Plan Disqualification

[Blinky the 3-eyed Fish]

I try and keep my plans qualified, so I am not sure of the answer to this. If a DB plan is disqualified, what happens to the assets in the plan. Let's say it's an owner who is the only one with a DB benefit.

My guess is he would have taxable income either at the individual or corporate level depending on who takes possession of the money. Any idea how this is reported as income on a tax return, either individual or corporate? Any other tidbits to worry about?

[Everett Moreland]

If you read IRC Section 409A you might conclude that you never want to have a disqualified plan

[Guest mjb]

The employee is taxed on the amount of the benefit which is vested, the employer loses the deduction for all open years in which contributions were made but can recapature deductions to the extent the employees is taxed on the benefits under IRC 83. Trust earnings are taxed under tax rates for taxable trust under IRC 671.I dont know how this principle works if a self employed person is the participant. Everett, I dont understand what your concern is under 409A other than it adds another layer of rules to the above rules.

[saabraa]

Most qualified plans hold the benefit in trust; this doesn't change when the plan is disqualified. But now it's a taxable trust that files Form 1041 to report taxable earnings and distributions.

The trust is still for the benefit of the participant. I agree that the participant realizes taxable income to the extent vested, and the employer is allowed a deduction to the same extent. But to clarify, that's only for the open years and applies to the benefit accrued in each open year. The remainder of the benefit does not become immediately taxable. As it's distributed, it then is taxable on the individual's 1040, without the right to roll it over.

So, in some cases, disqualification's bark is worse than its bite. If the corpus is small and the open year contributions are small and the participant is ok with taking the benefit into income as it's distributed, then you can live with a disqualification.

It's still a pension plan that, in our example, should look at the 5500EZ requirements to see if a filing is required.

[Blinky the 3-eyed Fish]

Ok, well this unfortunately applies to a specific situation of a takeover client. So, some more specifics are:

1) The participant accrued benefits through 2002 and the plan was frozen in before benefits accrued in 2003, so we are very near, if not already there, to having the 2002 year be closed. (I don't know if the corporate taxes were extended.)

2) Smaller contributions were made in 2003 and 2004, so those are obviously in jeopardy. But you are saying that it's the benefit accrual that determines the treatment of the dollars, not the contributions?

Then to summarize what I think you are saying. The trust will not be taxable to the individual until distributed. However, the captial gains, interest, dividends, etc. earned in the trust will be taxable each year since it is a taxable trust, thus negating the tax free deferrment.

[Everett Moreland]

mjb:

Thank you for questioning my assumptions about how IRC Section 409A applies to a disqualified plan. I'm starting to wonder whether 409A applies to a disqualified plan. I would appreciate any comments. Here's my analysis:

1. My understanding is that if a funded plan is never qualified, then 409A does not apply to the plan. Proposed Treasury Regulation Section 1.409A-1(b)(6) (quoted in 7 below).

2. My understanding is that if all participants fully vest before the first year a qualified plan becomes disqualified and IRC Section 402(b)(4) does not apply to the disqualification, then the disqualification does not cause the then-accrued plan benefits to be taxable under 402(b) before distribution. 402(b)(1) and (2); Treasury Regulation Section 1.402(b)-1(b)(1); IRM 4.72.12.2.3(2)c ("When a qualified plan becomes nonqualified, the employee-participant is not taxed on his/her account balance attributed to employer contributions while the plan was qualified or increases in the account balance attributed to trust earnings").

3. My concern is that, because these benefits are not taxable under 402(b) until distribution, they are untaxed vested nonqualified deferred compensation and so are immediately taxable under 409A, which adds to the regular tax a 20% penalty tax and interest for the deferral period. I am assuming that the plan does not satisfy 409A and that the benefits are not grandfathered under Proposed Treasury Regulation Section 1.409A-6.

4. IRM 4.72.12, which was issued with a date of 12/31/05, implies, in the sentence quoted in 2 above, that 409A does not apply, but IRM 4.72.12 does not refer to 409A.

5. IRS Notice 2005-1 (about 409A) and proposed Treasury regulations under 409A do not explicitly discuss this. One way to conclude that 409A does not apply is to conclude that the provision in 409A(d)(1) and (2) that 409A does not apply to a qualified plan means "qualified at the time of the contribution."

6. The following from the preamble to the 409A proposed regulations is the clearest IRS discussion I've found so far. It doesn't answer whether 409A can apply to a plan that become disqualified.

"Commentators requested clarification of the application of section 409A to participation by U.S. citizens and resident aliens in foreign plans. In this context, it should be noted that under these regulations, transfers that are taxable under section 402(b) of the Code generally are not subject to section 409A. See Sec. 1.409A-1(b)(6) of these regulations and Notice 2005-1, Q&A-4. Such transfers may consist of contributions to an employees' trust, where the trust does not qualify under section 501(a). Many foreign plans that hold contributions in a trust will constitute funded plans. To the extent that a contribution to the trust is subject to inclusion in income for Federal tax purposes under section 402(b), such a contribution will not be subject to section 409A." (70 Federal Register 57938 (October 4, 2004))

7. Following are the relevant parts of the 409A proposed regulations and IRS Notice 2005-1 cited by the IRS in 6. above:

1.409A-1(b)(6):

"If a service provider receives property from, or pursuant to, a plan maintained by a service recipient, there is no deferral of compensation merely because the value of the property is not includible in income in the year of receipt by reason of the property being substantially nonvested (as defined in Sec. 1.83-3(b)), or is includible in income solely due to a valid election under section 83(b). For purposes of this paragraph (b)(6)(i), a transfer of property includes the transfer of a beneficial interest in a trust or annuity plan, or a transfer to or from a trust or under an annuity plan, to the extent such a transfer is subject to section 83, section 402(b) or section 403©."

