IRS Position on Late Amendment

[Guest gaham]

FACTS: Employer presumably failed to timely amend for 401(a)(17) and 401(a)(31). (This was before we were involved.) The plan was amended retroactively for these purposes when it was also restated for GUST in late 1998. The Service has discovered this alleged failure in the determination letter process and is proposing Audit Cap with a sizable sanction as the only alternative to disqualification.

ARGUMENT: We have initially argued that while the plan may have been subject to disqualification for the years following the failure to amend, it was corrected pursuant to the GUST amendment citing as authority Internal Revenue Manual 4.72.12.2.1 and Rev. Rul. 73-79 (a qualified trust may lose its qualified status and then regain it by amendment) and that the years in which the plan was not qualified are now closed. IMPORTANT NOTE: The plan operationally complied with (a)(17) and (31) throughout this time so there was no operational correction needed. IRS says plan is disqualified immediately upon lapse of remedial amendment period and remains so unless requalified under its correction program (i.e., later amendment is meaningless.

QUERY: Is our argument worth pursuing?

[Belgarath]

Well, you can try, but I'd be surprised if it gets you anywhere. My understanding is that under Revenue Ruling 82-66, if a document defect isn't corrected by the end of the remedial amendment period, the amendment will only help for the plan year in which the amendment is adopted. So as in your situation, this leaves prior years hung out to dry. And the only way I know of to correct this is to submit under what is now VCP under the new Rev. Proc. 2003-44. And under Section 10(.07)(2) of that Rev. Proc., the fee in your situation is the Audit Cap fee, not the normal VCP fee. Good luck!

[mbozek]

If the a17 and a 31 admendments were included when the plan was amended for Gust then the plan was out of compliance only for years prior to 98. Under IRC 6501(a) the S/l for the IRS to recover back taxes by disqualifying the deduction for er contributions is generally 3 years. If the tax years prior to 98 are closed the IRS cannot recover back taxes from the er upon disqualification of the plan. If the IRS disqualifies the plan for closed years the amount of the employees' benefits attributable for the years prior to 1998 will be deemed after tax amounts for which no taxes can be collected upon distribution. I think the client should have tax counsel review all of the above issues to see if disqualfication is a cheaper alternative than Audit cap. Also some plans, e.g., prototype plans were deemed to be automatically amended by the IRS for a17/31 purposes without the need for the er to adopt an amendment. The sponsors were supposed to send the amendments to the employers who used the plan.

[imchipbrown]

I agree, but would add that Volume Submitter adopters generally have to sign the 17 and 31 amendments.

[Guest Paul Kelly]

What an unfair mess, especially considering that the ER is innocently seeking a DL for GUST. I've seen this scenario a handful of times, always with the (a)(17) and (a)(31) slip-up's, as IRS works DL apps for our GUST restatements that fall off the pre-approved VS. And, like Chip notes, IRS wants timely ER signatures on those model amendments on the VS clients. In some cases, we know that the client was sent the amendments (1994 or so), but the client now cannot prove up a timely executed copy.

Maybe we've just been lucky (knock), but despite identical IRS threats like Gaham's client now faces, so far no serious sanctions have been paid. Try any of these: (1) Play a little poker with IRS and threaten to withdraw the DL application. The specialist will state that the plan will be referred to Examinations; but Exam may not even pick it up -- especially if IRS needs to work up the likely exposure first. (2) Like Belgarath says, this ER is under Audit Cap. Propose to the DL specialist that the "negotiated" amount of the Max Sanction should be (in fairness) exactly equal to the VCP penalty for non-amenders. After all, this client submitted, and IRS did not pick up the case on exam (even though 2003-44 reads the way it does). (3) Remind IRS that the statute has run on most/all of the exposure, so that if IRS wants to make a federal (??) case out of it, it won't be cost effective. But quietly remember that the S/L for some participants might be the extended 6-year statute under 6501(e); also keep in mind that distributions rolled to IRAs could be disasters when disqual. is retro. Don't forward 5500's to the threat makers (to discern exposure) unless it serves your purpose; i.e., tax predictions on the ( now) non-exempt trust via the 5500 financials is quite different than the Form 1041 taxable income. Don't do IRS' work for them; more reason for the Exam division not to want the case.

Also, you could point out Mbozek's argument that some otherwise taxable money now has a basis, so IRS' revenue might be adversely impacted on that issue. (Mbozek: I like your idea, but I've never advised on this before. Does the participant's account really "deem" to after tax status, or is the ee instead taxed fully on what he gets when he gets it (without basis)? Leads to some very creative planning opportunities for frozen plans!)

