4.72.12  Revocation of IRC 401(a) Plans and/or Trusts

Manual Transmittal

April 04, 2014

Purpose

(1) This transmits revised IRM 4.72.12, Employee Plans Technical Guidelines, Revocation of IRC 401(a) Plans and/or Trusts.

Material Changes

(1) IRM 4.72.12.2(3) is revised to update the delegation order number and delete paragraph (4).

(2) IRM 4.72.12.2.3 is revised to change the subsection title and delete instructions pertaining to employee-participant prior to August 2, 1969.

(3) IRM 4.72.12.2.4 is revised to clarify that the reference to 401(a)(26) is applicable to defined benefit plans.

(4) IRM 4.72.12.3 is revised throughout to realign the instructions with those in IRM 4.71.3.3, Unagreed Form 5500 Procedures.

(5) Exhibit 4.72.12-1 is revised to update the examples with more current dates.

(6) Exhibit 4.72.12-1 Example 6 is deleted and Example 7 moves up.

(7) Editorial changes are made throughout this IRM.

Effect on Other Documents

IRM 4.72.12 dated December 31, 2005 is superseded.

Audience

TE/GE (Employee Plans)

Effective Date

(04-04-2014)

Robert S. Choi
Director, Employee Plans
Tax Exempt and Government Entities

4.72.12.1  (12-31-2005)
Overview

  1. Guidance is provided with regard to the technical and administrative procedures in the event a qualified retirement plan (under IRC 401(a) and/or trust under IRC 501(a)) loses its tax exempt status.

4.72.12.2  (04-04-2014)
Failure to Qualify in Operation

  1. Some of the most common causes for a plan’s failure to qualify in operation are:

    1. The plan has failed to meet the coverage requirements under IRC 410(b).

    2. Contributions or benefits provided under the plan are discriminatory within the meaning of IRC 401(a)(4).

    3. The plan and/or trust activity violates the exclusive benefit provision of IRC 401(a).

    4. The terms of the plan were not followed.

  2. Generally, in pre-Employee Retirement Income Security Act (ERISA) law, if a prohibited transaction occurred the trust lost its exemption; but IRC 4975 now substitutes excise tax and correction criteria in lieu of revocation. However, the payment of an excise tax does not prevent the Employee Plans (EP) specialist from proposing revocation if the exclusive benefit rule of IRC 401(a)(2) is violated.

  3. Delegation Order number 7-1, as revised, delegates to the Director, EP Examinations the authority to issue revocations of determination letters issued under the provisions of IRC 401, 403(a), 409 and 501(a) and this authority may be redelegated.

4.72.12.2.1  (12-31-2005)
Effective Date of Revocation

  1. Except under circumstances described in (2) or (3) below, where a plan fails to qualify in operation for a year open for examination, the revocation should be effective beginning with the plan year in which the plan first failed to qualify. Such a revocation is not controlled by IRC 7805(b).

  2. If the first year in which a plan failed to qualify could not be identified or is no longer open for examination, the revocation letter will merely state that any outstanding favorable determination letter previously issued on the date specified is revoked.

  3. Except in rare or unusual circumstances, the revocation of a favorable determination letter is not applied retroactively with respect to the employer to whom the determination letter previously was issued or to an employer whose tax liability was directly involved in such determination if all of the following are met:

    1. There has been no misstatement or omission of material facts.

    2. The facts subsequently developed are not materially different from the facts on which the determination letter was based.

    3. There has been no change in the applicable law.

    4. The determination was originally issued with respect to a prospective or proposed transaction.

    5. The employer directly involved in the determination letter acted in good faith in reliance upon the determination letter and the retroactive revocation would be to her/his detriment. To illustrate, the tax liability of each employee covered by a determination letter relating to a pension plan of an employer is directly involved in such determination.

