Plan disqualification

[Dennis Povloski]

I've come across a case where a dental practice has a 401k plan for it's staff, and each dentist was told by an Attorney/CPA/TPA that they could set up outside entities (the dentist being the only employee in each entity), and that these outside entities could have their own DB & 401(k) plans.

Everything that the client is telling me screams affiliated service group. I have no idea what basis the prior consultant justified these plans.

I explained that the clients should approach the IRS through one of the correction programs to see how to resolve this, and explained about adding back employees, making up contributions, and paying excise taxes.

Then, one of the dentists asked if it would be better to just have the plans disqualified.

The practice has about 25 employees in it. One of the dentists is in his early 40's and is about the same age as most of the employees. The other dentist is in his late 50's. The younger dentist has about $600k in his DB plan, and the older one has just over $1M in his plan.

By the way, the "individual plans" were effective 1/1/2004.

Has anyone seriously had to weigh plan disqualification as an option?

I know that the right answer is to call in the help of an ERISA attorney, but I'm still arming myself for the conversation I'm going to have to have with these guys.

Thanks!

[J Simmons]

Who owns the entity that employees the staff, and in what proportions if more than one?

[Dennis Povloski]

I'm still trying to untangle the whole mess, but the way I understand it, the two dentists are 50/50 owners of their practice. Each dentist initially, had a sole proprietorship that sponsored their individual DB & 401k. The sole proprietorship's income was derived from personal loans and consulting fees paid from the practice.

In the second year, the younger dentist set up an s-corp which owned office equipment that was leased to the dental practice (the S-corp's only source of income). The S-corp became the sponsor of his individual plans for the younger dentist.

I suspect that something similar happened for the older dentist but need confirmation.

[J Simmons]

Disqualification as a voluntary option rather than IRS detection and enforcement, I'm assuming that would entail amending each of the two dentist's Schedule C's and/or Forms 1120S to remove the deduction for each year of contribution to the individual DB & 401k. Then on the upped taxable income, there would be additional income tax and interest and penalties. The investment income would be taxable to the nonqualified trusts, so there would need to be Forms 1041 and taxes paid.

Then the dentists do not have the remaining dollars in tax-advantaged vehicles regarding future earnings.

The dentists might want to consider whatever claims they might have against the Attorney/CPA/TPA regarding the tax penalties and the fees they've paid before the statute of limitations runs out.

[Dennis Povloski]

Does the client also get taxed personally on the distribution of his benefits?

[J Simmons]

The extra income would be the individual's for the years that a Schedule C sole proprietorship was involved. For the years an S Corp was in existence, the extra income would flow through to the shareholders as dividends, per amended K-1's, and thus the need for the dentist's 1040s to be amended as well. The individual dentists would be taxed, but no entity would owe tax.

[masteff]

The younger dentist has about $600k in his DB plan, and the older one has just over $1M in his plan.

By the way, the "individual plans" were effective 1/1/2004.

Given the size of the assets, really should look at what the minimum corrective contribution to fix the plans would be and weigh that cost against taxes and penalties.

To illustrate:

Potential tax liablity = 1,600,000 * .35 = 560,000

Suppose average comp is $40,000

25 employees at $40k for 4 years = total comp of $4,000,000

$560,000/$4,000,000 = 14%

So, by the numbers in this example, as long as it cost less than 14% of total compensation to fix the plans, then it might be cheaper to give eligible employees a minimum benefit than to pay taxes and penalties.

You would need to determine actual eligible compensation. It might be significantly more or less than my guess. I'd think less because it probably wasn't 25 employees consistently and can probably use eligibility rules to exclude some (one year of service, etc).