Every tiime that we have pushed back on Gaham's issue (always asking that the specialist's supervisor joins in the discussions) we either get approved for the lower VCP fee or we simply receive a favorable DL in the mail a few weeks after the conference.

Sadly, there is a problem if IRS insists on its bare knuckle tactics and the dollars/assets are high. The ER (an ERISA fiduciary) has a conflict of interest in negotiating with IRS as to its (the ER's) position vis a vis sanction exposure, and the trust/participants'. E.g., Let's say IRS DQ's the plan and assesses the trust some significant taxes, penalties and interest. And/or -- some participants are hit with underpayment and other penalties and taxes.

A cautious fiduciary might just write the IRS whatever sanction check it demands.

[mbozek]

The 6 yr s/l may not apply because the omission of gross income was caused by the plan admin- the employee did not omit the distribution because it was reported to him as a pre tax amt hence there was no omission by the taxpayer. As far as the improper rollover is concerned, the total excess contribution tax (e.g. 36% for 6 years) may be a better deal than having the distribution accumulate in a tax deferred IRA balance because the funds can now be withdrawn as after tax income. Also the IRS would have to identify and track down each individual distributee top collect the tax. Finally I think the case of King Estate v. Comm., TC Memo 1984-343, answers the question on the s/l for collecting tax on account of the failure to report an item of income properly. (Failure of partnership to allocate income to partner in prior tax years did not prevent partner from treating income as after tax income after s/l for collecting tax had run.)

[Guest gaham]

Thanks P. Kelly. Your strategy points are particularly helpful. Also, here is what I've learned since my initial post. There seems to be a lack of uniformity in dealing with this issue within the IRS. I spoke with the voluntary corrections coordinator for the IRS Great Lakes region about this issue yesterday. He agreed with us that it appears that all of the "bad" years are closed for purposes of any tax on the employer and/or the trust. He also pointed out (as Paul Kelly does) that those employees who rolled over distributions during bad years are at risk with respect to their rollovers. He did not agree with mbozek's analysis that the disqualification converts a portion of the plan assets to after-tax dollars within the trust.

Our client's plan is being reviewed on the west coast and even though the employer is located in the Great Lakes region, he believes we have to deal with this issue through the IRS west coast region. The reviewing agent there is proposing a fee of $15,000 which is the presumptive fee for voluntary correction. The Great Lakes coordinator suggests that we go back to the reviewer and ask him to calculate what the maximum payment amount would be. (This is the appropriate course under Audit CAP.) Since the MPA would be zero, any negotiated percentage of zero is zero. I think we'll use this strategy along with some of P. Kelly's ideas. I've become convinced that anyone who pays the Service more than a nominal amount to fix this problem is paying too much!

[Everett Moreland]

You may elect to apply Revenue Procedure 2003-44, under which your VCP fee is $5,000 or $8,000, depending on the number of participants.

[mbozek]

I would like to know the basis for the IRS position that the benefits of participants in a disqualified plan are not converted to after tax dollars upon disqualfication. IRC 402(b) provides that contributions to a plan that does not meet the requirements of IRC 401(a) are included in the employee's gross income in accordance with IRC 83 to the extent of the value of the employee's interest in the trust. It has always been understood that that the loss of qualfied status results in immediate taxation of the participants' vested interest in the trust in the year of disqualfication under IRC 402(b). Also If the plan is not qualfied then the trust is no longer a tax exempt organization under IRC 501(a) and the earnings are taxable to the trust. Indeed the IRS published notices of adverse taxation in disqualified plans 20 years ago. I think that the IRS is in denial regarding the lack of sanctions under the IRC where the disqualifying event has occurred beyond the s/l for recovering back taxes in order to exploit the taxpayers's ingnorance of the lack of penalities. Under the 1998 IRS reform act a taxpayer can request the authority for an adverse IRS position and the legal consequenses if the plan was to be disqualfied along with the citations to authority and the penalities. However the client should retain tax counsel if it intends to rely on the disqualification alternative instead of paying a penalty under audit CAP.

[KJohnson]

Also, as to rollovers I think there is a split in the Circuits. I believe that the 2nd Circuit says that you pro-rate distribution amounts between contributions and earnings for periods when the plan was qualified with contributions and earnings for periods when the plan was not qualified. My research file indicates that Greenwald v. Commr. is the case 366 F.2d. 538 (2nd Cir. 1966) although I haven't gone back to look at it. I think there is contrary opinions in the 5th, 6th, and 7th which say that you just look at the qualified status of the plan at the date of the distribuiton.