Qualified Plan Disqualification and IRA Prohibited Transactions

For over 30 years, I’ve dealt with qualified plans and the problems incident thereto. (A qualified plan is one that meets the requirements of section 401(a).) I’ve also dealt with IRA problems, including prohibited transactions (PTs) experienced by self-directed IRAs. There aren’t a lot of definitive sources on what happens when a qualified plan becomes disqualified. Similarly, one code section and related regulations spell out the implications of a PT for a self-directed IRA. This report attempts to add some clarity as to these matters and calls for a change in the law regarding the correction of problems concerning qualified plans and self-directed IRAs.

I. Qualified Plan Disqualification

For a plan that was designed to be qualified, the failure to be qualified (at inception or later) can produce substantial tax deficiencies, penalties, and interest to the employer sponsor, the plan participant, and/or the trust. However, whether the potential exposure is great depends on specific facts, including the statute of limitations on assessment.

My first experience with a qualified plan problem occurred in 1989. It involved reaching a closing agreement with the IRS regarding a simple profit-sharing plan that had gone awry. At the time, there were no IRS correction programs in place. The plan had not been amended for numerous tax law changes. The matter was resolved through a closing agreement that primarily required a major retroactive amendment and the payment of a $10,000 nondeductible fee.

The benefits of tax qualification are (1) contributions to the plan are tax-deductible; (2) employees are not taxed on contributions to the plan, regardless of whether or when the benefits are vested; (3) benefits grow tax-free while held in a trust; and (4) while distributions are ordinarily taxable as ordinary income for income tax (but not FICA tax) purposes, plan benefits can be rolled over tax-free to an IRA or (sometimes) another qualified plan after termination of employment, etc. A retirement plan that fails to meet all the many tax qualification rules is not qualified. I don’t know if anyone has determined the number of rules a retirement plan must meet to be qualified, but I’d guess there are more than 1,000 for a typical 401(k) plan.

A plan that is not qualified is ordinarily referred to as a nonqualified plan. Generally speaking, benefits placed in a trust for the benefit of an employee under a nonqualified plan are taxed to the employee once vested. The employer is entitled to receive a deduction for a nonqualified plan when the employee recognizes income, in an identical amount. As discussed later, any taxable trust earnings of a trust maintained in connection with a nonqualified plan are annually subject to income taxation. Distributions are taxable to the payee, but part of any distribution is tax-free to the extent income was previously recognized on the benefits or after-tax contributions were made by the employee.

Because there is a tremendous number of requirements applicable to qualified plans, mistakes often occur. The IRS has created a corrections system to allow plan sponsors to fix plan defects. It is called the Employee Plans Compliance Resolution System (EPCRS) and is found in Rev. Proc. 2021-30, 2021-31 IRB 1. Under the EPCRS, plan sponsors or administrators can do things to correct failures to meet one or more tax qualification rules. Because the consequences of disqualification of a plan ordinarily are very bad (that is, costly) and often affect numerous employees and former employees, plan defects are almost always corrected using the EPCRS. But sometimes, as explained below, the EPCRS is not an option.

The EPCRS has various components. Under the self-correction program, corrections can be done without an IRS filing or IRS involvement. Otherwise, a filing with the IRS is necessary, and a user fee must be paid under the voluntary correction program. Before 2022, anonymous submissions were permitted, whereby a letter, etc., was sent along with a user fee, requesting approval of a correction method. The plan sponsor was not revealed unless and until a correction mechanism was agreed upon with the IRS. After 2021, anonymous filings are not permitted. Now, an anonymous, no-fee, pre-submission conference is available.

If defects are discovered on audit, resolution is possible using the audit closing agreement program. A fee is imposed that is meant to bear a reasonable relationship to the nature, extent, and severity of the failures, taking into account pre-audit correction. In a non-amender case (that is, failure to timely amend for tax law changes), the sanction amount is a percentage (greater than 100) of the voluntary correction program correction fee. In other cases, the sanction amount is negotiated based on the facts and circumstances, including a list of factors set forth in section 14.02 of Rev. Proc. 2021-30, which includes the maximum payment amount. (One might question how much negotiating leverage a plan sponsor has when one or more defects have been discovered on audit.)

The maximum payment amount generally is approximately equal to the tax the IRS could collect upon plan disqualification and is the sum for the open tax years of (1) tax on the trust,¹ plus interest and penalties; (2) additional income tax resulting from loss of employer deductions for plan contributions, plus interest and penalties; and (3) additional income tax resulting from income inclusion for participants in the plan,² including the tax on distributions rolled over (plus interest and penalties). A lot has been written about corrections programs. Because disqualification is rare, there is little authority on the implications of tax disqualification of a qualified plan.

The EPCRS corrections system does not cover IRAs. To a limited degree, it applies to simplified employee pensions (SEPs) and SIMPLE IRAs, which are plans in which benefits are funded through IRAs. Under section 408(d)(3)(I), the IRS is authorized to waive a failure to meet the 60-day rollover period applicable to a traditional 60-day rollover (that is, not a direct transfer). It may do so “where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.” IRS guidance now exists under Rev. Proc. 2020-46, 2020-45 IRB 995.

A. Income Tax

Section 402(b) sets forth the implications of failure of a plan with a trust to meet the tax qualification rules. Section 402(b)(1) provides the general rule concerning a plan not being qualified. (Section 402(a) provides that for an exempt trust relating to a qualified plan, the employee is liable for taxes in the year a distribution is received, subject to the rollover rules and the rules of section 72 that permit reduction in the taxable amount for any basis.) Section 402(b) deals with both plans with trusts not designed to be qualified and plans with trusts designed to be qualified, but for which one or more failures of the qualification rules occurs.

Under section 402(b)(1), contributions to a trust that is not exempt under section 501(a) (and a qualified plan’s trust ordinarily is tax-exempt under section 501(a)) during a tax year of the employer that ends with or within a tax year of the trust are included in income of the employee in accordance with section 83, except the value of the employee’s interest in the trust is substituted for the fair market value of the property. By referring first to contributions and then to value of the employee’s interest in the trust, this language is confusing. Regulations clarify.

