Small business tax solutions.

This series is based on questions from AICPA tax certificate of educational achievement (CEA) courses.

Q. Processing a court-issued qualified domestic relations order (QDRO) is a difficult problem for a qualified retirement plan. What happens when the plan makes an incorrect payment under a non-qualified domestic relations order (DRO)?

A. Many things occur, all of them bad, when an employer makes a DRO payment that violates the terms of its plan document. Consequences include tax penalties for participants and possible plan disqualification.

QDROs are one of the few exceptions to the Employee Retirement Income Security Act's anti-alienation provisions under Internal Revenue Code section 401(a) (13), which protect benefits from a participant's creditors. Without a QDRO, a former spouse generally could not collect retirement benefits from a participant's account. Under a QDRO, a spouse, former spouse or alternate payee can be given all or part of the benefits. The order either divides the benefit while keeping it in the plan until a later date or makes a complete distribution of the allocated amount.

A QDRO cannot force a plan to make a lump sum distribution unless the plan permits one, nor can the order force a plan that allows lump sum distributions to make one at a time not allowed by the plan. QDRO payments generally are made when other benefits are distributed. For example, some plans delay benefits until a participant retires or dies, also delaying QDRO payments.

These rules aren't always followed, especially when a plan administrator is ordered to make a distribution, or be held in contempt. This may happen when QDROs are written by those unfamiliar with qualified plans or with the plan in question. The order frequently is written by a lawyer concerned with having plan benefits paid to his or her client quickly, so payments sometimes are made when they should not be.

There is no easy way to avoid the problems of handling a DRO. Each plan administrator should have procedures for ascertaining whether an order is qualified and follows the plan terms. If an error is discovered, the plan administrator would apply to the Internal Revenue Service's closing agreement program and pay a significant penalty to have the plan brought back into compliance with ERISA.

Q. Can the leased employees of a not-for-profit organization (NPO) participate in the 401(k) retirement plan of the leasing company?

A. Leased employees may be eligible if the plan is sponsored by the leasing company and not by the client-recipient employer (the NPO) leasing the employees. But this may not be the case for long.

Since July 2, 1986, the effective date of the Tax Reform Act of 1986, NPO employers--those tax exempt under IRC section 501(c)--have not been able to sponsor or cosponsor 401(k) plans. NPOs that had such plans can continue to enroll employees. But whether or not leased employees working for NPOs can participate in the leasing company's 401 (k) depends on the plan's sponsor.

For the leasing company--also known as the administrative employer or professional employer organization (PEO)--the issues are complex. An IRS task force is considering whether the client company or the PEO is the true common law employer of the leased employees. The unofficial IRS position is that it wants to see jointly sponsored plans between client-recipient employers and PEOs, blocking new 401(k) plans since tax-exempt employers are not allowed to set them up.

If the IRS takes this position, it may become nearly impossible to administer a PEO 401(k). If more than one unrelated employer's employees were covered under a cosponsored plan, it would become a multiple-employer plan, complicating both implementation and administration.

A multiple-employer plan would have to be tested on an individual recipient employer basis, meaning each company cosponsoring a 401(k) with a PEO would have to prepare separate 401(h) and 401(m) tests for the leased employees. If one employer failed to pass the average deferral percentage test or any other IRC requirement, the entire plan could be disqualified.

If a plan is to be treated as a single employer plan of the PEO, there is no real answer as to whether employees leased to NPOs can participate. Only the IRS or the courts can decide. A PEO could raise the question when it filed for a determination letter on its 401(k) plan. But if the IRS later successfully challenged the PEO's common law employer status, the determination letter would not offer much protection.

GREG MATTHEWS, CPA, is a partner of G.E. Matthews & Associates, St. Petersburg, Florida.