  4. A qualified trust may lose its qualified status and then regain it. In this case the Service has maintained that after requalification all the assets of such trust are treated as assets of a qualified trust. See Rev. Rul. 72-368, 1972-2 C.B. 220, and Rev. Rul. 73-79, 1973-1 C.B. 194.

  5. The tax treatment of distributions from a plan depends on the status of the plan at the time of distribution. Baetens v. Commissioner, 777 F.2d 1160 (6th Cir. 1985); Benbow v. Commissioner, 774 F.2d 740; Woodson v. Commissioner, 651 F. 2d 1094 (5th Cir. 1981).

4.72.12.2.2  (12-31-2005)
Effect on Employer

  1. The employer can deduct the amount of the employer’s contribution in the nonqualified year to the extent that the amount is includible in the gross income of employees participating in the plan only if separate accounts are maintained for each employee where there is more than one employee. See IRC 404(a)(5) and Treas. Reg. 1.404(a)-12 and also the examples in Exhibit 4.72.12-1.

    Note:

    IRC 404(a)(6) does not apply to IRC 404(a)(5) deductions.

  2. The Treas. Reg. under IRC 402 and IRC 404, provide that if the status of the trust changes from nonexempt in one year to exempt in a succeeding year (third year), the deductibility by the employer (and inclusion in income by employees) of contributions made in the nonexempt year are not changed.

    Example:

    A contribution to a plan in the second year for which it was not exempt would be deductible by the employer only to the extent such a contribution is deductible as a contribution to a nonexempt trust even though the trust regains qualified status in a later year (third year). However in such later year the entire trust would be treated as part of a qualified plan for purposes of determining the tax treatment of distributions even though the employer was, in such year, deducting part (or all) of a contribution made in the second year (during which the trust was not exempt) under deduction rules relating to nonqualified plans. Upon distribution of benefits from the trust the recipient has a basis equal to the part of the distribution previously includible in the recipient’s income. See Treas. Reg. 1.402(a)-1.

  3. An employer has the burden to establish any claimed deduction for income tax purposes. Contributions that are not vested at the end of the plan year in which they are contributed to a nonqualified plan will be deductible in subsequent years as the contributions become vested. However, if a participant terminates prior to vesting in the nonexempt contribution and a forfeiture occurs the employer must be able to support the deduction claimed for such amount as includible in the gross income of employees as of or after reallocation.

4.72.12.2.3  (04-04-2014)
Effect on Employee-Participants

  1. After August 1,1969, the employee-participant is subject to tax when the employee’s interest becomes substantially vested.

    1. The amount taxable to an employee-participant when a qualified plan becomes nonqualified is the amount contributed by the employer each year, while the plan is nonqualified, in which the employee is substantially vested.

    2. As long as the plan remains nonqualified, amounts subsequently contributed by the employer to the trust (or premiums subsequently paid) are to be included in the income of the employee when contributed or paid to the trust (or insurer), or, if later, when the amounts including earnings thereon become substantially vested in subsequent years.

    3. When a qualified plan becomes nonqualified, the employee-participant is not taxed on her/his account balance attributed to employer contributions while the plan was qualified or increases in the account balance attributed to trust earnings. For further explanation of taxability to an employee, see Treas. Reg. 1.402(b)-1(b).

  2. For purposes of (2) above, the term "substantially vested" means that a participant’s interest is not subject to a substantial risk of forfeiture as defined in IRC 83(c)(1) and Treas. Reg. 1.83-3(b) and (c).

  3. The taxability examples in Exhibit 4.72.12-1 are based on Treas. Reg. 1.402(b)-1(b)(1) which provides that where a trust loses its exempt status, an employee's gross income includes the value of the employee’s interest in the trust which is substantially vested and is attributable to employer contributions made for the employee while the trust was not exempt. Thus the only monies subject to taxation to the employee when a plan ceases to be qualified are those amounts allocated as employer contributions or forfeitures that are substantially vested or those amounts that become substantially vested after the trust loses its exempt status.