Under section 83, a property transfer to an employee is taxable when it is freely transferable or no longer subject to a substantial risk of forfeiture (whichever comes first if not simultaneous). Under a qualified plan, section 83 vesting would ordinarily apply when the vesting requirements were satisfied. (But section 83 does not apply to qualified plan benefits.) Under section 402(b)(2), amounts distributed (that is, not rolled over) are subject to tax, subject to the tax-free receipt of basis rules (for amounts already taxed and after-tax contributions) under section 72. Under section 83(h), the employer is entitled to a deduction when and to the extent that the employee picks up income.

Section 402(b)(3) provides that the beneficiary of any trust described in section 402(b)(1) (that is, the trust of a nonqualified plan) is not considered the owner of any portion of that trust under subpart E of Part I of subchapter J (section 671 et seq.), relating to grantors and others treated as substantial owners. As noted below, regulations may sometimes call for a different result. So based on pertinent code language, for frozen nonqualified plan assets held in a trust (that is, one for which contributions are not now being made — including the trust of a plan that previously was qualified), the trust would pay tax on taxable annual earnings, but employees would pay no current tax on those earnings. It is unclear from the code whether employees would receive basis for the taxable earnings of the trust not picked up in income by them before distributions. Reg. section 1.402(b)-1(b)(5) provides for basis to the employee only to the extent that an amount is included in gross income (presumably meaning only by the employee).

Section 402(b)(4) provides an overriding rule for a failure to meet the coverage tests of section 401(a)(26) or 410(b).³ Subparagraph (A) provides that if one of the reasons a trust is not exempt from tax under section 501(a) is the plan’s failure to meet the coverage test of section 401(a)(26) or 410(b), the highly compensated employees (HCEs) must include in income for the tax year with or within which the tax year of the trust ends the value of their vested accrued benefit exclusive of after-tax contributions as of the close of the year of the applicable trust. Whether contributions are made for the year is irrelevant. Although not entirely clear, it appears that non-HCEs would experience the tax results applicable under section 402(b)(1), concerning taxation of vested contributions. However, subparagraph (B) of section 402(b)(4) provides that if the sole reason the plan’s trust is not exempt is a failure of the plan to satisfy section 401(a)(26) or 410(b), paragraphs (1) and (2) of section 402(b) won’t apply to any employee who was an NHCE during the year of the failure and for preceding years for which service was credited to the employee.

As noted, regulations exist regarding those section 402(b) rules. However, they are not entirely consistent with the code, and there is no provision in section 402(b) providing that they are legislative in nature (rather, they are interpretative). So the regulations cannot lawfully override a code provision. As stated by the court in Loving,⁴ “In the land of statutory interpretation, statutory text is king.” And the Supreme Court has held that a regulation can potentially fill a gap only if a statute is ambiguous.⁵

The regulations were drafted to cover both trusts of plans never intended to be qualified and plans that were qualified but later ceased to qualify. For a plan never intended to be qualified, receipt of a vested interest in a trust generally is taxable. There is little case law authority on plan disqualification effects (because plans are rarely disqualified, given the IRS corrections program and the potentially extreme impacts of disqualification), so it can be difficult to discern exactly how the regulatory rules work.

Reg. section 1.402(b)-1(a) generally provides, regarding the general taxation rule of section 402(b)(1), that contributions made on an employee’s behalf by an employer to a nonexempt trust are included as compensation in the gross income of the employee for his tax year in which the contribution is made, but only to the extent that the employee’s interest in that contribution is substantially vested at the time the contribution is made. “Substantially vested” is defined in reg. section 1.83-3(b). For retirement plans, the vested percentage (which essentially equates to substantially vested) for an account of a participant (and a participant can have more than one account in a plan) is 0 percent, 100 percent, or some percentage in between 0 and 100. Because virtually all individuals and most plans and plan trusts use the calendar year, taxation of a contribution amount will occur in the year of the contribution. It would appear this language resolves the code ambiguity regarding whether the taxable amount is the contribution amount or the vested interest in the trust.

Salary deferral contributions to a 401(k) plan are vested upon contribution. So under the regulations, assuming the general rule of reg. section 1.402(b)-1(a) applies, if a calendar-year plan with a calendar-year trust provided for only 401(k) contributions, upon contribution, the amount of the contributions would be included in income for any year in which the trust was not tax-exempt. (If the sole reason for disqualification was failure to meet the requirements of section 401(a)(26) or 410(b), this result would generally apply only to the HCEs.) For a plan with employer contributions, contributions fully vested upon contribution (for example, for an employee who had met the plan’s vesting requirements for employer contributions) would also be taxable as compensation in the year of contribution to the trust. Employer contributions to the trust might partially or fully occur in the year after the employer’s year to which the contributions relate.

The regulations provide rules for transition of a nonvested benefit to a vested benefit. These rules would apply to employer contributions not fully vested upon contribution. Reg. section 1.402(b)-1(b) provides:

Taxability of employee when rights under nonexempt trust change from nonvested to vested — (1) In general. If rights of an employee under a trust become substantially vested during a taxable year of the employee (ending after August 1, 1969), and a taxable year of the trust for which it is not exempt under section 501(a) ends with or within such year, the value of the employee’s interest in the trust on the date of such change shall be included in his gross income for such taxable year, to the extent provided in paragraph (b)(3) of this section. When an employee’s trust that was exempt under section 501(a) ceases to be so exempt, an employee shall include in his gross income only amounts contributed to the trust during a taxable year of the employer that ends within or with a taxable year of the trust in which it is not so exempt (to the same extent as if the trust had not been so exempt in all prior years).

