IRS Memorandum a Reminder to Employers to Avoid a Tax Disaster by Keeping Copies of Signed Plan Documents

In a recent Chief Counsel General Advice Memorandum (“Memo”), the IRS provides a helpful reminder that basic recordkeeping and organization techniques can avoid significant tax liability for employers and employees in the context of qualified retirement plans (e.g., a 401(k), 403(b), or pension plan). In the Memo, the author explains that employers that sponsor qualified retirement plans should anticipate that IRS agents conducting an audit will seek disqualification of a qualified retirement plan for failure to provide copies of signed plan documents.

The Val Lanes Case

In the underlying case that gave rise to the Memo, Val Lanes v. Commissioner, the IRS sought to disqualify the retirement plan in part because the sponsor could not produce signed plan documents. Ultimately, what saved the plan from disqualification in the court’s eyes was testimony that the plan documents were signed, and that a roof failure due to natural disaster caused extensive water damage, including the loss of the signed plan documents.

Plan Disqualification: a Tax Disaster for Employer and Employees

What does it mean for a qualified retirement plan to lose its tax-qualified status? In short, it is a tax disaster:

  • Contributions included in gross income of employees. Generally, employees would include in their income all prior contributions made to their benefit, in the calendar year when the plan is disqualified (or prior years if the plan is retroactively disqualified). Additionally, employer contributions become subject to Social Security and Medicare taxes (together, “FICA”) as well as Federal Unemployment Tax (“FUTA”), to the extent vested.
  • Loss of rollovers. Employees may lose the ability to roll over distributions.
  • Employer deductions limited and taxes owed. The employer may lose the deductions for some or all contributions made to the plan, and be liable for failure to properly report and withhold taxes.
  • The plan’s trust owes income. The plan’s trust is no longer tax-exempt; it must file a Form 1041 and pay income taxes on earnings.

The IRS is generally reluctant to disqualify plans, in particular because of the tax consequences for employees, but it has done so in the past. It tends to be less concerned about tax consequences for participants who are highly compensated. In lieu of disqualification, the IRS may seek sanctions against the employer through its Audit Closing Agreement Program.

Practical and Easy Steps to Steer Clear of Disqualification

In the Memo, the IRS warns that employers should not count on being able to rely on the same excuses as in Val Lines, as those facts were highly-specific. It notes that the burden of proof to show adoption is on the employer, and that it would be unlikely for an employer to meet this burden without providing a signed document. Therefore, employers should consider adopting the following easy practices to avoid disqualification for lack of signed plan documents:

  • Keep electronic copies of all signed plan documents, and make back-ups of those electronic documents just like other major business documentation.
  • Assign responsibility to human resources or finance personnel to manage the process of signing and maintaining plan documentation.
  • Provide copies of executed plan documentation to outside employee benefits counsel.

Personally speaking, I maintain what I refer to as a “clip file” of client plan documentation, which includes all executed plan documents and amendments, as well as a cover page designating the location and briefly describing the reason for each document. This is maintained both physically and electronically. Employers should consider this practice as well.

Therefore, even in the event of a natural disaster, an employer following the above practices can avoid a tax disaster by keeping plan documents safe in multiple hands and in multiple locations.

Please contact Eric W. Gregory in the Troy, Michigan office at 248-433-7669 if you have any questions or would like further information.