Plan Disqualification (Statute of Limitations)

[Scuba 401]

when is a plan actually considered disqualified?  does the IRS have to formerly disqualify before it is considered disqualified? i know the IRS can reach back to open years but was wondering how the SOL applies to plans that might not be qualified due to failures (but not formerly disqualified by the IRS)

[Degrand]

The failures are the cause of the disqualification.  The IRS can find a plan to be disqualified even during closed plan years.   I have seen the IRS take this position with plan document failures.   

[MoJo]

I think once "disqualified" it remains as such unless corrected via an IRS approved method (CAP program), so if the act that disqualified the plan took place 15 years ago and remains uncorrected (in the IRS' eyes), it is still not qualified, and the IRS can take "current" action against the plan/sponsor.

[Peter Gulia]

Before even the earliest of the IRS’s fix-it procedures, I remember lawyers and other practitioners saying that most plans are tax-disqualified—it’s just that the IRS hasn’t yet made that determination.  Although many of those remarks were merely flippant, some considered questions about an employer’s or payer’s duty in tax-reporting wages or a plan’s distribution.  For example:

 

1.    Imagine a plan’s administrator administered the retirement plan contrary to its governing documents (and contrary to a tax-qualification condition).  Is the plan tax-disqualified?  If the employer knows this happened, must the employer’s Form W-2 reporting treat amounts intended as non-Roth elective deferrals and matching contributions (if 100% vested and nonforfeitable) as not excluded from wages?

 

2.    Imagine an insurance company, even if neither a trustee nor an administrator, is responsible for Form 1099-R reporting.  Imagine it has full knowledge of the defect (perhaps because the bank or insurance company is the plan’s recordkeeper or its affiliate).  Consider a single-sum distribution that, if the plan were a tax-qualified plan, would be an eligible rollover distribution.  Must the insurance company code the distribution as not rollover-eligible?  Must the payer decline to process a direct-rollover payment?

 

(For both situations, assume the employer/administrator told the service providers the employer will not pursue any IRS correction, nor even self-correction.  Assume also that nothing about the defect involves a § 401(a)(26) or § 410(b) failure.  Assume the plan’s governing documents have nothing beyond an IRS-approved document and the employer is up-to-date for all amendments, including interim amendments.)

 

If you were advising the employer or the payer, how would you analyze what it must (or need not) do?

[Scuba 401]

4 hours ago, MoJo said:

I think once "disqualified" it remains as such unless corrected via an IRS approved method (CAP program), so if the act that disqualified the plan took place 15 years ago and remains uncorrected (in the IRS' eyes), it is still not qualified, and the IRS can take "current" action against the plan/sponsor.

my research indicates the IRS can force you to correct all years but in a disqualification situation can't collect taxes for closed years.  i guess i was wondering if a plan was not qualified due to its operation whether the SOL applies. i think the answer is yes but still a little confused by it. 

[Belgarath]

A nice general blurb. https://www.irs.gov/retirement-plans/tax-consequences-of-plan-disqualification

P.S. I also found this blurb in some old notes, FWIW.

Disqualification.  The tax advantages of a qualified retirement plan are:  (1) employer contributions to the plan are immediately deductible, (2) earnings on qualified trust assets are sheltered from income tax, and (3) participants only have to include amounts in gross income when they are distributed from the qualified plan.  While there are exceptions to each of these, they generally describe the tax attributes of a qualified plan.

 

Disqualification removes these tax benefits.  In general, disqualification will arise from the time the IRS determines that a plan failed to meet the Code § 401(a) requirements.  So disqualification is likely to be retroactive in nature, and it follows that the change in applicable tax rules for the employer, the trust, and the participants will likewise be retroactive.  This raises the distinct probability of underpayment interest, and the possibility of penalties being assessed.

 

The statute of limitations could serve to limit the period for retroactive inclusion.  Generally, the statute of limitations is 3 years from the return filing date.  However, Code § 6051(e) provides for a 6 year statute of limitations if the amount omitted from the tax return exceeds 25% of the amount of gross income claimed in the tax return.

 

If the plan is the subject of a favorable determination letter, the general position of the IRS is that the plan is entitled to Code § 7805(b) reliance on that letter.  As a result, disqualification would only apply from the time the IRS provides notice of the qualification defect (i.e. no retroactive disqualification).

[Luke Bailey]

Taxes can only be assessed based on returns filed or that should have been filed, and each of those returns has a statute of limitations. With a qualified plan, you have the trust (which would need to have filed 1041s for the years when it was not qualified), the individual participants (who would have to have included their vested interests in income on their 1040's  if plan not qualified), and employer, who would lose deduction on Schedule C, 1065, or 1120-C or -S for amounts contributed to trust and not included in employees' income.

If a plan is disqualified and IRS catches it and does not exercise its discretion to enter into a closing agreement, then taxes would be due on the trust back to effective date of plan (no 1041's filed, so the statute of limitation never starts to run), and the statutes of limitation on individuals would be 3 or 6 years (6 if the inclusion would exceed 25% of the individual's gross income). The employer's statute of limitations will probably be 3 years, but it's complicated, plus for all of these IRS will try to get tolling agreements.

The trust income calculation is very tricky, because you get deductions for distribution of income. Finally, the biggest issue is that rollovers that occurred were attempted at the time the plan was in a disqualified state are not valid rollovers.

Suffice to say, statutes of limitations can and will apply and are sometimes a useful defense in negotiating closing agreements, but the tax liability can really add up for the still open years.

If you correct, the correction is back to the point in time where the disqualification error occurred, at least that is IRS's opening position. The statute of limitations is irrelevant to the concept of correction because the doctrinal view within IRS is that qualification, even though relevant for determining taxpayers' income for open years, as outlined above) is a state that must be continuous, i.e., a break in the pass carries forward into the future forever until corrected, because you have tainted assets in the trust for bad years, even if at some point you operated the plan correctly.

[Peter Gulia]

What Luke Bailey said.

 

And on the IRS’s side of the negotiation is the penalty for each incorrect W-2 wage report and taxes and interest due from each failure to withhold income tax from wages for which § 401(k), § 403(b), or § 457(b) provided no exclusion.

 

******

 

Further, consider that some certified public accountants decline to be associated with a business organization’s income tax return if the return would include a position that depends on the retirement plan having been tax-qualified and the CPA knows the plan was not tax-qualified.

 

Of those, many will proceed on receiving satisfactory assurances that the employer/administrator has engaged a lawyer or other practitioner for a correction that will be effective, retroactively, for the period of the tax return.