Paragraph (b)(3) mainly limits the regulation’s applicability to contributions made after August 1, 1969. The regulations provide an example of how a benefit converting from partially vested to fully vested is taxed. The method isn’t simple. The second sentence of the above quote applies when a formerly exempt trust transitions to being a taxable trust, and it limits amounts included in income to only contributions made after disqualification (that is, years in which the trust is not exempt). It is not clear if both sentences apply or only the second sentence applies to a plan disqualification situation. The parenthetical at the end of the second sentence would apply only to a plan that never was qualified. If both sentences apply, increases in vested benefits, as calculated under the regulations, would produce annual income to the employee. Reg. section 1.402(b)-1(b)(4) provides, for purposes of paragraph (b)(1), that if only part of an employee’s interest in the trust becomes substantially vested during any tax year, only the corresponding part of the value of the employee’s interest in that trust in includable in gross income for that year. Based on the general regulatory language of reg. section 1.402(b)-1(a), only the second sentence should apply. If distributions are taxable to the extent not previously taxed (discussed below), the matter is one of income timing.

Reg. section 1.402(b)-1(b)(5) provides: “The basis of any employee’s interest in a trust to which this section applies shall be increased by the amount included in gross income under this section.” It appears that “this section” refers to reg. section 1.402(b)-1, so all amounts picked up under the general rule of reg. section 1.402(b)-1(a) and wholly or partially under the following rule (reg. section 1.402(b)-1(b)(6)) should produce basis. What about trust earnings not taxed to the employee? Would an “amount included in gross income under this section” include an amount not reported many years prior because of the employer’s failure to know the plan had been disqualified? While that seems possible, it seems the IRS would clearly argue strenuously against that if there was an audit.

Reg. section 1.402(b)-1(b)(6) provides:

Treatment as owner of trust. In general, a beneficiary of a trust to which this section applies may not be considered to be the owner under subpart E, part I, subchapter J, chapter I of the Code of any portion of such trust which is attributable to contributions to such trust made by the employer after August 1, 1969, or to incidental contributions made by the employee after such date. However, where such contributions made by the employee are not incidental when compared to contributions made by the employer, such beneficiary shall be considered the owner of the portion of the trust attributable to contributions made by the employee, if the applicable requirements of such subpart E are satisfied. For purposes of this paragraph (6), contributions made by an employee are not incidental when compared to contributions made by the employer if the employee’s total contributions as of any date exceed the employer’s total contributions on behalf of the employee as of such date.

Note that this language is inconsistent with section 402(b)(3). To the extent inconsistent, it is not lawful for the case law reasons supplied above. Given that the material is in regulations, taxpayers might be able to apply the rules to their advantage, but the rules should not be usable against them.⁶

Subpart E relates to the grantor trust rules of sections 671 through 679. Thereunder, the grantor is taxed on trust earnings. A participant would have a power defined in sections 671 through 679 if the ability to take a distribution exists. Other less potent rights trigger application of the rules. Under section 677, the ability to decide to have income distributed or held for future distribution triggers the rules. With a plan that permits distributions only after termination of employment, a section 677 power presumably would not exist until after termination of employment. However, under section 673, the right to a reversion, which ordinarily does not exist for a qualified plan, might make all qualified plan vested benefits subject to subpart E for a sole proprietor with no employees.

It is important to note when the regulations were issued and amended. Reg. section 1.402(b)-1 was last amended in 2007. Before that, the most recent amendment occurred on July 21, 1978. The 1978 amendment was substantial, and it added reg. section 1.402(b)-1(b)(6). Before the enactment of ERISA in 1974, three revenue rulings had permitted pretax elective deferrals to qualified plans under some circumstances: Rev. Rul. 56-497, 1956-2 C.B. 284; Rev. Rul. 63-180, 1963-2 C.B. 189; and Rev. Rul. 68-89, 1968-1 C.B. 402. When ERISA became law in 1974, it made elective deferrals taxable, so any such contributions would have been post-tax in nature. However, the Revenue Act of 1978 thereafter created current section 401(k), making elective deferrals pretax employer contributions effective after 1979. It also made the three revenue rulings the law for plans in existence on July 27, 1974. It is unclear how the change in the law affects this regulation. Rev. Rul. 68-89 treated employee contributions as employer contributions for purposes of the estate tax and section 2039(c). It appears the position can be taken that elective deferrals qualify as employee contributions. (Taking that position might be beneficial to a participant.)

Returning to reg. section 1.402(b)-1(b)(5), a trust’s earnings ordinarily would not be subject to tax under “this section.” Rather, the employee is taxable only on vested contributions to his account. But “this section” could include trust earnings if the employee was required to report them in his income. Thus, the basis rule might apply to trust earnings when the employee is treated as the grantor and subject to annual taxation under subpart E (but not otherwise). In that case, for a disqualified (former) 401(k) plan without matching contributions, the annual earnings of the employee in his account would be included in his income.

A side issue is how custodial accounts fit in the picture. The assets of a qualified plan ordinarily must be held in trust. However, under section 403 of ERISA, if the plan covers at least one self-employed person, a custodial account qualifying under section 401(f) can be used in lieu of a trust. The above rules assume a trust applies. A trust that is not exempt is a separate taxpaying entity. The trustee is the legal owner of trust assets. A taxable custodial account’s earnings are ordinarily taxed to its owner. Who is the owner of a qualified plan? Perhaps it’s the employer, but perhaps it’s the participants. It seems that the use of a custodial account should not put one in a better or worse place than that of a trust. In this regard, the flush language of section 401(f) provides: “For purposes of this title, in the case of custodial account or contract treated as a qualified trust under this section by reason of this subsection, the person holding the assets of such account or holding such contract shall be treated as the trustee thereof.”

B. Trust Taxation and Deductions

If a plan is disqualified, the trust of the plan becomes an ordinary trust, generally subject to taxation under the income tax rules governing trusts (sections 641 through 685). There are simple trusts (section 651), which must distribute all their income annually, and complex trusts (section 661), which are all trusts that are not simple trusts. So a trust of a plan that previously was a qualified plan would be a complex trust.

