A retirement plan sponsor has a fiduciary duty to ensure that the plan complies with all federal and state rules and regulations, such as the Internal Revenue Code and ERISA. Plan sponsors must follow the plan’s provisions and can’t deviate from those provisions unless amending the plan. Not following the provisions can lead to plan disqualification. Before that happens, sponsors should correct any missteps.
Consequences of disqualification
When a plan is disqualified, the ramifications affect not only the plan trust and the employer sponsoring the plan, but the employees as well:
Employees must include contributions in gross income. For the years the plan is disqualified, the employee must include in income any vested employer contributions made on their behalf. In some situations, highly compensated employees must also include any employee contributions that weren’t previously taxed. (See the sidebar “Disqualification reality.”)
Rollovers not allowed. Distributions from a disqualified plan aren’t an eligible rollover. Therefore, an employee can’t roll them into another retirement plan. The distributions are taxable to the participant.
Employer deductions are limited. On the employer side, any employer contributions can’t be deducted until the contribution is includable in the employee’s gross income. This means that nonvested contributions lose their deduction until they become vested. In addition, an employer can’t deduct contributions for accounts that aren’t separated by employee, as is the case with a defined benefit plan.
Income tax owed on the trust earnings. The plan’s trust is no longer considered tax-exempt and the plan must file Form 1041, “U.S. Income Tax Return for Estates and Trusts.” The trust will need to pay income tax on the earnings.
Contributions are subject to Social Security, Medicare and federal unemployment taxes (FUTA). 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’s made, the employer is liable for the payment of FICA and FUTA taxes on them.
How to correct mistakes
Because the consequences of plan disqualification are so negative, it’s critical to correct mistakes before a plan can be disqualified. When plan sponsors find they’ve made an error, they can correct the failures under the Employee Plans Compliance Resolution System (EPCRS), which consists of two IRS correction programs:
1. The self-correction program (SCP). The SCP program is used for “insignificant” operational errors for any type of plan. EPCRS lists factors considered in determining whether an error is considered insignificant or significant. The plan sponsor can make the correction without contacting the IRS or paying a fee. Certain plans may use the SCP to correct a significant operational error if action is taken in a timely manner.
2. The voluntary correction program (VCP). The VCP program is used for plan sponsors that can’t or don’t want to use the SCP program, and it allows them to voluntarily correct errors before an audit, pay a fee and receive IRS approval of the correction.
If a plan doesn’t use the SCP or VCP program to correct a plan error and the IRS finds the mistake due to a plan audit, the plan will be subject to the audit closing agreement program (Audit CAP). The IRS can impose significant fees in this stage of the program.
Compliance is the key
The IRS has a plan checklist that sponsors can review for tips to maintain their plan in compliance with the law. Keep in mind that this isn’t a comprehensive guide, but more of a tool to summarize major compliance issues. In addition, the IRS created the Employee Plans Team Audit (EPTA) program, which lists the top trends across all types of plans for disqualification. Visit irs.gov for additional information.
Sidebar: Disqualification reality
In Yarish v. Commissioner, a highly compensated employee (HCE) participated in his company’s employee stock ownership plan (ESOP). The HCE was fully vested from the start of the plan until its date of termination, and none of the money had been taxed.
At the end of 2004, the HCE rolled over his vested ESOP balance to an IRA, normally a nontaxable event. However, the ESOP was found to be disqualified for certain plan years, including 2004.
At issue in the case was the meaning of “an employee’s investment in the contract” under Internal Revenue Code Section 402(b)(4)(A) and the amount that should be included as taxable income for specific years. The HCE claimed that only the annual increase for 2004 should be included in income. The IRS Commissioner argued the entire vested amount should be taxable because, even though earlier plan years were out of the limitations period, the vested balance had never been included in income and was therefore taxable in 2004.
According to the U.S. Tax Court, the purpose of Sec. 402(b)(4)(A) is to “penalize highly compensated participants in plans that fail to satisfy certain coverage and participation requirements.” Thus, the court concluded that, when a plan is disqualified, an HCE must include in income that portion of the vested accrued benefit that hasn’t previously been taxed.
For more information contact QPAC at [email protected].