Tax Consequences of Plan Disqualification

If a plan is determined to be disqualified by the Internal Revenue Service (IRS), more than just the employer is affected. Employees who received employer contributions must claim them as income, which could result in amended tax return filings and taxes owed. The Plan Trust holding the assets owes income tax on the earnings inside the trust. Rollovers out of the plan are no longer tax-exempt and are subject to taxation. Employer contributions are subject to Social Security, Medicare and Federal Unemployment taxes and Employer deductions are limited.

A plan can be disqualified for various reasons.

  • Disqualification can occur if the plan document is not amended timely, if mandatory provisions have not been added, or if provisions have been included that are not allowed.
  • Disqualification can occur if the terms of the plan document are not followed when “operating” or administering the plan. This is the most common type of failure.
  • Disqualification can occur when a plan cannot pass nondiscrimination testing requirements as the document is written.
  • Disqualification occurs when a company is not legally permitted to sponsor a 401(k) or 403(b) plan.

A disqualified plan can regain tax-exempt status by correcting the error which caused the initial disqualification. The IRS offers the Voluntary Correction Program to correct errors for large and small plans on a tiered fee schedule. If the plan is being audited by the IRS, however, the errors must be corrected through the Audit Closing Agreement Program.

If you think your plan might currently have a potentially disqualifying failure, RMS is available to assist you. We can walk you through the steps to correct the error and ensure your plan is in compliance. The IRS also has Plan Fix-it Guides for 401(k) Plans, SARSEPs, SEPs and SIMPLE IRAs to help you with the most frequent errors; how to find, fix and avoid mistakes; and a link to an overview of the Employee Plans Compliance Resolution System.

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