The ordinary trust rules are subject to section 404(a)(5) regarding deductions to the employer. Under this section, the employer ordinarily is entitled to a deduction for a contribution when the employee picks up income. And if the plan covers more than one employee, separate accounts must be maintained for a deduction to be available. A pure defined benefit plan ordinarily could not meet this rule, but defined contribution plans would meet it. It is unclear whether a cash balance plan would meet it. Reg. section 1.404(a)-12(b)(3) provides that a disqualified plan can be amended to create separate accounts.

Reg. section 1.404(a)-12(b)(1) supplies an example showing how the deduction rules work:

For example, if an employer A contributes $1,000 to the account of its employee E for its taxable (calendar) year 1977, but the amount in the account attributable to that contribution is not includible in E’s gross income until his taxable (calendar) year 1980 (at which time the includible amount is $1,150), A’s deduction for that contribution is $1,000 for 1980 (if allowable under section 404(a)).

Note that this example provides that the $150 of earnings would be includable in income of the employee, not just the contribution amount. This regulation may not square with the section 402(b) regulations.

For a complex trust, generally, all taxable net income not distributed is subject to income tax. As a taxpaying entity, a trust is an awful choice. For 2022, a trust hits the highest income tax bracket of 37 percent once taxable income exceeds $13,450. Distributions generally carry out the taxable income to beneficiaries who receive them, but the income amount is limited to the trust’s distributable net income (DNI). So for a disqualified plan, a distribution could produce income to an “in pay” participant that exceeds (and possibly greatly exceeds) that participant’s share of the trust’s income. A later distribution to another participant in a later year when the trust had little or no taxable income might go untaxed or undertaxed. It’s neither a good result nor a fair result. However, reg. section 1.663(c)-1 permits a trust to be treated as separate trusts for purposes of the DNI rule when more than one beneficiary exists if the beneficiaries have substantially separate and independent shares, as would ordinarily be the case for a defined contribution plan.

As noted, section 402(b)(2) provides: “The amount actually distributed or made available to any distributee by any trust described in paragraph (1) [relating to a nonexempt trust] shall be taxable to the distributee, in the taxable year in which so distributed or made available, under section 72.” Section 72 allows after-tax contributions and other amounts for which basis exists (for example, because of prior income recognition) to be received tax free. This language appears to be inconsistent with the rules ordinarily applicable to complex trusts, which (under section 662) specifically limit amounts taxable to employees and the amount deductible to the employer to the amount distributed and sourced from DNI. In Rev. Rul. 74-299, 1974-1 C.B. 154, and Rev. Rul. 2007-48, 2007-2 C.B. 129, the IRS resolved the issues by taking the position that the employee is taxed on amounts distributed plus amounts becoming vested (even if much greater than the employee’s share of the trust’s DNI in excess of basis), while the trust is entitled to a deduction only for the participant’s share of the trust’s DNI. Given that both section 83 and section 402 (and section 404) generally grant deductions when income is recognized, this position (which is not law) is asymmetrical and seems unreasonable.

C. Suing in Court

Title I of ERISA includes numerous substantive rules that retirement plans of private sector plan sponsors must meet. Almost all these substantive rules are carried over and apply equally to Title II of ERISA, concerning plan qualification under section 401(a) et seq. Many more rules exist under the code and its regulations. While employees have been successful enforcing Title I rules in court, they generally have been unsuccessful when trying to enforce qualification rules found only in the code.⁷ Because employees can sue under Title I to enforce their rights under the plan, they should be able to successfully sue to enforce a tax rule that is part of the plan.

D. Securities Laws

The SEC generally takes the position that involuntary contributions made to a qualified plan are exempt from securities laws’ registration requirements. It has also taken the position that voluntary contributions to qualified plans are exempt. But a disqualified plan presumably would not so qualify.

II. Self-Directed IRAs and PTs

In recent years, investment in self-directed IRAs has grown immensely. Self-directed IRAs permit investment in real estate and privately held companies — two investments the major IRA providers generally have not wished to accommodate. However, the code and regulations provide relatively little specific guidance on what is impermissible, and case law is scant. There is a tremendous amount of gray area.

Under section 4975, a PT gives rise to a 15 percent excise tax on the amount involved. The tax rate is increased to 100 percent if correction does not occur within a statutory time frame. If a third-party fiduciary commits a PT, it must pay the tax. If the IRA owner or a beneficiary commits a PT with respect to a self-directed IRA, the excise taxes do not apply. Instead, the IRA ceases to be an IRA on the first day of the year in which the PT occurs, and the assets are deemed to have been distributed on that day in a taxable distribution. If the IRA is a Roth IRA, the basis in the IRA could be recovered free of income tax. Basis in a traditional IRA would also reduce the income amount.

The apparent goal of the PT rules is to place retirement assets out of reach of the IRA owner for purely personal needs. The PT rules are rather rigid. They don’t consider facts that make an action less harmful or unharmful. So actions that might not seem bad (or are not bad) can be PTs.

A PT is defined as one of specified transactions between or involving a plan and a disqualified person. The term “plan” includes a qualified plan and an IRA. A disqualified person is defined as including a fiduciary for an IRA and a person providing services to an IRA.

A fiduciary is defined as a person who (1) exercises any discretionary authority or control regarding management of a plan or exercises any authority or control regarding management or disposition of the plan’s assets; (2) renders investment advice for a fee or other compensation, direct or indirect, regarding any moneys or other property of the plan, or has any authority or responsibility to do so; or (3) has any discretionary authority or responsibility in the administration of that plan. The owner of a self-directed IRA is a fiduciary. The IRA trustee-custodian is also a fiduciary (and a disqualified person).

Under complex rules, family members of disqualified persons are also disqualified persons. Spouses, ancestors, lineal descendants, and spouses of lineal descendants are deemed family members. Also included in the definition of disqualified persons are corporations, partnerships (including limited liability companies) of which or in which an IRA fiduciary directly or indirectly (including through family member ownership) owns 50 percent or more of the equity or capital or profits interests. If a partnership or LLC is a disqualified person, each 10 percent or greater partner or joint venturer in the partnership or LLC is a disqualified person.

