Retroactive Disqualification of
Pension or Profit Sharing Plans

By Lee G. Knight and Ray A. Knight

In a number of cases, the IRS has retroactively disqualified profit-sharing or pension plans. The employer, participants, and the related trusts are all negatively impacted when this happens. The authors explain the impact on all parties and analyze two such cases to determine what went wrong.

Most people seldom consider the possibility, much less the effect, of the IRS retroactively disqualifying qualified pension or profit-sharing plans. In the past, the IRS rarely challenged the qualified status of plans already approved. Several recent cases, however, suggest the IRS has stepped up its efforts in this area, and the effect of disqualification on plan participants can be devastating--even more so than on the employer who caused the disqualification. Taxpayers and their advisors can no longer overlook this area and must become informed of the general parameters of the problem.

This article overviews the tax consequences of retroactive plan disqualification by first presenting and analyzing a disqualified hypothetical plan. The article then analyzes two cases of first impressions where the Tax Court upheld the IRS's right to retroactively disqualify defined contribution plans. This combined analysis should not only demonstrate the severity of this problem but also provide a better basis for advising employees, employers, or plan trustees.

A Hypothetical Plan

Plan Overview. XYZ Company's qualified profit-sharing plan and related trust have been in existence for six years. The plan provides for full and immediate vesting. Participants may not withdraw funds until they retire, become disabled, separate from service, or die. Separate accounts are maintained for each employee.

In year seven, before any contributions are made, the IRS disqualifies XYZ's plan retroactive to its inception. The reason for the disqualification is that XYZ has allowed its highly compensated employees to direct their own investments while denying this opportunity to other plan participants.

One XYZ employee, Ellen Smith, retires in year seven after the IRS retroactive disqualification. Ms. Smith receives a distribution equal to the balance in her account at that time.

All parties involved with XYZ's plan are calendar-year taxpayers. The normal three-year statute of limitations has closed years one through three for both XYZ and the participants. Neither XYZ nor the participants understated income by more than 25% or committed any other act that would extend this normal limitations
period.

Participant Treatment of Contributions. Contributions to nonqualified plans are includable in the taxable income of plan participants. The timing of inclusion, however, depends on the points at which the employees' interests in the contributions become substantially vested. If the contributions are substantially vested when made, as with XYZ's plan, the contributions are includable in the employees' incomes in the years made. Otherwise, they are includable in the employees' incomes in the year they become substantially vested.

Following these provisions, the contributions made to XYZ's plan in all six retroactive years are includable in the employees' incomes. However, the three year statute of limitations protects participants for the first three years. The IRS can seek back taxes, interest, and penalties from XYZ participants only for the contributions made to employees' accounts in years four through six.

If XYZ's plan had provided for full vesting after three years of service instead of immediately, the contributions for years one through three would have been includable in the employees' incomes in year four. The statute of limitations in this situation would have afforded no protection to XYZ participants.

Employer Treatment of Contributions. Employers may deduct contributions to nonqualified pension or profit sharing plans in the years amounts attributable to the contributions are includable in their employees' incomes. Thus, XYZ may deduct the contributions for all six retroactive years. If XYZ's plan had provided for vesting at the completion of three years of service rather than immediately, XYZ's contributions for years one through three would not have been deductible until year four. The closing of the statute of limitations for years one through three has no effect on XYZ.

Participant Treatment of Distributions. Amounts distributed or made available to participants from nonqualified plans generally are taxed under the annuity rules of IRC Sec. 72. Under these rules, the employee is taxed on the entire distribution less his or her investment (i.e., basis) in the contract. The employee may include in basis any employer contributions includable in the employee's income under IRC Sec. 402(b).

The statute of limitations clouds the determination of XYZ employee Ellen Smith's basis in the profit sharing plan. Should she include in basis only the employer contributions actually taxed, years four through six, or should she include all six years since they were includable in income? Taking the latter, more aggressive, position, she could argue that excluding the contributions for years one through three allows the IRS to open an otherwise closed statute of limitations

.

