It’s not unusual for the IRS to conduct audits of qualified employee benefit plans. Plan sponsors are expected to stay on top of related changes in the tax law. If the tax agency uncovers compliance errors and the plan sponsor does not fix them, the plan could be disqualified. There are also penalties and fees that can be devastating to a business.
In one decision, the Tax Court said a single-participant profit sharing plan was disqualified from tax-favored status because it had not been amended to comply with Internal Revenue Code changes enacted in 2000 and 2001.
Here are the details of this case, along with an explanation of the negative tax consequences that can occur when a plan is disqualified.
Facts of the Case: The Christy & Swan Profit Sharing Plan was established in 1976 for a real estate business owned by David Swan, Jr. He was the only plan participant and he served as the plan’s trustee.
Unfortunately, the plan was never amended to comply with tax law requirements added by legislation enacted in 2000 and 2001.
In 2007, IRS audited the plan’s Form 5500-EZ (the annual return required for small qualified plans). Swan, as the plan trustee, gave the IRS a declaration stating that the plan had been “amended by general reference” to incorporate all statutory and regulatory changes necessary to retain its qualified status. The IRS disagreed and attempted to convince Swan to participate in the agency’s closing agreement program whereby the plan’s qualified status could be preserved by paying a reasonable sanction and making the necessary amendments.
Swan declined that opportunity. He then argued that the plan had ceased to exist (because it had long since ceased taking contributions or admitting new participants) and had morphed into a “Repository Trust” that was simply holding funds for the plan’s beneficiary (who was Swan).
“As such, any subsequent rules or laws applicable to profit sharing plans are not applicable as this plan ceased to be a profit sharing plan as of 1/1/01,” Swan wrote in a letter to the IRS.
In 2009, the IRS sent Swan a letter informing him that the plan was disqualified due to failure to make required tax law amendments. Later that year, the plan took its case to the Tax Court — seeking a declaratory judgment that it had not lost its qualified status.
The Tax Court’s Decision
The Tax Court affirmed that the IRS had acted properly in revoking the plan’s qualified status. The Court noted the requirements that a plan must satisfy in order to be a qualified (under Section 401(a) of the Internal Revenue Code) must be “strictly met.” References to such requirements in plan correspondence were not enough.
The Tax Court treated Swan’s claim that the plan had become a “Repository Trust” as implying that it had been terminated in 2001 and therefore was not required to be amended to reflect 2000 and 2001 tax law changes. However, to formally terminate a plan, specific requirements must be met — including establishing a termination date, determining participants’ benefits on that date and distributing the plan’s assets to participants as soon as administratively feasible after that date. The Christy & Swan plan had done none of these things. (Christy & Swan Profit Sharing Plan, T.C. Memo 2011-62)
Trustees of small business retirement plans should heed this decision. Tax law and administrative details that may seem trivial or irrelevant may actually be critical to maintaining the plan’s qualified status. If a plan loses that status, each participant is taxed on the value of his or her vested benefits as of the disqualification date. That can result in a large (and completely unexpected) tax hit for participants.
In addition, contributions and earnings that occur after the disqualification date are not tax-free. They must be included in the participants’ taxable incomes. The employer’s tax deductions for plan contributions are also at risk. Finally, withdrawals after the disqualification date cannot be rolled over into another tax-favored retirement plan or account (such as an IRA).
Bottom line: An unexpected plan disqualification can trigger serious tax problems.