Disqualified Plan, Not-For-Profit

[Rball4]

If a DB plan is close to failing testing and you get the "what happens if we fail" question from a client, you can generally say that the IRS can disqualify the plan and the contributions will no longer be deductible. That usually gets them to comply. But what if the client is a not-for-profit? If the plan is disqualified, what are the implications? Is it just possible benefit restrictions, which the client may not care about? Has anyone run into this kind of situation?

[Belgarath]

Perhaps this will help. Obviously, not all of this will apply to a tax-exempt employer, but some of it does.

Tax Consequences of Plan Disqualification

When an Internal Revenue Code section 401(a) retirement plan is disqualified, the plan’s trust loses its tax-exempt status and becomes a non-exempt trust. Plan disqualification affects three groups:

1. Employees
2. Employer
3. The plan’s trust

Consequence 1: General Rule - Employees Include Contributions in Gross Income

Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions. There are exceptions/modification in certain circumstances.

Consequence 2: Employer Deductions are Limited

Once the plan is disqualified, different rules apply to the timing and amount of the employer’s deduction for amounts it contributes to the trust. Unlike the rules for contributions to a trust under a qualified plan, if an employer contributes to a non-exempt employees’ trust, it cannot deduct the contribution until the contribution is includible in the employee’s gross income.

Consequence 3: Plan Trust Owes Income Taxes on the Trust Earnings

The XYZ Profit-Sharing plan’s tax-exempt trust is a separate legal entity. When a retirement plan is disqualified, the plan’s trust loses its tax-exempt status and must file Form 1041, U.S. Income Tax Return for Estates and Trusts, and pay income tax on trust earnings.

Revenue Ruling 74-299 as amplified by Revenue Ruling 2007-48 provides guidance on the taxation of a nonexempt trust.

Consequence 4: Rollovers are Disallowed

A distribution from a plan that has been disqualified is not an eligible rollover distribution and can’t be rolled over to either another eligible retirement plan or to an IRA rollover account. When a disqualified plan distributes benefits, they are subject to taxation.

Consequence 5: Contributions Subject to Social Security, Medicare and Federal Unemployment (FUTA) Taxes

When an employer contributes to a nonexempt employees’ trust on behalf of an employee, the FICA and FUTA taxation of these contributions depends on whether the employee’s interest in the contribution is vested at the time of contribution.

If the contribution is vested at the time it is made, then the amount of the contribution is subject to FICA and FUTA taxes at the time of contribution. The employer is liable for the payment of FICA and FUTA taxes on them. If the contribution is not vested at the time it is made, then the amount of the contribution and its earnings are subject to FICA and FUTA taxation at the time of vesting. For contributions and their earnings that become vested after the date of contribution, the nonexempt employees’ trust is considered the employer under IRC section 3401(d)(1) who is responsible for withholding from contributions as they become vested.

[Andy the Actuary]

Let's not overlook the potential devastating bad press that could affect donor giving. And of course, you will be unanimously selected as the reason to serve up to the Board of Directors as to why all of this is happening.

[mbozek]

If the employer anticipates that plan will not be maintained in accordance with the rules of the IRS then plan should be terminated while it meets the requirement for qualification to prevent taxation to the plan participants if the plan is DQed. Employer should not continue to maintain a plan that cannot meet the requirements for Qualification because fiduciaries/employer could be sued by the employees for adverse tax consequences resulting from the failure to keep plan tax qualified.

Best advice is to inform client that plan should not be allowed to fail qualification requirements because of risk to plan sponsor/fiduciaries if plan is DQed.