  4. Any loss in value of the assets purchased with employer contributions made during a taxable year ending with or within a taxable year of the trust for which it was not exempt is recognized to the participant only when all trust assets are distributed. See Rev. Rul. 71–251, 1971–1 C.B. 129. The employer would receive a deduction based on the full amount of the contribution included in the gross income of the participant.

4.72.12.2.4  (04-04-2014)
IRC 402(b)(4)

  1. IRC 402(b) provides rules for taxation of beneficiaries of nonexempt employee benefit trusts. Under IRC 402(b), if a plan fails to satisfy the qualification requirements under IRC 401(a):

    1. The tax-exempt status of trust earnings is revoked.

    2. Employer deductions for contributions may be deferred or eliminated.

    3. All employees must include the value of post disqualification accruals or contributions in income in accordance with IRC 83. Thus, if contributions are made to the plan with respect to vested account or benefits, employees must include these amounts in income.

  2. IRC 402(b)(4) contains special rules that apply if the plan fails to satisfy IRC 401(a)(26) (for defined benefit plans) and IRC 410(b). If the plan fails to satisfy either of these sections, each highly compensated employee (HCE) must include in income an amount equal to the employee's entire vested accrued benefit not yet included in income. If, however, the plan is not qualified solely because it fails to satisfy the IRC 401(a)(26) or IRC 410(b) requirements, no adverse tax consequences are imposed on nonhighly compensated employees (NHCEs). See IRC 402(b)(4) IRC.

    1. Under the integrated approach to IRC 401(a)(4) and IRC 410(b) underlying the Treas. Reg., any failure to satisfy IRC 401(a)(4) is viewed by the preamble to the IRC 401(a)(4) Treas. Reg. as failure to satisfy IRC 410(b).

    2. Consequently, failure to meet the requirements of IRC 401(a)(4) will cause IRC 402(b)(4) to apply with respect to a plan and will therefore subject HCEs to the special sanctions contained in that section.

    3. Similarly, if the plan satisfies all qualification requirements other than IRC 410(b) and IRC 401(a)(26), no adverse tax consequences will be imposed on NHCEs.

    Example 1: Plan X was examined and determine to be nonqualified for two reasons: (i) the pension plan made distributions in single sums without obtaining spousal consent, and (ii) the plan covered only eight of 60 employees. Of these eight employees, three are HCEs.

    Under IRC 402(b)(4)(A), all of Plan X’s covered employees would incur adverse tax consequences. The three HCEs must include the present value of their entire nonforfeitable employer provided accrued benefits in income.

    Example 2: Plan Y, a profit sharing plan, fails coverage under IRC 410(b). This is the only reason the plan is not qualified. The HCEs must include their entire employer provided account balances in income; and there are no adverse tax consequences to any other employee. The Plan Y trust is taxable. In the next year, the HCEs must include in income the value of their account at the end of the year less their "investment in the contract," i.e., the amount previously taxed.

4.72.12.3  (04-04-2014)
Revocation Procedures

  1. The procedures for revocation are found in IRM 4.71.3.3, Unagreed Form 5500 Procedures.

4.72.12.3.1  (12-31-2005)
Examination Step

  1. Consider all facts revealed in an examination before proposing revocation to an exempt trust because the adverse effect caused by such a revocation upon both the employer and the participants is significant. However, if facts and circumstances clearly show a plan has failed to qualify in operation, the revocation procedure should be initiated after the issue(s) is discussed fully with the group manager.

