A special “ChrERISAmas Story” for the benefits of our readers …
Here’s a tale that we heard from the end of 2018. It illustrates how retirement plan operational defects from years ago can cause plan qualification problems today — even if you never thought you’d be haunted by them. Be careful. This tale could scare the Dickens out of you!
Scrooge Accounting Services maintains an integrated, age-weighted profit sharing plan with most of the benefits going to the sole shareholder/director/president/trustee/plan administrator, Evan E. Zarr, CPA. Because of extremely high turnover, only one other employee had ever become eligible to participate in the plan, the overworked and underpaid junior bookkeeper, Robert Cratchitt.
Zarr and Cratchitt were working late on Christmas Eve 2018 on some last minute tax planning for some of their clients. As they were getting ready to call it a night, Cratchitt handed Zarr the plan’s 20-page application for a hardship distribution that Cratchitt had completed in great detail (something about his small son Timothy’s medical bills). Zarr denied the request! On Christmas Eve!
That was the last straw for Cratchitt. He said he could no longer work for the oppressive Zarr and that he quit and wanted all of his plan benefits immediately. Cratchitt collected his green eye shade and pocket protector and disappeared out the back door, mumbling something about the IRS or DOL and that old section 415 violation in 2012.
“Section 415 violation? Bah humbug! That was years ago,” Zarr thought as he sat in his office admiring the numerous pieces of fine art purchased by his self-directed account under the plan.
Later that night, just as he was dozing off to sleep, Zarr was startled by what appeared to be the plan’s former administrator and consultant, I.M. Straight of Straight-Arrow Plan Services, hovering in Zarr’s bedroom. Zarr had fired Straight years ago over a disagreement about that very same section 415 violation. Straight reminded Zarr that he had warned him that Scrooge Accounting Services had contributed too much to the plan for Zarr’s account and because his allocations exceeded the section 415 limit, the plan document required that the excess amount be allocated to the plan’s only other participant — Cratchitt.
Straight also reminded Zarr how he had cautioned him that failure to follow the plan documents and the violation of the section 415 limit were plan disqualifying defects that could come back to haunt him some day. Then, just before vanishing as quickly as he had appeared, Straight echoed Zarr’s last words before he had fired Straight, “I am not going to worry about it because this year will be closed in just three short years and then the problem will be gone forever—and so will you!”
Needless to say, Zarr had trouble getting back to sleep as he tossed and turned, wondering how a plan problem that happened so many years ago could possibly be of any importance now. After all, he reasoned, the year is now closed for tax purposes and how would the IRS ever discover such an old problem anyway? Comforted somewhat by his knowledge of the Code’s statute of limitations, he soon dozed off again. But only momentarily.
His efforts at slumbering were interrupted again. Now what? Two voices and flashing blue and green neon lights! He forced his eyes open only to see the profiles of two heads, one blue and one green, that looked remarkably like the logo of a well-known employee benefits law firm. The heads were talking to one another (and were obviously very well-versed in employee benefits law).
“You know, Marcel, our new client, Scrooge Accounting Services, may have a real plan qualification problem, as well as having to respond to an ERISA complaint regarding benefits that the plan’s only other participant is threatening to bring before the IRS and the DOL.”
“Yes, Ken, that’s what I heard from Kevin. It sounds like Zarr thinks that the statute of limitations will come to his rescue. Hah!”
“He probably won’t be too happy when we tell him about the Tax Court’s opinions in favor of the IRS’s views on plan disqualification in the Boggs and Martin Fireproofing cases.”
“It certainly sounds as if the Tax Court supports the IRS’s position that disqualifying defects, even from closed years, cause the plan to be disqualified in open years unless and until the defects are corrected.”
“At least as to Code section 415 and discrimination violations. What about other violations?”
“Well, I think the answer may depend upon whether the defect has a carryover effect from one year to the next. If it does, then the plan still may fail the qualification requirements even though the year of the defect is closed. It’s too bad his plan’s defects aren’t the kind that we have identified as not having a carryover effect.”
