Bankruptcy Question

Here is an interesting situation: The IRS , during an audit of a 401(k) Plan, has informed the plan sponsor that they were using the incorrect definition of compensation in withholding from eligible employees. They are requesting that the sponsor go back to 2002 to make the appropriate corrections. Here are the two questions that have arisen:

The plan sponsor no longer has the payroll records back to 2002, but does have the compliance testing from their TPA (who is no longer in existence). They are wondering if they can use the compensation information from these tests in order to perform the calculation, informing the IRS that this is all they have and it's their best estimate as to the amounts due. The plan sponsor is doing the corrections on their own.

Second, during this whole thing, the plan sponsor went bankrupt in 2001, and emerged from bankruptcy in 2005. They are wondering if they could be responsible for the corrections during a period of time where they were bankrupt.

If anybody has thoughts on this, I would be interested in hearing them. Thanks.

I've had mixed success with the IRS in using the "records don't exist" argument.  Theoretically, those records should be maintained as long as necessary to calculate the benefits due.  In a defined contribution plan, one would think that after the year is "closed" that would be sufficient, but the the IRS - as the case at hand demonstrates, doesn't always agree.

As far as the bankruptcy goes - and other with more experience should weigh in here - I think the bankruptcy handles debts/liabilities that existed as of the date of filing - not those incurred after the filing but while the administration of the bankruptcy is still ongoing.  Indeed, in the situations where I've dealt with bankrupt companies, we kiss goodbye what they owe us before the filing, but make them pay up for services performed post filing regardless of whether the administration is complete.

I think an issue in the background here is the legal responsibility, if any, of the plan sponsor to maintain the qualification of the plan. As far as I know, not a lot on that. Obviously, there are typically a lot of reasons why the employer will not want to see it's plan disqualified, but the plan is a separate legal person and, theoretically, taxpayer, as are the participants. The employer's deduction is most likely secure in any event, because the worst that can happen is the deduction for unvested contributions is delayed until the amounts vest. Of course plan documents and employee communications, and other facts and circumstances, could affect the answer to the question.

To the extent there is an argument that the employer has no direct legal liability itself if the plan becomes disqualified, this strengthens the employer's negotiating position while it is in bankruptcy, but has no effect once it has emerged.