Failing to Update Retirement Plans – How to Avoid IRS Plan Disqualification & Penalties by Using VCP
September 23, 2022
In our fast paced world, many retirement plans are drafted and then often neglected. In extreme cases, plans are put aside without ever being updated. Some plan sponsors have failed to restate their plans for years or even decades. For many individuals, retirement plan accounts represent the largest portion of their wealth. As the following discussion will illustrate, the failure to protect this most valuable and important asset by keeping the retirement plan in full compliance with applicable retirement plan laws could result in some very nasty, costly and unforeseen financial repercussions.
The retirement plan laws have always required that plans be updated for tax law changes. Before 2003, the IRS allowed plans to be periodically restated for tax law changes that occurred over many years. This resulted in large, periodic major plan restatements. However, since 2003 the IRS has required amendments to retirement plans for each new tax law resulting in more frequent “interim amendments.” [For those of you interested in a more detailed discussion of these required interim amendments since 2003, please go to my questions answered at my Linked-In profile.] For many plans, the deadlines for many of these plan restatements or interim amendments have now expired. Current rules provide that plans that have not been redrafted to comply with required prior restatements or interim amendments cease to be qualified as of their applicable deadlines.
In the worst case scenario, the IRS may demand that the plan be retroactively disqualified. If the IRS is successful in disqualifying the plan, the plan sponsor’s tax deductions for contributions taken in the year of disqualification and in later years would be disallowed. The taxes owed by the plan sponsor due to the disallowance of previously claimed retirement plan deductions plus applicable interest and penalties could be enormous. In addition, participants of the plan would have to treat as taxable income the value of their plan account as of the date of such disqualification. The taxes, interest and penalties to the participants from the date of plan disqualification could be equally exorbitant. This would be a truly disastrous and harsh result for both the employer plan sponsor and participants in the disqualified plan.
However, in most cases, the current policy of the IRS is to impose monetary penalties instead of the more severe penalty of plan disqualification. Even so, when the IRS raises these failures as the result of an audit the penalties can be quite severe. Penalties can range from $2,500 to $80,000 depending on the failures involved and the size of the plan. It is worth noting that in recent years, the IRS has increased its auditing of retirement plans.
Here is Good News: How to Solve This Looming Problem
The IRS has a voluntary remedial program called the VCP (voluntary compliance program) to correct these plan document deficiencies. The IRS position is that retirement plans may be re-qualified only by having the plan sponsor voluntarily come forward before an IRS audit by submitting the newly drafted delinquent restatements and/or interim amendments to the IRS in accordance with some very detailed procedures and documentation pursuant to Revenue Procedure 2008-50. Once the IRS reviews and hopefully approves the application and the newly drafted required documentation, the plan is deemed to be in full compliance with applicable law and such plan is retroactively tax qualified.
Instead of paying a steep monetary penalty, the VCP submission results in the paying of a filing fee to the IRS. Sometimes, if the violation is quite limited the filing fee can be as low as $375. (Remember, you will still need to pay for documentation services associated with plan restatements and interim amendments. However, these costs would have been incurred in any event to keep your plan in full compliance with the law.) The important point here is that the use of the VCP program avoids the risk of plan disqualification or the imposition of a large monetary penalty.
How We Can Help:
Numerous VCP program applications under the applicable Revenue Procedure 2008-50 have been submitted by this office. This application along with the needed plan restatements and interim amendments must be carefully drafted to ensure efficient negotiations and a successful outcome with the IRS.
The Bottom Line:
Plan sponsors should immediately and voluntarily move to correct plan deficiencies pursuant to the more taxpayer friendly and cheaper VCP program before the IRS audits your plan. Once the IRS commences an audit, the VCP submission strategy is no longer an option and your plan is exposed to disqualification and/or severe monetary penalties.
Looking forward, you must establish a program with your plan adviser to ensure that your plan is kept in compliance with the laws concerning plan restatements, interim amendments and the changing IRS submission requirements and deadlines. This will avoid having to deal with all of these problems again in the future. In fact, the Revenue Procedure requires a disclosure in the VCP application as to what new procedures the plan sponsors will use to avoid this problem in the future.