Employer eligibility failure

[t.haley]

I have a client with a 401k plan originally effective in 2001. Problem is they are a governmental entity and doesn't meet the requirements for a "grandfathered" governmental 401k plan. I have reviewed the correction procedure in the EPCRS and just want to confirm my understanding of it. It appears that the correction procedure under VCP is to cease all contributions and "distribute" the assets in the form of rollovers to the new plan (I am guessing a 457(b) plan). Is this correct? Has anyone else filed a VCP submssion for this type of failure? Thanks in advance for your comments.

[Peter Gulia]

Beyond thinking about correction procedures for Federal income tax purposes, a governmental employer in the circumstances you describe should want advice about its duties under State law, and a participant should want advice about his or her rights under States' laws.

A governmental employer has power to create a retirement plan only to the extent provided by State law. If State law didn't empower the employer to create the plan it mistakenly assumed that it created, the effect of State law might be that the plan never happened. An employer should want to consider what steps it might take to contain its undo and restoration obligations, especially if some of the "participants" have "account" investments with a loss.

In my experience, a governmental employer faced with these circumstances can negotiate a conclusion with the IRS and the State and local governments involved. Often, the fitting solution is something different than the presumptive IRS-standard correction.

To get the best advice and solutions, an employer might prefer advice from someone who (1) confers legal rights to keep communications about how to fix the problems protected from disclosure, (2) is knowledgeable about governmental plans, and (3) is an outsider, unconnected to the State and local governments (or any employee) involved.

[Everett Moreland]

A governmental employer has power to create a retirement plan only to the extent provided by State law.

Mr. Gulia: Are you saying that the power of a state or local government to compensate its employees is insufficient to allow the government to create a retirement plan, that express authority to create a retirement plan is needed?

[Peter Gulia]

Yes, a power to pay compensation generally might not include a power to establish a particular kind of retirement plan. (Any one conclusion is beyond what this bulletin board is about because the questions and answers vary widely from State to State, and even within one State based on which governmental employer and what acts are involved.)

A State statute that empowers a specified class of governmental employers to pay salaries or wages to its employees often is construed or interpreted not to include a power to establish a retirement plan. Also, if a State has statutes stating governmental employers' powers concerning 403(b) contracts, 457(b) plans, and defined-benefit pension plans but lacks such a statute concerning a 401(a) defined-contribution plan, a court, attorney general, or other decision-making authority might interpret the absence of a statute when others are provided for parellel purposes as some evidence that the legislature did not intend to provide authority for what's missing. That kind of reasoning might have further support when the "plan" mistakenly assumed was one that under Federal tax law could not have had the tax treatment mistakenly assumed.

Between an employer and its employee, an agreement to do something that can't be legally valid usually isn't legally enforceable. And relevant law might treat as void or voidable an act that was beyond a governmental employer's powers. So if it turns out that an employer lacked power to establish a 401(k) plan, an employer that failed to pay wages (under a mistaken assumption that a wage reduction was allowed as a "plan" contribution) ought to start thinking about what remedies an employee has on that failure to pay wages.

A bulletin board of this kind is about helping another practitioner get some pointers about ideas to pursue. The answers to a specific situation involve a careful reading of the statutes, court decisions, and other sources of law involved.

[Guest Sieve]

On the other hand, statutory authority (or lack thereof) for establishing such a plan aside, there is a case or ruling out there somewhere (the citation of which JSimmons probably has handy) which indicates that if even one tiny division or unit of a governmental entity had a pre-existing 401(k), the grandfather provison may cover the entire governmental entity.

[Peter Gulia]

It was Letter Ruling 2000-28-042 (April 19, 2000), issued to the State of Idaho. That non-precedent ruling was based on a nice set of facts that supported treating a State and many of its agencies and political subdivisions as one employer. Since then, the IRS has not issued a similar ruling to anyone.

Again, even if an employer might be recognized as within the transition rule of Section 1011(f)(2)(B) of the Tax Reform Act of 1986 as amended by Section 1011(k)(8) of the Technical and Miscellaneous Revenue Act of 1988, that transition rule results only in the non-application of the general rule of Internal Revenue Code 401(k)(4)(B).

It's State law, not the Internal Revenue Code, that provides what power a governmental employer does or doesn't have.

[J Simmons]

Private Letter Ruling 200028042, April 19, 2000, issued to the State of Idaho is indeed the ruling that Larry referred to. Here are a few others since that first one that also extend a governmental 401k plan to related governmental entities: Private Letter Ruling 200125094, March 27, 2001; Private Letter Ruling 200250039, September 5, 2002; and Private Letter Ruling 200307093, November 19, 2002