Notice 2005-1, Q&A-4(e):

"If a service provider receives property from, or pursuant to, a plan maintained by a service recipient, there is no deferral of compensation merely because the value of the property is not includible in income (under § 83) in the year of receipt by reason of the property being nontransferable and subject to a substantial risk of forfeiture, or is includible in income (under § 83) solely due to a valid election under § 83(b). . . . . For purposes of this paragraph, a transfer of property includes the transfer of a beneficial interest in a trust or annuity plan, or a transfer to or from a trust or under an annuity plan, to the extent such a transfer is subject to § 83, § 402(b) or § 403©."

[saabraa]

Ok, well this unfortunately applies to a specific situation of a takeover client. So, some more specifics are:

1) The participant accrued benefits through 2002 and the plan was frozen in before benefits accrued in 2003, so we are very near, if not already there, to having the 2002 year be closed. (I don't know if the corporate taxes were extended.)

2) Smaller contributions were made in 2003 and 2004, so those are obviously in jeopardy. But you are saying that it's the benefit accrual that determines the treatment of the dollars, not the contributions?

Then to summarize what I think you are saying. The trust will not be taxable to the individual until distributed. However, the captial gains, interest, dividends, etc. earned in the trust will be taxable each year since it is a taxable trust, thus negating the tax free deferrment.

Your summary is accurate.

However, my 'top of the head' initial response has been modified by subsequent reading. Looking at a vintage 1993 excerpt from BNA portfolio #374, it makes at least 2 more noteworthy points: 1) There's a 'separate share' requirement. It says (citing IRC 404(a)(5) and I.R. reg. 1.404(a)-12(b)(3)), if there's more than 1 participant, the employer takes a contribution deduction only if a separate account is maintained for each employee. BNA says additionally that this requirement will typically be met by a DC plan but not typically by a DB. There's an implication that a 1 person DB does meet the separate share requirement.

The discussion says where the separate share requirement is lacking, that's where you can use the increase in accrued benefit to determine the participant's income. (1.402(b)-1(a)(2). Apparently other methodologies are available as options. Still other rules arise with annuity contracts. It appears to me, at first glance, there's no discussion of employer deduction when there's a lack of the separate share aspect.

Maybe most of this is moot in your one person plan. There's a discussion of the entire A/B being taxable to the participant if he's a HCE in a plan that's being disqualified solely on account of 410(b) coverage and/or 401(a)(26) participation failure(s).

My summary: Hopefully/presumably your situation substantially fits my initial answer. A one person plan meets the separate share rule, so we don't need to get into finer points of increase in accrued benefit versus current year employer funding. If the participant's 100% vested, each year's contribution is taxable on the 1040 and deductible on the employer' 1120 or, for the self employed, 1040. Returning to the 1041 trust tax return, distributions are deductible on that return. So, generically speaking, if a $100,000 corpus earned $10,000 of realized income for a given year, with $9,900 being distributed to the participant, plus a $100 'specific' deduction, then the trust has no tax to pay.

A disqualified trust reverts to calendar year status, by the way.

[Locust]

Of course you could try to correct the plan.

If it really is disqualified, many issues. I've heard of companies arguing that the S/L applies, but there are many issues and ambiguities, and it may not be worth the hassle or the worry, so I think correction is always an approach to consider.

You have to be extremely careful about the statute of limitations - it's often greater than 3 years and it gets very technical about when the statute begins to run and what may toll the statute.

The plan needs a good tax lawyer.

[david rigby]

Might there be any plan provision which would trigger plan termination upon disqualification?

[Guest Carol the Writer]

The only thing that I can add from past experience is that the accrued benefit paid out of a disqualified plan is NOT counted against the 415 limit for future plan(s). This was my understanding, anyway.

[SoCalActuary]

Wanting to be disqualified is one consideration. Is this a desirable choice, or are you looking for the

pro's & con's of choosing to be DQ'ed?

Wanting to correct a disqualification is another. I have seen DQ's that were corrected in later years

so the only problems were on accruals and trust earnings while the DQ existed. In one such case,

the IRS did not try to pursue the closed years on the S/L, and we had already remedied the problem so

they only got one year of taxation. This was a non-amender under TRA 86.

[Blinky the 3-eyed Fish]

Correction is the desirable alternative, although there may not be a choice from the sound of it. We will see. I will have to request 7805-B relief. At this point I am gathering all information to inform the client of what to expect, although it will be a long while before anything is resolved.