Exhibit 4.72.12-1 
Examples of Employer Deduction and Participant Taxation for NonQualified Plans

Example 1 This limitation is needed to distinguish from cases where 402(b)(4) applies. F is a NHCE of M Corporation whose profit-sharing plan has a calendar year plan year. F is a calendar year taxpayer. On January 1, 2011, the plan ceased to be qualified. On that date F had an account balance of $30,000 in which F had a nonforfeitable interest of 45 percent ($13,500). On December 1, 2011, the employer made a contribution to the plan of which $7,000 was allocated to F's account. There were no forfeitures allocated to the account.
  F had also completed an additional year of service for vesting and had a nonforfeitable right to 50 percent of such contribution ($3,500).
  For 2011, under Treas. Reg. 1.402(b)-1(b)(1), F would include in gross income $3,500, the vested portion of the employer contribution made to the plan during the employer's taxable year during which the trust was not exempt. F does not include the value of the increase in her/his vested right to the account balance at January 1, 2011 or the earnings thereon in income because these monies are attributable to employer contributions made to the plan while the trust was exempt. Assume no earnings are allocated in 2011 which are attributable to the $7,000 contribution allocated on December 1, 2011.
  Under IRC 404(a)(5), M could deduct in 2011, $3,500, the amount of the contribution includible in F's income.
  Worksheet for Taxation of Participants in Nonqualified Defined Contribution Plans
  Defined Contribution
  Nonqualified year for which no earnings are allocated to nonqualified contributions and/or forfeitures.
    A. Employer contributions and forfeitures for participant for year: $7,000
    B. Multiply by participant's nonforfeitable percentage under the plan at the calendar year end: x .50
    C. Amount includible in participant's income: $3,500
Example 2 S, a NHCE, first participated in the G Corp. money purchase pension plan on January 1, 2006. The plan provides that forfeitures are used to reduce future employer contributions. These contributions are fixed by the plan at 5 percent of total compensation. S earns $25,000 per year. Both S and the plan are on a calendar taxable year. The plan ceased to be a qualified plan on January 1, 2011. On December 15, 2011, a $1,250 amount was credited to S's account. This amount consisted of $1,100 of employer contributions and $150 of forfeitures. S has a nonforfeitable right to 80 percent of this amount.
  S would include in income for 2011 $1,000 ($1,250 x .80). The employer would deduct $880, which is the portion of its contribution which was includible in S's income, ($1100 x .80).
  Note: Although no part of the forfeiture allocated to S's account was deductible in this case, forfeitures includible in participants' income would be deductible by the employer to the extent the employer could demonstrate that the forfeiture resulted from employer contributions made during a nonqualified year and not previously deducted. For example, if $25 of the forfeitures in this case had resulted from such contributions, the employer would have been able to deduct an additional $20, the amount includible by the employee, i.e., ($25 x .8).
  Worksheet for Taxation of Participants in Nonqualified Defined Contribution Plans  
  Defined Contribution  
    Nonqualified year for which no earnings are allocated to nonqualified contributions and/or forfeitures  
  A. Employer contributions and forfeitures for participant for year*: $1,250
  B. Multiply by participant's nonforfeitable percentage under the plan at the calendar year end; x .80
  C. Amount includible in participant's income: $1,000
    * Contribution $1,100; Forfeiture $150  
Example 3 F, a NHCE, is a participant in the S Corporation Profit-Sharing Plan. The plan calls for periodic contributions in an amount to be decided upon by the employer. This amount is to be allocated under a fixed formula to employee's accounts. The amount allocated is to be increased by forfeitures.  
    Both F and S Corp. are calendar year taxpayers. The plan ceases to be qualified on January 1, 2008. On December 15, 2008, $7,250 is allocated to F's account.  
    This amount consists of a $7,000 employer contribution and a $250 forfeiture. F has a nonforfeitable right to 60 percent of his account balance for 2009.  
    F, under Treas. Reg. 1.402(b)-1(b)(1) and (2), would include in income for 2009, $7,250 x .60 or $4,350. S Corporation would deduct $4,200 the nonforfeitable part of the contribution, $7,000 x .60.  
