When 401(k) Plans Go Bad—Avoiding Disqualification

As a small-business owner, you probably either have, or have considered adopting, a 401(k) plan. 401(k) plans have assumed their starry status in the retirement universe because of the favorable tax benefits they provide to both employers and employees.

Most importantly, employers get an immediate tax deduction for contributions they make to their plans, and employees benefit from pre-tax contributions and tax-deferred, or in some cases tax-free, accumulation of investment earnings. But these tax benefits come at a cost. Employers must follow strict and often complicated laws in the Internal Revenue Code, and regulations promulgated by the government agencies charged with interpreting those laws—primarily the Internal Revenue Service and the Department of Labor.

Tax Effects of Plan Disqualification

Plans that comply with the tax rules are said to be “qualified” and therefore entitled to their favorable tax status. But plans that run afoul of the rules (for example, by improperly excluding participants, missing contributions, or failing discrimination tests) can become “disqualified.” The potential consequences of disqualification are severe:

Employees are taxed on their pretax contributions in the year those contributions are made to the plan, rather than the year the contributions are paid from the plan.
In general, employees are taxed on employer contributions, and plan investment earnings, in the year they vest, rather than the year benefits are paid; in certain cases, highly paid employees are taxed on the entire value of their accounts (to the extent not already taxed).
Employers take deductions for plan contributions in the year their employees vest in that contribution, rather than the year the employer made the contributions to the plan.
The plan trust must pay taxes on its earnings.
Distributions from the plan are ineligible for special tax treatment and cannot be rolled over tax free to IRAs or other qualified employer plans.

Even worse, a plan may be disqualified retroactively if the plan defect occurred in a prior year. This means that employers and employees would likely need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for underreporting income in those prior years could also be imposed. And while the IRS generally can’t go back more than three years (six years if there was a substantial underreporting of income) to collect taxes for any earlier year, the IRS might require correction of those closed years if an employer seeks to requalify its plan.

IRS to the Rescue

Luckily, the IRS has adopted several programs that may help you avoid the potentially disastrous consequences of disqualification.

The Self-Correction Program, or SCP, is generally the program of choice if you’re eligible. This program allows you to self-correct many plan errors—and preserve the tax-favored status of your plan—without contacting the IRS or paying a fee, and there are no application or reporting requirements. “Correction” generally means that the plan and participants must be placed in the same position they would have been if the failure had not occurred. The program is available for any errors that occur when you don’t follow the written terms of your plan. You can correct insignificant errors at any time. And you can even self-correct significant operational errors if you act promptly. (“Egregious” errors can’t be corrected using SCP.)

If you’re not eligible for SCP (or if you’d like the comfort of IRS approval of your corrections), the next step is the Voluntary Correction Program (VCP). This program is available only if your plan is not being audited. You must submit an application to the IRS describing the plan failure(s), describe how you intend to correct those failures, and detail the administrative changes you intend to adopt to avoid those failures occurring in the future. You must also pay a compliance fee, ranging from a few hundred dollars to $25,000, depending on the nature of the failure and the number of plan participants. If your application is approved, the IRS will generally agree not to disqualify your plan because of the disclosed failures if you complete the approved corrections within 150 days.

If you don’t use SCP or VCP to voluntarily correct plan errors, and the IRS discovers the failures itself (for example, during a plan audit), you may still be able to preserve your plan’s tax benefits by using the Audit Closing Agreement Program (Audit CAP). Under this program, you must correct the plan failures, enter into a “Closing Agreement” with the IRS, and pay a penalty equal to a negotiated percentage of the additional taxes that would have been payable had the plan been disqualified.

The qualified plan rules are complicated. Working with a retirement plan professional can help you avoid mistakes that could lead to the ultimate penalty of disqualification.

If you have questions, contact the experts at Henssler Financial: