There have been some well known cases in which qualified
plans were disqualified retroactively by the IRS for less than
major violations of the rules. In one of the most well known,
Tionesta Sand and Gravel 73 T.C. 758 (1980), affd without opinion
642 F. 2d 444 (3d Cir. 1981), a plan was disqualified for failing
to contain language requiring full vesting on any plan termination
or complete discontinuance of contributions, even though no plan
termination had occurred. However, as a result of the IRS'
formal correction program for plan mistakes, plan disqualification
has become a very rare event.
Retroactive plan disqualification can have the following serious
Trust income becomes taxable.
Deductions for contributions to defined contribution plans are
disallowed to the extent participants are not vested.
The plan sponsor is penalized for failing to withhold income
tax and FICA relating to vested contributions.
Participants are taxed while in the plan, even if the plan
denies them a distribution to satisfy the liability.
Plan distributions are not eligible for rollover to an IRA or
other eligible plan.
However, we were recently reminded that disqualification is not
a thing of the past by not one, but two cases in which the Tax
Court upheld the IRS' retroactive disqualification of plans.
The first case, Hollen, involved a seeming abuse of the ESOP
rules, but the second case involved an ordinary profit sharing plan
that was neglected and had not been timely amended. Taken together,
these cases set out some important rules about the IRS' ability
to disqualify a plan, and lay out a blueprint of what not to do if
you want to avoid any question about your qualified plan's tax
In the Hollen case, the court determined that adopting
amendments with the wrong effective dates - a problem not unique to
ESOPs - was alone a valid reason for disqualification.
The plan automatically incorporated by reference any changes in
the law, so specific amendments were not required.
The missing amendments were not required because the plan was
simple. It didn't matter that qualified transportation
benefits weren't included in the definition of compensation as
required, because the employer didn't provide them.
The plan terminated before the amendment deadline. (Actually,
the trust was not liquidated, so it was still an ongoing plan.
However, IRS rules also require early adoption of required
amendments when a plan terminates before the adoption
The IRS' ability to revoke qualified status is limited
by the 3 year statute of limitations for assessing taxes, so the
plan could not be disqualified back to 2001.
It is important to note that had these plan sponsors done
regular compliance audits and paid a modest penalty, they could
have adopted required amendments late without jeopardizing
qualification under the IRS' voluntary correction program.
They could also have tried to work out a settlement with the IRS
preserving qualification under its closing agreement program (also
known as "CAP"), which is available even if the IRS
catches the problem on audit or when reviewing a determination
Plan disqualification will probably remain a rare sanction
applied primarily to very small plans, but the message sent by
these cases applies equally to all plan sponsors:
Review amendment requirements each year to ensure timely
Do regular compliance audits to check for problems.
Adopt required IRS boilerplate regardless of whether it is
If IRS reviewers or auditors still contend that your plan is
not in compliance, try to take advantage of CAP, because the burden
of proof to show the IRS abused its discretion in disqualifying a
plan will be on you, and your chances of getting the Tax Court to
overrule the IRS are not good.
Carol Buckmann has practised in the employee
benefits field for over 25 years, advising clients on all aspects
of employee benefits and retirement plans, including questions
relating to 401(k), defined benefit and employee stock ownership
plans, welfare plans, fiduciary responsibility, prohibited
transactions and plan asset issues arising in investment fund
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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