What to do if the IRS audits your pension plan.
The disqualification of a plan that accumulated large sums of money is a traumatic experience for the business owner, the employees, the owner's accountant and other professional advisers. The employer faces disallowed employer contributions to the plan for all years not barred by the statute of limitations; employees may have taxable income to the extent of their vested interests; and the pension trust loses its tax-exempt status and is taxed as a complex trust.
NEW ALTERNATIVES TO PLAN DISQUALIFICATION
The IRS developed a program to serve as an alternative to plan disqualification. An IRS newsletter dated January 1992 describes this program as follows:
"A new alternative method of resolving plan qualification issues... involves the use of the Service's closing agreement program (CAP) [which] has become a permanent element in the expanding employee plans examination program.
"Under CAP, Employee Plans agents may enter into closing agreements with taxpayers to resolve plan qualification defects without the sanction of disqualification. Taxpayers who do not enter into a closing agreement to resolve plan defects in form or operation, of course, are subject to retroactive disqualification of their plans."
In general, cases with disqualification defects are eligible for inclusion in the CAP. However, the CAP will not be applied to cases involving significant discrimination in favor of highly compensated employees; exclusive benefit violations resulting in the diversion of trust assets; and repeated, deliberate or flagrant violations.
WORKING OUT A CAP
In order to enter into a closing agreement, a taxpayer must agree to correct all plan defects completely, both retroactively and prospectively. (A retroactive correction may require reallocation of plan assets, as if the defect never occurred.) Correction also may involve making plan amendments and implementing the procedures necessary to bring the plan into compliance with Internal Revenue Code section 401(a).
In addition to correction, the taxpayer must agree to make a nondeductible payment to the U.S. Treasury; in return, the IRS will not revoke the plan's qualified status. The amount of this payment will be based on
* A particular case's equities, such as the number of affected nonhighly compensated pension plan participants.
* The relative insignificance of the defect in the context of all the facts in the case.
* Taxpayer actions (such as promptly and completely correcting the defect and requesting a closing agreement) after the discovery of a disqualifying defect and before the selection of the plan for audit.
The closing agreement program and the administrative error policy directive described below are essential to the IRS's broadened examination effort. They provide pragmatic alternatives to the technical disqualification sanction. Compliance-minded practitioners should keep these alternative IRS policies in mind when moving to correct pension plan defects.
RESOLVING OPERATIONAL VIOLATIONS
In addition to the CAP, the IRS also issued an administrative policy directive authorizing agents to resolve certain minimal operations violations simply by requiring correction. An operations violation of section 401(a) requirements is not a disqualifying event if all the following criteria are satisfied:
* The operations violation made by the plan must be an isolated, insignificant instance.
* The plan either must have a history of section 401(a) compliance (other than the nondisqualifying event) both in form and operation or must have corrected the operations violation before examination, with no evidence of noncompliance in other areas.
* The plan sponsor or plan administrator must have established practices and procedures (formal or informal) to ensure section 401(a) compliance, including procedures involving the area in which the violation occurred.
* The established procedures must have been followed; the operations violation occurred through an oversight or mistake in applying those procedures.
* Any dollar amounts (such as excess contributions or excess allocations) are insubstantial in view of the entire case.
* The taxpayer must have immediately and completely corrected the violation upon discovery, so no participant or beneficiary suffered a loss.
HOW TO AVOID IRS AUDIT PROBLEMS
Given the widened scope of the new program, CPAs should advise companies or small business clients to take the following actions:
1. The business owner must make sure all qualified plans are amended in a timely fashion.
2. The plan sponsor or plan administrator should assign an employee with pension administration expertise or engage a competent pension consultant to monitor the plan in operation.
3. The plan sponsor or plan administrator must establish a checklist of items to be monitored in the administration of the plan.
4. For statute of limitation purposes with respect to the pension trust, the optional trust statement, schedule P (form 5500), should be attached to the annual return or report each year.
5. Any error by the plan administrator should be corrected immediately upon discovery. Correcting an error before receiving an IRS audit notice is important and will be helpful in negotiating a resolution.
6. If the IRS determines there is an error in the plan operation or that the plan has defective language, the plan sponsor should correct the error immediately to limit the number of years for which the plan may be disqualified should the defect or error trigger plan disqualification.
EXPANDED IRS PENSION AUDITS
An IRS official confirmed at a meeting with the AICPA employee benefits taxation committee in December 1991 that the agency will devote greater resources to examinations and audits of pension plans. In such a climate, it is important that CPAs keep clients and companies aware that qualification defects do not necessarily require the severe penalty of disqualification. Alternative resolutions, including the CAP and corrective action program, may be applicable.
Seymour Goldberg, CPA, JD, is a senior partner of the law firm Goldberg & Ingber, P.C., Garden City, New York, and a professor of law and taxation of Long Island University. He has written articles for the Journal and is the author of an AICPA continuing professional education training program, Coping with Problems ub Pension and Profit-Sharing Plans, portions of which have been used as material for this article.