    Worksheet for Taxation of Participants in Nonqualified Defined Contribution Plans  
    Nonqualified year for which no earnings are allocated to nonqualified contributions and/or forfeitures.  
  A. Employer Contributions and forfeitures for participant for year*: $7,250
  B. Multiply by participant's nonforfeitable percentage under the plan at the end of the calendar year: x .60
  C. Amount includible in participant's income: $4.350
  *Contribution $7,000; Forfeiture $250  
Example 4 P, a NHCE, is a participant in the S Corp. profit sharing plan. The plan ceased to be a qualified plan on January 1, 2010. P and the plan are calendar year taxpayers.  
    The following chart shows the history of P's account balance attributable to employer contributions made while the plan was qualified (pre-2010). Also shown are employer contributions and account balances attributable to employer contributions and earnings on these, during years for which the plan is not exempt..  
Year Ending Acct. Bal. + Earnings
200912 10,000
201012 12,000
201112 14,200
201212 15,845
Post 2009 Contributions
Year Ending Employer Contribution Nonforfeitable Right Nonqualified Account Balance and Earnings
201012 1,000 70 percent 1,000
201112 1,000 80 percent 2,200
201212 1,000 90 percent 3,300
  In 2010 P would include in income $700, the nonforfeitable amount attributable to employer contributions made during a year when the plan was nonqualified. S would deduct $700.
  In 2011, P would include in income the nonforfeitable portion of the 2011 employer contribution, $800. Also, P would include the value of the nonqualified account (less the current year's allocation) multiplied by the increase in P's vesting (1,200 x .10) or $120. Thus, P's total inclusion for 2011 is $920.
  In 2012, P would include in income $900, the current year's employer contribution ($1,000) multiplied by P's nonforfeitable portion (90 percent). Also, P would include the value of the nonqualified account (less the current year's contribution) $2,300 multiplied by the increase in P's nonforfeitable percentage for the year (.1) or $230. Thus, P's total inclusion for 2012 is $1,130.
S Corporation's deductions are computed as follows:
2010: $700 nonforfeit. part of E'r contribution
2011: $800 nonforfeit. part of E'r contribution
  $100 increase in vesting in 2010 contrib.
  $900 Total deduction
2012: $900 nonforfeit. part of 2012 E'r contrib.
  100 increase in vesting in 2011 contrib.
  100 increase in vesting in 2010 E'r contrib.
  $1,100    
2010 Worksheet for Taxation of Participants in Nonqualified Defined Contribution Plans
Defined Contribution
Nonqualified year for which no earnings are allocated to nonqualified contributions and/or forfeitures
A. Employer Contributions and forfeiture for participant for year*: $1,000
B. Multiply by participant's nonforfeitable percentage under the plan at the calendar year end: x .70
C. Amount includible in participant's income: $700
*The taxable year of the participant during which the amounts were allocated if such amounts are employer contributions or forfeitures made during a taxable year of the trust for which it was not exempt.
2011
Nonqualified Years for which earnings are allocated to nonqualified contribution and/or forfeitures.
A. Employer Contributions and forfeitures for participant for year:* $1,000
B. Multiply by nonforfeitable percentage at the calendar year end: x .80
C. Subtotal: $800
D. Total "nonqualified" account (other than current year allocation): $1,200
E. Increase in vesting: .10
F. Amount includible in respect to increase in vesting (D x E): $120
G. Total includible in gross income for second year (C + F): $920
* The taxable year of the participant during which the amounts were allocated if such amounts are employer contributions or forfeitures made during a taxable year of the trust for which it was not exempt.
2012
Nonqualified Years for which earnings are allocated to nonqualified contribution and/or forfeitures.
A. Employer Contributions and forfeitures for participant for year:* $1,000
B. Multiply by nonforfeitable percentage at the calendar year end: x .90
C. Subtotal: $900
D. Total "nonqualified" account (other than current year allocation): $2,300
E. Increase in vesting: .10
F. Amount includible in respect to increase in vesting (D x E): $230
G. Total includible in gross income for second year (C + F): $1,130
