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IRS Qualification for governmental plans

Guest Jhagan

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Guest Jhagan

Is it necessary for governmental plans to submit for a qualification letter? Is it true that governmental plans are considered "Qualified" until not qualified? What are the benefits of tax qualification?

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Guest CVCalhoun

In theory, no plan (governmental or otherwise) need submit a request for an IRS determination letter in order to be qualified. See Treas. Reg. § 1.501(a)-1(a)(2). This section states that an organization other than a 401(a) organization must file an application in order to be exempt from tax under section 501(a). Thus, a governmental plan which meets the requirements of section 401(a) will be exempt from tax under section 501(a), whether or not it requests or obtains an IRS determination letter.

The primary theoretical advantage of obtaining an IRS determination letter is that if the IRS issues a favorable letter, and later changes its mind on the interpretation of some provision of the qualification requirements, it will not impose any adverse change retroactively on a plan which has a determination letter and has abided by the terms of that letter. The primary practical advantage of obtaining an IRS determination letter is that most IRS agents, if presented with a current favorable determination letter, will not further question the qualification of the plan.

In the past, governmental plans often did not obtain qualification letters. This occurred for a variety of reasons. First, until recently, governmental plans were seldom audited. Thus, many plans felt that requesting a letter would bring the IRS into a situation which it was otherwise unlikely to examine. This reasoning has, however, become less popular after some recent well publicized audits of state plans, as well as overall IRS programs to audit colleges, universities, and hospitals which has resulted in the disqualification of certain governmental plans operated by such entities.

A more serious reason for not obtaining an IRS determination letter is that historically, the IRS has seldom issued determination letters without requiring at least some minor changes. Any such changes must be adopted within 90 days after the issuance of a determination letter in order to make the determination letter effective. Many state plans are embodied in statutes, and may be hard to amend during the 90-day period (especially if the legislature is not in session during that period). Moreover, state legislatures have been known to amend legislative language after it has been approved by the IRS, at which point the IRS letter may not give much protection.

The IRS has shown some willingness to adjust the timing of issuing a determination letter to a plan which is embodied in legislation, to allow for coordination with a legislative session. However, in some instances there is concern as to whether a legislature will adopt amendments requested by the IRS at all, or will substantially modify them before adopting them. In such instances, the protection to be gained from a determination letter must be balanced against the possible negative inferences which might arise if a state failed to adopt plan amendments after being told by IRS that such amendments were necessary to qualification.

Regardless of whether a governmental plan obtains an IRS letter, it is important that the plan comply with qualification requirements in order to avoid both adverse income tax consequences to participants, and adverse withholding tax consequences to employers which contribute to the plan. You can click here for a list of which qualification requirements do and do not apply to governmental plans.


Employee benefits legal resource site

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Another thorough answer from Carol.

But let me be specific about one item she mentioned, that of avoiding adverse consequences to participants (her last paragraph).

When a paticipant terminates employment and receives a distribution, there is often a desire to rollover that to an IRA. An IRA is supposed accept money only from a qualified plan. Therefore, the participants will certainly want the plan to be qualified.

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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