While a disqualified person is specifically statutorily defined, the term “plan” is not well defined, except for a listing of types (qualified, IRA, etc.) that qualify as plans. An IRA is a plan, and each IRA is considered separate from each other IRA. So, disqualification of an IRA as the result of a PT does not disqualify any other IRA of the owner for which a PT has not transpired. Here, family attribution doesn’t apply.

A. Prohibited Acts

Subject to exemptions, under section 4975(c)(1), PTs include any direct or indirect:

There are some specific exemptions. Under section 4975(d)(9), a disqualified person can receive any benefit to which he is entitled as a plan participant, such as the pro rata share of investment earnings of a trust fund. There is no pertinent exemption for an exchange of cash or anything else for an increased interest in an entity that is a disqualified person. Not included in the list of PTs is a transaction between disqualified persons. A plan (including an IRA) can be a disqualified person. It is unclear whether such a transaction would be exempt, but it probably would not be exempt if a PT would otherwise exist due to the plan’s status as a plan.

B. Case Law Authorities

A few cases can affect the analysis. Swanson is a very important case regarding businesses.⁸ The taxpayer in Swanson implemented a plan to produce tax-free income by having his IRA establish a domestic international sales corporation. The DISC (Worldwide) received commissions from a corporation wholly owned by the taxpayer. Thus, the company took deductions for amounts paid to the DISC that would be completely tax-free when the DISC distributed its income to the IRA. The IRS attacked the transaction using the PT rules. It lost. Significantly, the opinion states:

A corporation without shares or shareholders does not fit within the definition of a disqualified person . . . It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person under section 4975(e)(2)(G). [Emphasis in original.]

The plan asset rules were not considered by the Swanson court, although they were effective for part of the years in issue (but after the year of entity formation). Under the plan asset rules of 29 CFR section 2510.3-101, assets of an entity in which the plan owns an interest (as well as the interest in the entity) are deemed owned by the plan. (Coverage of those rules is beyond the scope of this report.)

The holding of Swanson is controversial. Many persons believe it means that formation of a corporation (or a partnership or LLC) cannot be a PT. However, after the corporation has been formed, ownership of 50 percent or more by the plan (or IRA) causes the entity to be a disqualified person. Many believe that such a designation would prohibit additional equity infusions by the IRA. Others disagree. They believe that Swanson does not so provide, because the IRA account owner was acting only as a fiduciary (and section 4975(a) excludes such a person from the definition of qualified person for purposes of who must pay the tax). Two Labor Department advisory opinions are sometimes cited for this conclusion.

In FSA 200128011, the IRS essentially acquiesced in the Swanson decision. So it would be reasonable to assume that formation of a corporation, partnership, or LLC does not result in a PT.

In Peek,⁹ the Tax Court held that a personal guarantee of a loan to a corporation by a seller of business assets to the corporation was a PT, when the corporation was formed with the assets of two IRAs owned by two unrelated individuals. The corporation was a disqualified person because each IRA owned half the stock. The court substantively found that the guarantee by the IRA owners was a loan transaction between the IRA and the IRA owners, even though the guarantee was made to an unrelated party. It is questionable whether a guarantee qualifies as a loan or other transaction between a plan and a disqualified person under the facts presented. Another case that found a loan guarantee to produce a PT is Thiessen.¹⁰

Under Spink,¹¹ the receipt of an incidental benefit by a plan sponsor of a retirement plan does not result in a PT. Accordingly, the receipt of an incidental benefit by an IRA owner, including a return on an investment, should not be problematic.¹²

What if a self-directed IRA experiences a percentage ownership increase for a joint venture that is a disqualified person in exchange for a supplemental contribution? Potentially pertinent to the issue is Ellis.¹³ In that case, the Tax Court analyzed a situation in which a taxpayer’s IRA formed an entity with a third party. The plan was for the IRA to own 98 percent of the entity from inception. However, although almost all of the IRA’s planned contribution was made on June 23, 2005, the remainder necessary to get to 98 percent was made on August 19, 2005. The initial contribution was enough to cause the entity (an LLC) to be a disqualified person. Thus, under a literal reading of the code, the second contribution should have been a PT. The court ultimately held that a PT did not exist as a result of the second contribution, but a PT existed on other, unrelated grounds.

It is unclear why the Tax Court in Ellis had no problem with the supplemental contribution made roughly two months after the initial contribution, when the initial contribution caused the LLC to be a disqualified person. Perhaps it thought the preconceived plan was simply being fulfilled, and a two-month spread between the contributions was not problematic. The court did not significantly analyze the issue, at least not in its opinion. Perhaps the court was thinking that anything done in the same year does not present a problem. It’s difficult to say.

C. SEPs Not Qualifying

A SEP is described in section 408(k). While not nearly as numerous as the requirements for qualified plans, there are several SEP requirements. Similarly, simple retirement accounts (SIMPLE IRA plans) can be established by an employer under section 408(p). Other than potential excise taxes for nondeductible contributions, it appears there are no disqualification rules, etc., specific to these (not qualified under section 401(a)) plans. Would a violation of one or more of the pertinent IRA requirements under the code give rise to a PT for each IRA maintained under these plans? It seems unlikely. A failure might result in application of the rules applicable to taxation of nonexempt trusts. The IRS has extended the EPCRS to SEPs and SIMPLE IRAs.

D. PT Rules and State Laws

The PT rules concerning self-directed IRAs deem a distribution to occur on January 1 of the year of the PT. Must state law regarding ownership of property be interpreted that way? Does a deemed distribution under federal tax law amount to a state law transfer of ownership? Technically, no. Does Congress have the power to decree that? Probably not. I’ve served as co-counsel in a case in which creditors took the position that the IRA rules apply for state law purposes.¹⁴

III. UBTI

Both qualified plans and IRAs are potentially subject to the unrelated business tax of section 511. Under this section, the unrelated business taxable income of a qualified plan or an IRA is taxed in the way an individual is taxed, except the plan or IRA is treated as a trust (meaning the highest bracket is reached quickly).