* The taxable year of the participant during which the amounts were allocated if such amounts are employer contributions or forfeitures made during a taxable year of the trust for which it was not exempt.
Example 5 An employer maintains a qualified defined contribution plan. The employer's taxable year and the plan year both end on June 30. On July 1, 2010, the plan loses its qualified status. On June 30, 2011, the plan's allocation date, $5,000 is contributed to the account of a calendar year, NHCE who is 100 percent vested in her/his account balance. The tax consequences to the employee and the employer are as follows.
  Employee. Treas. Reg. 1.402(b)-1(a)(1) provides that a contribution made during a taxable year of the employer which ends with or within the taxable year of the trust for which it is not so exempt shall be included as compensation in the gross income of the employee for her/his taxable year during which the contribution is made, to the extent vested. Thus, the employee includes $5,000 in gross income as compensation for the calendar year ending December 31, 2011.
  Employer. Treas. Reg. 1.404(a)-(12)(b)(1) provides that a deduction is allowable under IRC 404(a)(5) only in the taxable year of the employer in which or with which ends the taxable year of the employee in which an amount attributable to such contribution is includible in her/his income. Here, the employee has included the $5,000 contribution in the year ending December 31, 2011. This year ends within the employer's taxable year ending June 30, 2012. Thus, the employer will deduct the $5,000 contribution for its taxable year ending June 30, 2012.
Example 6 R, a NHCE, is a participant in a defined contribution plan which ceased to be qualified on January 1, 2011. In December 2011, a $1,000 employer contribution is allocated to R's account. This amount is used to purchase 50 shares of common stock at $20 per share. R has a nonforfeitable right to 100 percent of R's account.
  In 2012, a further $1,000 is allocated to R's account. The stock purchased in 2011 is now selling for $15 per share on a national exchange and R's 50 shares have a fair market value of $750. For 2012 R would include $1,000 in income.
  If R's nonforfeitable interest was less than 100 percent in 2011 she would include in income an amount which is the result of the increase in her nonforfeitable interest multiplied by the current (2012) value of the account. Her basis would increase accordingly.
  Thus if R's nonforfeitable percentage increased from 60 percent on December 31, 2011 to 70 percent on December 31, 2012, R would include in income $75. This is the result of multiplying the increase in R's nonforfeitable interest (10 percent) by the value of the account on December 31, 2012 minus the 2012 contribution ($750).
    2011 Calculation: $1,000 @ 60 percent =
(2011 Contribution)
$600.00
    2012 Calculation: $1,000 @ 70 percent =
(2012 Contribution)
$700.00
2011 Acct. Balance 2012 Contribution Acct. Balance Change in Vesting Taxable Amt.
$1,750.00 -$1,000.00 = 750.00 x. 10 = $75.00
Any losses in the value of R's account would not be recognized by R until distribution of R's entire interest. See Rev. Rul. 71-251, 1971-1 CB 129.
2011
Worksheet for Taxation of Participants in
Nonqualified Defined Contribution Plan
Defined Contribution
Nonqualified year for which no earnings are allocated to nonqualified contributions and/or forfeitures
  A, Employer Contributions and forfeitures for participant for year*: $1,000
  B. Multiply by participant's nonforfeitable percentage under the plan at the calendar year end: x .60
  C. Amount includible in participant's income: $ 600
  2012
  Nonqualified Years for which earnings are allocated to nonqualified contribution and/or forfeitures.
  A. Employer Contributions and forfeitures for participant for year*: $1,000
  B. Multiply by nonforfeitable percentage at the calendar year end: x .70
  C. Subtotal: $ 700
  D. Total "nonqualified" account (other than current year allocation): $ 750
  E. Increase in vesting: .10
  F. Amount includible in respect to increase in vesting (D x E): $ 75
  G. Total includible in gross income for second year (C + F): $ 775
  * The taxable year of the participant during which the amounts were allocated if such amounts are employer contributions or forfeitures made during a taxable year of the trust for which it was not exempt. Upon distribution of benefits from the trust the recipient has a basis equal to the part of the distribution previously includible in the recipient's income.

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