Tax Consequences of Plan Disqualification

Ever wonder what all the hoop-la is around keeping your plan documents up to date, following the nondiscrimination rules and operating the plan in accordance with its written terms?  The following is an article from the Internal Revenue Service's website that details the consequences of having your plan disqualified.

When an Internal Revenue Code (IRC) §401(a) retirement plan is disqualified, the plan's trust loses its tax-exempt status and becomes a nonexempt trust. Plan disqualification affects three groups:

1. Employees
2. Employer
3. The plan's trust

Example: Pat is a participant in the XYZ Profit-Sharing Plan. The plan has immediate vesting of all employer contributions. In calendar year 1, the employer makes a $3,000 contribution to the trust under the plan for Pat's benefit. In calendar year 2, the employer contributes $4,000 to the trust for Pat's benefit. In calendar year 2, the IRS disqualifies the plan retroactively to the beginning of calendar year 1.

Consequence 1: General Rule - Employees Include Contributions in Gross Income

Generally, an employee would include in income any employer contributions made to the trust for his or her benefit in the calendar years the plan is disqualified to the extent the employee is vested in those contributions.

In our example, Pat would have to include $3,000 in her income in calendar year 1 and $4,000 in her income in calendar year 2 to reflect the employer contributions paid to the trust for her benefit in each of those calendar years. If Pat was only 20% vested in her employer contributions in calendar year 1, then she would only include $600 in her calendar year 1 income.

Exceptions: There are exceptions to the general rule (see IRC §402(b)(4)):

• If one of the reasons the plan is disqualified is for failure to meet either the additional participation or minimum coverage requirements (see IRC §§401(a)(26) and 410(b)) and Pat is a highly compensated employee (see IRC §414(q)), then Pat would include all of her vested account balance (any amount that wasn't already taxed) in her income. A non-highly compensated employee would only include employer contributions made to his or her account in the years that the plan is not qualified to the extent the employee is vested in those contributions.
• If the sole reason the plan is disqualified is that it fails either the additional participation or minimum coverage requirements, and Pat is a highly compensated employee, then Pat still would include any previously untaxed amount of her entire vested account balance in her income. Non-highly compensated employees, however, don't include in income any employer contributions made to their accounts in the disqualified years in that case until the amounts are paid to them.

Note: Any failure to satisfy the nondiscrimination requirements (see IRC §401(a)(4)) is considered a failure to meet the minimum coverage requirements.

Consequence 2: Employer Deductions are Limited

Once the plan is disqualified, different rules apply to the timing and amount of the employer's deduction for amounts it contributes to the trust. Unlike the rules for contributions to a trust under a qualified plan, if an employer contributes to a nonexempt employees' trust, it cannot deduct the contribution until the contribution is includible in the employee's gross income.

• If both the employer and employee are calendar year taxpayers, the employer's deduction is delayed until the calendar year in which the contribution amount is includible in the employee's gross income.
• If the employer has a different taxable year than the employee (a non-calendar fiscal year), the employer cannot take a deduction for its contribution until its first taxable year that ends after the last day of the employee's taxable year in which the amount is includible in the employee's income.

For example, if the employer's taxable year ends September 30 and a contribution amount is includible in an employee's gross income for the employee's taxable year that ends on December 31 of year 1, the employer cannot take a deduction for its contribution until its taxable year that ends on September 30 of year 2.

Also, the amount of the employer's deduction is limited to the amount of the contribution that is includible in the employee's income and whether a deduction is allowed depends on whether the contribution amount is otherwise deductible by the employer. Finally, if the plan covers more than one employee and it does not maintain separate accounts for each employee (as may be the case with a defined benefit plan), then the employer is not able to deduct any contributions.

In our example, assuming both the employer and Pat are calendar year taxpayers, the employer's $3,000 deduction in calendar year 1 and $4,000 in calendar year 2 would be unchanged because that is when Pat would include these amounts in her income. However, if Pat were only 20% vested, then the employer would only be able to deduct $600 in calendar year 1 (the vested part of her employer contribution) which is the amount Pat would include in her calendar year 1 income.

Consequence 3: Plan Trust Owes Income Taxes on the Trust Earnings

The XYZ Profit-Sharing plan's tax-exempt trust is a separate legal entity. When a retirement plan is disqualified, the plan's trust loses its tax-exempt status and must file Form 1041, U.S. Income Tax Return for Estates and Trusts (instructions), and pay income tax on trust earnings.

Revenue Ruling 74-299 as amplified by Revenue Ruling 2007-48 provides guidance on the taxation of a nonexempt trust.

Consequence 4: Rollovers are Disallowed

A distribution from a plan that has been disqualified is not an eligible rollover distribution and can't be rolled over to either another eligible retirement plan or to an IRA rollover account. When a disqualified plan distributes benefits, they are subject to taxation.

Consequence 5: Contributions Subject to Social Security, Medicare and Federal Unemployment (FUTA) Taxes

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 is made, then the amount of the contribution is subject to FICA and FUTA taxes at the time of contribution. The employer is liable for the payment of FICA and FUTA taxes on them. If the contribution is not vested at the time it is made, then the amount of the contribution and its earnings are subject to FICA and FUTA taxation at the time of vesting. For contributions and their earnings that become vested after the date of contribution, the nonexempt employees' trust is considered the employer under IRC §3401(d)(1) who is responsible for withholding from contributions as they become vested.

Calculating Specific Plan Disqualification Consequences

Calculating the tax consequences of plan disqualification depends on the type of retirement plan. For example, the tax consequences for a 401(k) plan differ from the consequences for a SEP or SIMPLE IRA plan.

How to Regain Your Plan's Tax-Exempt Status

Generally, if a plan loses its tax-exempt status, the error that caused it to become disqualified must be corrected before the IRS will re-qualify the plan. You may correct plan errors through the IRS Voluntary Correction Program. However, if your plan is under examination by the IRS, you must correct the errors through the Audit Closing Agreement Program.

Note: This is a general overview of what happens when a plan becomes disqualified for failure to meet qualification requirements (see IRC §401(a)). These examples provide general information and you should not rely on them as legal authority as they do not apply to every situation. For more information, see Rev. Rul. 74-299 and Rev. Rul. 2007-48 (and the law and regulations discussed in those rulings).

                                                                   Page Last Reviewed or Updated: March 20, 2012

The American Red Cross has an emergency need for people to give blood and platelets now. Blood donations are down more than ten percent since the beginning of June, resulting in a deficit of more than 50,000 pints of blood as the summer gets started.

The number of people giving blood typically drops at this time of year, but hospital patients still need blood to help them on their road to recovery. "Many people are just not available to give blood at this time of the year," said Dr. Richard Benjamin, chief medical officer for the Red Cross. "Schools aren't in session, businesses are on holiday schedules and people are on vacation. We're asking everyone to remember those who need blood and to add giving blood to their summer plans."

Blood donations drop when schools are out for the summer. Combined with the unseasonably hot weather so early in the year and businesses not scheduling blood collections due to the mid-week Fourth of July holiday, there is a shortfall of more than 50,000 blood donations before the summer really gets rolling. Because each donation can be manufactured into as many as three different blood products - red cells, plasma and platelets - the early blood donation deficit has resulted in about 150,000 blood products not being available for hospital patients who need them.

WHO CAN GIVE

Individuals who are 17 years of age (16 with parental permission in some states), meet weight and height requirements (110 pounds or more, depending on their height) and are in generally good health may be eligible to give blood. People should bring their Red Cross blood donor card or other form of positive ID when they come to donate. It must be at least 56 days since their last blood donation.

The Red Cross asks anyone who is eligible to please consider making a blood donation appointment now. All blood types are needed. To make an appointment to give blood or find a blood drive nearby, call 1-800-RED CROSS (1-800-733-2767) or visit redcrossblood.org.