I suspect there is not a clear answer, but there is probably a pretty good argument you can do it. The ability of an employer to pay and deduct investment management fees under Section 162 rather than have them be subject to 404 or 415 limits is not in the Code, as far as I know, but under Treas. reg. 1.404(a)(3)(d) and rulings, such as PLR 9252029. You could argue, strongly I think, that IRC sec. 404(h) makes 1.404(a)(3)(d) applicable to the SEP "plan" just as much as it would be applicable to a qualified trust. The IRS could for its part, I guess, argue that the personal control exerted by the employee over his or her individual IRA makes the payment of these expenses so personal to the employee that payment of them by the employer should be considered a fringe benefit, still deductible under 162, but includable on the employee's W-2 under Section 61(a)(1). If the employer were a C corp, it could probably defend strongly against that assertion by arguing that the fees were for "qualified retirement planning services" under 132(m), for which there are not yet any regulations, but it does not appear that 2% S corp shareholders would qualify as "employees" for purposes of 132(m). However, the 61(a)(1) argument might be a stretch for the Service to begin with.

I would correct the things for the period you were hired to work on. And give them a letter advising them of the issues and your concerns. Since you haven't reviewed the prior years, you don't really "know" there's an issue. Our engagement says we're under no obligation to audit or review prior years. If they want to fix it, they can hire you to do so. If not, it's not on you. Don't make their problem your problem.