“Yep. Those old defects sure can come back to haunt you. Zarr probably never thought that meek and mild Cratchitt would understand that his account balance under the plan should be bigger than it is as a result of that old section 415 violation, let alone threaten to complain to the IRS and the DOL about it (not to mention Zarr’s refusal to grant his request for a hardship distribution, and the art in Zarr’s office).”
“So, who’s Zarr gonna call? Ghostbusters?”
“Well, that’s us! We should provide Zarr with some of the information from our website about the ways that Zarr can fix his plan and save himself from all of the adverse consequences from plan disqualification. Then we should meet with him to discuss his options.”
“Let’s do that as soon as possible. At least he’s not under audit yet!”
The lights went out. The voices stopped. Zarr rubbed his eyes and scratched his head. He vaguely began to remember glancing at some information on the law firm’s website about the IRS’s programs for correcting plan defects. But, by then, distressed though he was about all this, the ordeal had exhausted him to the point that he could no longer keep his eyes open — but only for what seemed like a millisecond.
What sounded like a loud knock shocked him awake. As he went to answer the door, he realized that he now seemed to be at his office and that the calendar on the office wall showed the date as December 24, 2018. He opened the door and there appeared one of the IRS’s toughest retirement plan auditors whom Zarr had run into recently when the IRS began auditing one of his client’s plans.
“I’m here for the audit of your plan per my letter of 30 days ago. Do you have all of the records that I requested, especially the records from 2012?”
“What? 2012 is a closed year and has nothing to do with the year under audit!”
“Well, that may be, but we have received some information (from a source that I can’t disclose) indicating a plan disqualifying defect may have occurred in 2012 and still has not been corrected. So, we think your plan may have been disqualified all these years. If that is true, then we will require that you file amended corporate income tax returns for all open years because of the disallowance of some or all of Scrooge’s deductions for the contributions to the plan. You will have to amend your personal income tax returns to include your share of the contributions in your income each open year. And, you will have to file trust income tax returns for 2012 and all of the subsequent years. You see, all of these trust years are still open because, according to our records, for some reason you stopped filing the Form 5500 beginning with your 2012 return.”
“You can’t do that. 2012 is a closed year!”
“Not so! You’re a CPA. Haven’t you heard of the Tax Court’s opinions in the Boggs and Martin Fireproofing cases?”
With that, Zarr seemed to pass out in his office. The next thing he knew, he was sitting up in his bed wondering what was going on. Now he was fully awake. Then and there he resolved to call those benefits lawyers before the end of the year so that he could fix his plan.
It was morning by then and he was thinking quite clearly. He went to the law firm’s website and read the summaries of the IRS’s correction programs carefully. As he did so, it dawned on him that his client whose plan was under audit (by that tenacious IRS auditor in his dream) may have a similar problem. The client had a plan with some old operational defects, but that plan had been merged with the client’s other plan that was squeaky clean. Could the old merged plan’s defects cause the clean plan to be disqualified? Could the defects now be corrected under one of the IRS’s correction programs? Zarr decided that he would ask the benefits lawyers about this, too.
He also started thinking about some of his other clients. Did any of them have old defects that could cause problems now? What defects have a carryover effect? Which ones don’t? Zarr decided that he was going to alert all of his clients that they should let him know if they have any problems like this so that they can seek the help they need.
Well, that all became too grim to think about on a holiday. Rather than continue to dwell on such problems, he decided to give that young Cratchitt a call and patch things up. Yes, he would make sure that his account balance was corrected. And about that hardship distribution? Sure, he can have the hardship distribution that very day even though the banks were closed — after all, Cratchitt’s account was not that big and Zarr could pay him out of Scrooge’s petty cash. In fact, he’d let Cratchitt take a little extra out of the plan so he could buy a nice turkey for Christmas dinner. (But that’s another story.)