UBTI generally is net income from a commercial business that is “regularly carried on.” The UBTI rules exist to prevent tax-exempt entities from having a competitive advantage over for-profit entities. However, there are exceptions to the rules, including an important exception for real estate and passive income such as interest. Still, the exceptions are generally subject to the debt financing exception of section 514, such that debt-financed business income of an IRA (including real estate) generally is UBTI to the extent that an asset’s purchase is financed by debt. So if an IRA borrowed funds and used them to purchase an interest in real estate, UBTI generally exists. It is important to note that only net taxable income is potentially taxable.

Under section 512(b)(7), there are exceptions to the UBTI rules. Generally, all dividends, royalties, and interest income are exempt. Most rental income from real property is also exempt. And there is an important exemption for the sale, exchange, or other disposition of property other than (1) stock in trade or other property of a kind that would ordinarily be included in inventory, and (2) property held primarily for sale to customers in the ordinary course of a trade or business.¹⁵ However, these exceptions are subject to override (that is, they do not apply) if and to the extent that the debt-financed rules of section 514 apply. Under section 512(c), an unrelated trade or business carried on by a partnership (or limited liability company) for a partner or member results in UBTI to the partner or member to the extent of its proportionate interest in the partnership or LLC.

Section 514 generally provides that for income that would ordinarily be exempt from the UBTI rules, UBTI exists to the extent the net taxable income is debt-financed. Basically, the percentage produced by dividing the average debt financing for the year for the project by the adjusted basis of a project is multiplied by the taxable income from the project (or, for a partner or LLC member, the partner’s or member’s share of the taxable income) to produce the UBTI. Ordinarily, a project’s adjusted basis is its original cost, plus any improvements, minus depreciation. If the asset producing the UBTI is sold, a percentage of the profit is treated as UBTI, based on the highest debt-to-adjusted-basis ratio in the 12-month period preceding the sale.

Section 514(c)(9) provides a real estate exception to the debt-financed income rules. Under it, if numerous conditions are satisfied, there is no UBTI. However, only a qualified organization can take advantage of this exception. Included in the definition of a qualified organization is a tax-exempt trust (of a tax-qualified plan). An IRA does not fit this definition.¹⁶

IV. Statutes of Limitations and Reporting

If a taxpayer discovers a plan defect, there’s a good chance it occurred in one or more prior years. Those years might be long ago. How the statute of limitations fits into any analysis could be important. Generally, a plan can be disqualified only for an open year. Under section 6501, a three-year statute of limitations ordinarily applies. A six-year statute applies if the taxpayer omits from gross income an includable amount if the amount exceeds 25 percent of the gross income stated in the return. Under section 6501(c), there is no statute of limitations for false or fraudulent returns with the intent to evade tax. There also is no statute of limitations for a willful attempt to evade tax, or a failure to file. Section 6503(g) potentially extends the statute of limitations under section 4975 in limited circumstances.

In calculating the EPCRS potential correction amounts, the IRS likely ordinarily uses a three-year statute if all required returns have been timely filed. Except for income tax attributable to UBTI, the filing of Form 5500, “Annual Return/Report of Employee Benefit Plan,” or its equivalent (for example, Form 5500-EZ, “Annual Return of a One-Participant (Owners/Partners and Their Spouses) Retirement Plan or a Foreign Plan”) starts the statute running. For UBTI, Form 990-T, “Exempt Organization Business Income Tax Return (and proxy tax under section 6033(e)),” on which UBTI is reported, starts the statute running. Importantly, Announcement 2007-63, 2007-30 IRB 65, provides that the filing of Form 5500 will set the time for which the statute of limitations begins to run for the plan’s trust. And concerning whether a three-year or six-year statute may apply, Announcement 2007-63 provides for a six-year statute for an abusive tax avoidance transaction, thus solidifying the position that three years is the general rule.

Form 5500 generally must be filed annually for a qualified plan. However, instead, Form 5500-SF, “Short Form Annual Return/Report of Small Employee Benefit Plan,” may generally be filed if the participant total at the beginning of the plan year is less than 100. Both forms 5500 and 5500-SF are filed electronically. Also, instead of those forms, Form 5500-EZ must ordinarily be filed annually by a qualified plan maintained by a single person once plan assets exceed $250,000 at year-end. (If assets are below that threshold, a return apparently need not be filed.) Form 5500-EZ has a space to check for the final year of plan existence. Form 5310, “Application for Determination Upon Termination,” can be filed to ask the IRS if the plan remains qualified through its termination. There is no requirement that a Form 5310 be filed.

Section 7805(b)(8) provides that the Treasury secretary may prescribe the extent, if any, to which any ruling (including any judicial decision or any administrative determination other than by regulation) concerning the internal revenue laws should be applied without retroactive effect. For years, the IRS has taken the position that it won’t retroactively disqualify a plan that has received a favorable determination letter from the IRS for a period before the letter’s effective date. However, the IRS has in the past informally said it would require operational compliance with tax qualification rules. How this works under Announcement 2007-63 is unclear.

Even though the statute of limitations has run, the mitigation provisions of the code potentially allow the IRS to adjust filed return figures under some circumstances. The rules are complex. They apply if a determination (as defined in section 1313) is described in one or more paragraphs of section 1312 and, on the date of the determination, correction of the effect of the error referred to is prevented by the operation of any law or rule of law except the mitigation provisions and section 7122 (ordinarily not applicable). In that case, the effect of the error can be corrected by an adjustment made in the amount and manner specified in section 1314.

Section 1312(3) applies to a double exclusion of an item of gross income. It provides:

(A) Items included in income. The determination requires the exclusion from gross income of an item included in a return filed by the taxpayer or with respect to which tax was paid and which was erroneously excluded or omitted from the gross income of the taxpayer for another taxable year, or from the gross income of a related taxpayer.