In rebuttal, the IRS could argue Ms. Smith has some duty of consistency--that is, years one through three are either included in both income and basis or excluded from both income and basis. The IRS also may point to Reg. 1.402 (b)-1(b)(5) that provides the basis of an employee's interest in a nonexempt trust is increased by the amount included in gross income. Whether this regulation is specifically linked to investment in the contract under IRC Sec. 72, however, is unclear.

Impact on Trust. The retroactive disqualification means that the trust loses its tax-exempt status and becomes liable for back taxes on trust earnings during the retroactive years. In XYZ's case, the six-year statute of limitations for the trust's failure to report more than 25% of gross income would enable the IRS to reach all six retroactive years. But how the charges for these taxes would be allocated to participant's accounts, especially the accounts of participants who were cashed out in the retroactive years, is unclear from statutory and regulatory provisions.

Impact on Social Security Taxes. Contributions to qualified pension or profit-sharing plans are not subject to Social Security taxes. Contributions to nonqualified plans, however, are subject to Social Security taxes when 1) the services are performed or 2) there is no risk of forfeiture of the rights to such amounts, whichever comes later.

Because XYZ's plan was qualified during years one through six, neither XYZ nor the participants would have paid Social Security taxes on contributions made during those years. The retroactive disqualification in year seven, however, makes XYZ and the participants liable for those taxes--subject of course to the wage base limits applicable to Social Security participants and the three year statute of limitations.

Some Retroactive Disqualifications Have Different Impact

If the IRS retroactively disqualifies a plan because it fails to meet minimum coverage requirements or minimum participation rules for qualified plans, the effect on plan participants is not the same as that outlined for XYZ. With either of these violations, the nonhighly compensated employees are not penalized--that is, they continue to be taxed under the rules applicable to qualified plans. The highly compensated employees, on the other hand, are taxed on their entire vested benefits, less their investments in the contracts, in the year of disqualification.

How the IRS treats the trust in this exception area is not clear. Conceivably, it could be 1) wholly exempt, 2) wholly nonexempt, or 3) exempt as to nonhighly compensated employees and nonexempt as to highly compensated employees.

Real World Cases

Buzzetta Construction [92 TC 641 (1989)] and Martin Fireproofing Profit Sharing Plan and Trust [92 TC 1173 (1989)] are the first in a rather lengthy line of cases where the IRS has questioned plan compliance after formally approving a plan. At issue in both cases is whether a violation of IRC Sec. 415 contribution limits is proper grounds for retroactively disqualifying a plan.

Nature of Violation. IRC Sec. 415 imposes two different limits on the annual addition to a participant's account balance in a qualified profit-sharing or other defined contribution plan. The first limits the addition to 25% of the participant's compensation for the year. The second limits the addition to a fixed dollar amount ($30,000 for 1996 plan year) that is indexed based on cost of living. Both of these limits are qualification requirements.

In Buzzetta Construction, the accountant administering the plan contributed the proper percentage of each participant's compensation, but inadvertently exceeded the overall dollar limit for some of the highly paid executives. In Martin Fireproofing, the contribution limit for only one participant, the founder and former president, who remained an employee of the company at a fixed annual salary, was exceeded. In the years at issue the founder waived his fixed salary, but his profit-sharing account still was credited with a percentage of his salary.

The IRS disqualified both the Buzzetta and Martin Fireproofing plans after discovering on audit the IRC Sec. 415 contribution limit violations. The Tax Court upheld both disqualifications, and, citing Automobile Club of Michigan, [353 US 180 (1957)] pointed out 1) the IRS has broad authority to revoke its rulings retroactively, 2) the courts can review a revocation only for abuse of discretion, and 3) the taxpayer bears the burden of proving the IRS abused its discretion.

