To preserve its tax-exempt status, a qualified retirement plan must comply with legal and regulatory requirements, both in form (the plan documentation) and in operation (how the plan is operated in accordance with the plan document). Plan sponsors must work with their service providers to ensure that plans are properly maintained and to limit plan defects.
When the IRS discovers that a plan is not in compliance with qualified plan requirements, disqualification (originally the IRSâ€™s only course of action) is a possible outcome. When a retirement plan is disqualified, the planâ€™s trust loses its tax-exempt status and becomes nonexempt. As a result, employees, the employer, and the planâ€™s trust are all negatively impacted. A retirement planâ€™s trust is a separate legal entity that is tax exempt. If a plan is disqualified, the trust loses its tax-exempt status and must pay income taxes on trust earnings.
Participants Lose Out
When a plan is disqualified, it means participants must include as taxable income any vested contributions the employer makes to the plan on their behalf in any calendar year for which the plan is deemed disqualified.
IRS Example: Pat is a participant in the XYZ Profit Sharing Plan. The plan has immediate vesting of all employer contributions.
â€˘ In calendar year one, the employer makes a $3,000 contribution to the trust under the plan for Patâ€™s benefit.
â€˘ In calendar year two, the employer contributes $4,000 to the trust for Patâ€™s benefit.
â€˘ In calendar year two, the IRS disqualifies the plan retroactively to the beginning of calendar year one. Pat would have to include $3,000 in her income in calendar year one and $4,000 in her income in calendar year two to reflect the employer contributions paid to the trust for her benefit in each of those calendar years.
Note: If the plan has a five-year graded vesting schedule and Pat is only 20% vested in her employer contributions in calendar year one, then she would include $600 (20% x $3,000) in her income for the year.
Sponsors Lose Out, Too
Disqualification also impacts the plan sponsor. The sponsorâ€™s tax deduction for amounts it contributed to the trust may be delayed or restricted as a result of a plan disqualification based on the deduction rules that apply when the plan is deemed nonqualified. Generally, sponsors of qualified plans cannot deduct contributions as of the point at which the plan is considered to be disqualified.
Fallout for Rollovers
Plan disqualification has an impact on rollovers, too. Plan distributions that were rolled over to other eligible retirement plans or individual retirement accounts (IRAs) are no longer considered eligible rollover distributions. As a result, all eligible rollover distributions that were rolled into an IRA or other qualified plan after the point the plan was considered to be disqualified would not be eligible for rollover and would be subject to taxation at that point.
Because the consequences for innocent, non-highly compensated plan participants can be extremely negative, the IRS established a program to assist plan sponsors in correcting the most common operational and plan document errors and retaining the planâ€™s tax-exempt status. The IRS Employee Plans Compliance Resolution System (EPCRS) encompasses three programs for correcting operational and plan document errors: the Self-Correction Program (SCP), the Voluntary Compliance Program (VCP), and the Closing Agreement Program (CAP). Through EPCRS, a plan sponsor can correct plan errors, pay a preset fee to regain its compliant status, and avoid the negative consequences of disqualification.
More details on the tax consequences of plan disqualification may be found in an IRS publication: Employee Plans News, Issue 2012-1, March 20, 2012 (www.irs.gov/pub/irs-tege/epn_2012_1.pdf ).
Make Compliance a Focus
Maintaining compliance is key to avoiding disqualification. A strong partnership between employer and service provider can help ensure that all the necessary steps are taken to make certain the plan is in compliance with the vast number of regulatory requirements that need to be satisfied. One of the best ways to assure proper compliance is to keep your service providers informed of any major changes in business circumstances that could impact the operation of your plan.
To learn more about regulatory compliance and plan disqualification, contact a Lumin Financial advisor.
Disclosure: Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific investment, or investment strategy. Investments involve risk and are not guaranteed. Information has been gathered from sources believed to be reliable, but cannot be represented as accurate or complete. Before investing, you should consult your investment, tax, or legal advisor.