(B) Items not included in income. The determination requires the exclusion from gross income of an item not included in a return filed by the taxpayer and with respect to which the tax was not paid but which is includible in the gross income of the taxpayer for another taxable year or the gross income of a related taxpayer.

For an IRA, part (A) might apply if a return was filed for a year after a PT existed and income reported thereon. A determination includes a Tax Court ruling and a closing agreement on the matter. The adjustment required under section 1314 basically requires the tax to be computed for the year the error existed.

Section 1311(b)(2)(A) provides the following regarding a determination made under section 1312(3)(B):

In the case of a determination described in section 1312(3)(B) (relating to certain exclusions from income), adjustment is to be made under section 1311 et seq. only if assessment of a deficiency for the taxable year in which the item is includible or against the related taxpayer was not barred, by any law or rule of law, at the time the Secretary first maintained, in a notice of deficiency pursuant to section 6212 or before the Tax Court, that the item described in section 1312(3)(B) should be included in the gross income of the taxpayer for the taxable year to which the determination relates.

Based on this material, it appears that the statute of limitations would bar an action concerning a failure to report income in a year for which the statute of limitations has expired. The regulations seem to confirm this conclusion.¹⁷ There are few authorities in this very complex area.

If a taxpayer discovers a plan defect, there’s a good chance it occurred in one or more prior years. And the ordinary statute of limitations may have run for those years. What should one do? Generally speaking, each tax year stands on its own, and there is no duty to file an amended return for any past year.¹⁸ The IRS encourages the filing of amended returns to correct errors. A couple of regulations provide that a taxpayer should file an amended return if the statute of limitations remains open.¹⁹

V. Reporting Requirements

Section 6047 generally requires reporting for IRA distributions exceeding $10, under regulations or forms issued by the Treasury secretary. Regulations apparently do not exist. Section 3405(e) relates to qualified plan distributions. Sections 6047 and 3405(e) may not work well together. The IRS has issued Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” with instructions making the form applicable to qualified plans and IRAs. Under reg. section 1.408-6, trustees and issuers of IRAs are required to disclose specific information to participants. Included in the information required to be disclosed is the following:

If the benefited individual or his beneficiary engages in a PT . . . the account will lose its exemption from tax by reason of section 408(e)(2)(A), and the benefited individual must include in gross income, for the taxable year during which the benefited individual or his beneficiary engages in the PT, the fair market value of the account.

This language clearly is designed to place the IRA owner on notice of the duty to report income because of a PT. Reliance is not tied to an IRS reporting form (for example, Form 1099-R). Under reg. section 1.408-7, the trustee of an IRA is required to report distributions to beneficiaries. It makes no mention of a duty of an IRA owner to report a PT to the IRA trustee or custodian. It appears that there is such a duty only if the contract between the IRA owner and the trustee or custodian calls for it. And unfortunately, an owner of a self-directed IRA may experience a PT and never know it, or not know of it until many years later.

VI. Basis of Amounts Distributed

For a qualified plan or a traditional IRA, a distribution generally produces ordinary income to the extent the value distributed exceeds the after-tax contributions.²⁰ In this regard, an asset could have been sold tax-free in the plan or IRA, its cash proceeds distributed in a taxable transaction, and the distributed proceeds used to repurchase the asset. For a qualified plan or any IRA, the adjusted basis of an asset other than cash received through distribution ordinarily is its FMV.²¹ (Under section 402(e)(4), there is an exception for specified company stock distributions from qualified plans, for which the basis from the trust carries over.)

As noted, when a qualified plan is disqualified, its assets are deemed owned by an ordinary, potentially taxable trust. Under section 643(e), if a trust distributes assets, gain or loss ordinarily is not recognized absent an election under section 643(e)(3). What, then, is the basis of an asset held in a trust of a qualified plan when the plan ceases to be qualified and its assets are thus deemed to become held by an ordinary (potentially taxable) trust? It is highly likely that the asset’s adjusted basis would simply carry over.

VII. Withholding and FICA Tax, Etc.

Under the ordinary income tax rules applicable to nonqualified plans, the employer and the employee receive an equal deduction and income amount. And the timing generally matches up. The FICA tax issues described below would need to be considered. FUTA tax also potentially applies to compensation amounts related to a nonqualified plan.

Except for elective deferrals to a 401(k) plan, contributions to, and distributions from, qualified plans are not subject to FICA or self-employment (SECA) tax. The Medicare tax also does not apply. In contrast, nonqualified plan benefits are subject to the FICA/SECA and Medicare taxes. The FICA tax rate is 6.2 percent, and it applies equally to employer and employee. The SECA tax applies to self-employed persons, and the rate is 12.4 percent. Once compensation exceeds the Social Security wage base — $147,000 for 2022 — the income is Social Security tax-free. The Medicare tax is 1.45 percent for employees and 2.9 percent for self-employed persons. There is no cap.

When taxation occurs for FICA and SECA tax purposes (and Medicare tax purposes) is different from the ordinary income tax timing rules applicable to nonqualified plans. Under section 3121(v), benefits of a nonqualified plan are taxable as of the later of when services are performed or when there is no longer a substantial risk of forfeiture regarding the benefit. Regulations issued under section 3121(v) distinguish account balance plans from non-account-balance plans. A pension plan is a non-account-balance plan. Under the rules for such plans, the present value of the vested additional accrued benefit that the participant becomes entitled to during the year is taxable. Specific rules exist for computation under the regulations. It appears likely that the section 3121(v)(2) regulations can be used to compute the income and deduction amounts for both income tax and FICA, SECA, and Medicare tax purposes. Under section 3402(a)(1), withholding would be necessary for taxable FICA earnings.