Relief Provisions in Regulations of Limited Usefulness. In both cases, the plan trustees argued the IRS should have applied the relief provisions in the contribution limit regulations. The Tax Court, however, determined the regulations offer relief only if the excess contributions result from misallocating forfeitures or from a "reasonable error" in estimating compensation, or "under other limited facts and circumstances which the IRS finds justify the availability of the rules." The court found none of these circumstances in either case. In Buzzetta Construction, ignorance of the law and the plan provisions caused the error. In Martin Fireproofing, the fault was failure to take into account the founder's salary waivers, not a "reasonable error" in estimating. And because the regulations allow the IRS to judge when other limited circumstances warrant relief, the Tax Court felt it could not override that judgment unless the IRS abused its discretion.

Harm to Rank-and-File Employees Not a Defense. In both cases, the overfunding violations related only to the accounts of employee-owners or highly compensated employees. Yet, disqualification actions harmed all participants, including the rank-and-file employees.

Trustees in the past counted on the harm inflicted on the innocent rank-and-file employees to protect their plans. In these cases, however, the existence of these innocent employees did not cause the court to limit disqualification to the overfunded participants, nor did it sway the court to find the IRS had abused its discretion. The court seemed to be influenced by its finding in Buzzetta Construction that the violations were material, but in Martin Fireproofing it suggested that de minimus violations do not necessarily warrant special relief. The only positive note on relief for plan participants in either court opinion was a suggestion that in "different" circumstances it might be abusive for the
IRS to disqualify a plan because of an inadvertent error, particularly if the disqualification would have substantial adverse effects.

Disqualification Not Limited to Violation Year. The IRC Sec. 415 contribution limits are annual limits, but in Martin Fireproofing a sharply divided court (nine to six) held that the retroactive disqualification extended from the year of the first contribution limit violation until remedial action took place.

The upshot of this holding in Martin Fireproofing is that a retroactive disqualification will touch all open years (that is, those not closed by the statute of limitations), regardless of when the violation occurs. To minimize the damage to the trust (which will be taxed on its income during the open years), the employer (which will lose its deduction for unvested contributions during the open years), the participants (who will be taxed on contributions as they are vested during the open years), plan trustees, and administrators must ensure they file the proper forms for starting the statute of limitations.

Because a profit sharing trust normally does not file an income tax return, the filing of the form for this purpose, Form 1041, will not start the statute of limitations. The IRS has stipulated that only the filing of a trustee statement on Schedule P with Form 5500 will start the limitation period. The Tax Court in Martin Fireproofing, however, held that under certain circumstances the statute of limitations will begin to run without the filing of Schedule P. The otherwise proper filing of a completed Form 5500-C was found to start the limitations period because it contained enough information to calculate tax liability and represented an "honest and reasonable" attempt to comply with the tax law. However, Form 5500-C would not have been considered a return for the purpose of starting the limitations period if it had not specifically identified the trustees and been signed under penalty of perjury by an identified trustee. Form 5500-R, an abbreviated version of Form 5500-C, also would not have been considered a return for this purpose because it would not have contained the trust income data needed to satisfy the Tax Court's test. Thus, while Schedule P is not essential to starting the limitations period, its filing affords all affected parties more certainty in this crucial area.

Vigilance Is the Word

Concerns about qualifying a pension or profit-sharing plan should not stop with the receipt of the IRS's determination letter. In recent years, the IRS has been increasingly willing to retroactively disqualify plans and allow the adverse consequences to fall equally on all participants, not just those involved in
the disqualification. A line of cases
also now supports this type of action
by the IRS.

This trend places a new burden on all parties. Trustees, administrators, and their tax advisors must be vigilant in ensuring their plans remain qualified in operation. Participants and their tax advisors must be aware of the tax consequences of retroactive disqualification and to the extent possible monitor their plans for continued compliance with the statutory and regulatory requirements for qualified pension and profit-sharing plans. *

Lee G. Knight, PhD, is the E.H. Sherman Professor of Accountancy at Troy State University. Ray A. Knight, JD, CPA, is a senior manager with the Atlanta office of KPMG Peat Marwick LLP.