Prospect with a massive coverage failure

[John Feldt ERPA CPC QPA]

Potential prospect is a controlled group, 2 employers each with a plan, plans started a couple years ago.

ER 1 plan: safe harbor match, 60 eligibles total, 10 are HCEs, no profit sharing.

ER 2 plan: non-safe harbor match. 450 NHCEs, no HCEs, no PS.

Matching formula is the same structure as the match formula in plan 1.

Can't aggregate a SH plan with a non-SH plan.

Coverage for plan 1 is 10%

Suggestions for passing coverage?

[Kevin C]

Ouch! I hope they have a large balance in their corporate checking account. I don't know of any way to fix it other than amending Plan 1 to retroactively make enough excluded employees participate that you will pass coverage. I would expect the retroactive missed deferrals and match to get expensive. Does Plan 1 allow the use of average benefit testing?

This sounds very similar to a plan we picked up for 2014 that was previously done by a firm in NM. If you change your situation to a single company, eliminate plan 2 and make the company about 1/3 that size, you get our client's former situation. After two years of asking the former TPA are you sure we can do this? and being told yes, they were told they had two years that needed expensive corrections.

[jpod]

I've never really studied this in depth but I believe there is a rule in the Code that says if the only reason for disqualification is the failure to satisfy 410(b) then the impact of disqualification falls solely on the HCEs. This rule - and how to implement it - may be something to explore further.

[John Feldt ERPA CPC QPA]

Thanks, I will take a look and then see if Sal has anything on that.

[Belgarath]

From the IRS Employee Plans News - in March, I think...

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 nonexempt trust. Plan disqualification affects three groups:
1. Employees
2. Employer
3. The plan’s trust

Example: Pat is a participant in the XYZ Profit-Sharing Plan. The plan has immediate vesting of all employer contributions. In calendar year 1, the employer makes a $3,000 contribution to the trust under the plan for Pat’s benefit. In calendar year 2, the employer contributes $4,000 to the trust for Pat’s benefit. In calendar year 2, the IRS disqualifies the
plan retroactively to the beginning of calendar year 1.
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.
In our example, Pat would have to include $3,000 in her income in calendar year 1 and $4,000 in her income in calendar year 2 to reflect the employer contributions paid to the trust for her benefit in each of those calendar years. If Pat was only 20% vested in her employer contributions in calendar year 1, then she would only include $600 in her calendar year 1
income.
Exceptions: There are exceptions to the general rule (see IRC section 402(b)(4)):
• If one of the reasons the plan is disqualified is for failure to meet either the additional participation or minimum coverage requirements (see IRC sections 401(a)(26) and 410(b)) and Pat is a highly compensated employee (see IRC section 414(q)), then Pat would include all of her vested account balance (any amount that wasn’t
already taxed) in her income. A non-highly compensated employee would only include employer contributions
made to his or her account in the years that the plan is not qualified to the extent the employee is vested in those
contributions.
• If the sole reason the plan is disqualified is that it fails either the additional participation or minimum coverage
requirements, and Pat is a highly compensated employee, then Pat still would include any previously untaxed amount of her entire vested account balance in her income. Non-highly compensated employees, however, don’t
include in income any employer contributions made to their accounts in the disqualified years in that case until the
amounts are paid to them.
Note: Any failure to satisfy the nondiscrimination requirements (see IRC section 401(a)(4)) is considered a failure to meet the minimum coverage requirements.
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
nonexempt employees’ trust, it cannot deduct the contribution until the contribution is includible in the employee’s gross income.
• If both the employer and employee are calendar year taxpayers, the employer’s deduction is delayed until the calendar year in which the contribution amount is includible in the employee’s gross income.
• If the employer has a different taxable year than the employee (a non-calendar fiscal year), the employer cannot take a deduction for its contribution until its first taxable year that ends after the last day of the employee’s taxable

year in which the amount is includible in the employee’s income. For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s gross income for the employee’s taxable year that ends on December 31 of year 1, the employer cannot take a deduction for its contribution until its taxable year that ends on September 30 of year 2. 9 For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s
For example, if the employer’s taxable year ends September 30 and a contribution amount is includible in an employee’s
gross income for the employee’s taxable year that ends on December 31 of year 1, the employer cannot take a deduction for its contribution until its taxable year that ends on September 30 of year 2.
Also, the amount of the employer’s deduction is limited to the amount of the contribution that is includible in the employee’s income and whether a deduction is allowed depends on whether the contribution amount is otherwise
deductible by the employer. Finally, if the plan covers more than one employee and it does not maintain separate accounts for each employee (as may be the case with a defined benefit plan), then the employer is not able to deduct any
contributions.
In our example, assuming both the employer and Pat are calendar year taxpayers, the employer’s $3,000 deduction in calendar year 1 and $4,000 in calendar year 2 would be unchanged because that is when Pat would include these amounts in her income. However, if Pat were only 20% vested, then the employer would only be able to deduct $600 in calendar year 1 (the vested part of her employer contribution) which is the amount Pat would include in her calendar year
1 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 (instructions), 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.
Calculating Specific Plan Disqualification Consequences
Calculating the tax consequences of plan disqualification depends on the type of retirement plan. For example, the tax consequences for a 401(k) plan differ from the consequences for a SEP or SIMPLE IRA plan.
How to Regain Your Plan’s Tax-Exempt Status
Generally, if a plan loses its tax-exempt status, the error that caused it to become disqualified must be corrected before the IRS will re-qualify the plan. You may correct plan errors through the IRS Voluntary Correction Program. However, if your plan is under examination by the IRS, you must correct the errors through the Audit Closing Agreement Program.
Note: This is a general overview of what happens when a plan becomes disqualified for failure to meet qualification requirements (see IRC section 401(a)). These examples provide general information and you should not rely on them as legal authority as they do not apply to every situation. For more information, see Rev. Rul. 74-299 and Rev. Rul. 2007-48 (and the law and regulations discussed in those rulings).

[GMK]

page 3 of this:

http://www.asppa.net/Document-Vault/Docs/Conferences/Benefits%20Conference%20of%20the%20South/2013/GS02.aspx

says it's true, for what it's worth.

[jpod]

Perhaps, however, I am wrong and trust earnings and deductions for the ENTIRE PLAN are still at risk (i.e., only the HCEs suffer income-inclusion but the other adverse tax consequences apply to the entire plan). As I said I never really explored this. It does seem odd, however, that if you set up a separate plan just for the 10 HCEs, and another plan for 50 NHCEs, the NHCE plan skates home free.

[John Feldt ERPA CPC QPA]

Thanks Belgarath and GMK - aware of the disqualification option, but they're not looking for that taxable solution just yet. Certainly a discussion of this will be included. I am curious what the IRS might be willing to negotiate for making this pass so it does not have a taxable solution.

Certainly giving the QNEC to enough NHCEs to pass, picking those that are still around today who were there when the error occurred, etc. But just how willing would the IRS be to negotiate regarding the size of the QNEC?

[Flyboyjohn]

Sounds like a problem that should be fixed (or at least paid for) by the prior TPA and has anonymous VCP written all over it.