Plan Disqualification Happens If You Don’t Follow Basic Rules!

A recent Tax Court case, Hollen v. Commissioner (2011, T.C. Memo 2011-2), offers a stark reminder that the IRS can and will seek to disqualify a tax-qualified retirement plan if the plan sponsor fails to comply with key legal requirements and fails to correct the failure. In Hollen a dentist had established an employee stock ownership plan (“ESOP”) that was intended to meet the requirements of Code Section 401(a), which contains the key rules that all tax qualified retirement plans (including 401(k) plans, profit sharing plans and money purchase pension plans) must meet. The plan was established in 1986, but since that time the dental practice consistently violated two core requirements. First, the plan document was not updated on a timely basis to reflect changes in law. Second, the plan was not operated in accordance with the plan document. These “plan document failures” and “operational failures” likely could have been corrected under the IRS’ Employee Plans Compliance Resolution System (“EPCRS”) had the plan sponsor taken appropriate and timely action. The plan sponsor in Hollen learned the hard way that the price for the plan sponsor’s failure to take corrective action can be painful.

Arguing that the plan sponsor had utterly failed meet even the most basic qualification requirements, the IRS succeeded in having the ESOP disqualified retroactive to the date of inception. Disqualification results in the disallowance of all tax deductions taken with respect to plan contributions (creating a hefty tax liability for the plan sponsor) AND triggers the income taxation of benefits previously excluded from income (creating a tax liability for participants). The Hollen case shows that the IRS is willing to go to the mat in cases where employers ignore basic rules. But the take home message is simple: when for whatever reason a qualified plan experiences a documentary or operational failure, don’t wait until the IRS comes calling before taking corrective action under EPCRS.