Avoid the Negative Consequences of Plan Disqualification

Correct Any Missteps Before It’s Too Late

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 cannot deviate from those provisions, unless amending the plan. Not following the plan’s provisions can lead to plan disqualification. Before that happens, sponsors should correct any missteps.

Consequences of Plan 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 were not previously taxed. (See the sidebar “Disqualification Reality.”)

Rollovers not allowed. Distributions from a disqualified plan do not constitute an eligible rollover. Therefore, an employee cannot roll the distributions into another retirement plan. The distributions are taxable to the participant.

Employer deductions are limited. On the employer side, no employer contributions can 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 cannot deduct contributions for accounts that are not 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 is made, the employer is liable for the payment of FICA and FUTA taxes on the contributions.

How to Correct Missteps

Because the consequences of plan disqualification are so negative, it is critical to correct any missteps before a plan can be disqualified. When plan sponsors discover they have made an error, they can correct the error 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 cannot or do not 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 does not use the SCP or VCP program to correct a plan error, and the IRS discovers the error 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 is not 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 provides a comprehensive listing of common plan errors noted during examinations of all plan types, to help you avoid potential plan disqualifications. Visit irs.gov for additional information.

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