Section 409A also needs to be considered. Under that section, benefits under a nonqualified deferred compensation plan that provides for a deferral of compensation are subject to income taxation and a 20 percent additional tax plus interest unless the plan meets numerous requirements, including that the timing of benefit payments be fixed when the benefits are earned. If section 409A applies, these payment obligations occur when the benefits are not subject to a substantial risk of forfeiture. The definition of a substantial risk of forfeiture is different from the definition under sections 83 and 3121(v)(2). However, based on reg. section 1.409A-1(b)(6), if the pension plan in issue is fully funded, section 409A probably does not apply.

VIII. Practical Considerations

The system is set up so that contributions to qualified plans are generally deductible, the contributions grow tax-free, and benefits are taxable upon distribution unless rolled over to another qualified plan or an IRA. Contributions to traditional IRAs are also generally deductible; IRA benefits generally grow tax-free; and distributions from IRAs produce ordinary income unless rolled over. But what if the system breaks down because a qualified plan ceases to be qualified, or an IRA is deemed distributed because of a PT? The system — including custodians, trustees, and banks (particularly smaller entities) — generally are not equipped to deal with those possibilities.

Qualified plans ordinarily are not disqualified because (1) there is a program to correct defects, and (2) disqualification tax costs can be substantial. The costs of fixing a problem are usually less, and often much less, than the costs of dealing with a disqualified plan. I have handled many qualified plan correction matters and done many filings with the IRS to correct defects. Ordinarily, the IRS is accommodating and works with taxpayers to fix problems.

Last year, for a very complex matter, the IRS was unwilling to reach a compromise regarding an anonymous voluntary correction program filing I made on behalf of a client. And IRS employees were unwilling to negotiate. This was the first time I had such an experience. There was no bad faith, etc., involved. The proposed correction involved detailed analysis of the discrimination regulations under section 410(b). The IRS reviewer told me he did not understand the rules and said his supervisor also did not understand the rules. After many attempts to simplify the matter in response to requests by the IRS for simplification, the reviewer said the IRS would not agree to a correction but would be willing to refund the user fee that had been paid. Ultimately, that was what was done. The taxpayer was left with a disqualified plan. The matter also involved a SIMPLE 401(k) plan, which was supposed to be the only plan of the employer. So both plans could be disqualified.²²

Self-directed IRAs and PTs also produce results that can be unorthodox. If a taxpayer experiences a PT but doesn’t know it until many years later, the result for tax purposes is that the IRA ceased to be an IRA on the first day of the year the PT occurred. If the taxpayer transferred the benefits through rollover after the year of the PT to another IRA custodian, believing the rollover was tax-free (even though it wasn’t), the new custodian will generally want to issue a Form 1099-R once it is informed of the recently discovered PT. But the account never was an IRA upon the transfer that was believed to be a tax-free rollover. Rather, the transfer was of assets deemed owned by the IRA owner. So the transfer was substantively made from one after-tax account to another after-tax account. The IRA custodian may want indemnification for doing something outside what it ordinarily does, or it may simply tell the taxpayer, “tough,” and issue a Form 1099-R for some year. The tax system does not allow a custodian to simply pick a year and report income for that year just because its system is not set up for anomalies. But trustees and custodians will want to err on the side of the IRS, thinking (probably rightfully) that the IRS won’t come after them if they do so.

IX. Proposed Legislation

This year a bill titled the Securing a Strong Retirement Act of 2022 (H.R. 2954) was proposed. It passed the House of Representatives by a 414-5 vote. Some call it the Secure Act II or Secure II. Because the bill passed the House by such a huge margin, there is a good chance it, or something close to it, will eventually pass in the Senate. The act includes some important provisions concerning qualified plans and IRAs.

Section 308 of the act would generally end the time limit on self-correcting minor errors under the EPCRS absent a finding of the errors on audit. The loan correction procedures of Rev. Proc. 2021-30 would be codified and deemed to cover Labor Department issues as well. The EPCRS would be expanded to generally pick up IRA defects. Those expanded corrections would apply only to “eligible inadvertent failures,” which are generally defined as mistakes made in good faith when the plan administrator or IRA custodian has practices and procedures in place reasonably designed to promote and facilitate overall compliance in form and operation with code requirements.

Section 322 of the act would limit the amount of a self-directed IRA deemed distributed because of a PT to the amount involved, instead of requiring income recognition for the entire account balance. However, under current law, the result of this proposed provision can be accomplished by segregating the assets to be involved in a potential PT in a separate IRA. There is no limit on the number of IRAs an individual can maintain, and an unlimited number of tax-free transfers (not 60-day rollovers) can be done.

The Senate came up with its own Secure Act II bill in June. It is titled the Enhancing American Retirement Now (EARN) Act. It is different, but not radically different, from the House bill. The EARN Act, which appears to be in summary form (that is, not a formal bill) as of the writing of this report, unanimously passed the Senate Finance Committee in June.

X. Needed Legislation

The IRS is not required to deal with a plan sponsor or administrator regarding the correction of a plan defect. As noted, I’ve experienced a situation in which the IRS refused to do so, presumably largely because of the reviewer’s lack of knowledge regarding the (admittedly complex) discrimination rules. But complexity, which often leads to the problem in the first place, should not prevent a plan from being eligible for correction, assuming there was no bad faith by the plan sponsor or administrator. The law needs to be changed to grant people acting in good faith the right to correct defects at a reasonable cost.

For IRAs, a PT might have existed a decade or more before discovery. Once the PT occurred, the account became a taxable account. The earnings should have been reported on the personal returns of the IRA owner beginning with the year of the PT. The fact that they weren’t (because the owner thought the IRA was still an IRA) doesn’t mean the IRS can go back beyond the open statute of limitations to attack the original PT and require income recognition for any year. It is limited to what the law allows. Perhaps the statute of limitations needs to be extended to deal with such cases. As of now, that situation is messy because the custodian will likely want to issue a Form 1099-R for some year, even though it lacks legal authority to do so. Aside from extending the statute of limitations, the law could require reporting of PT income in the year of discovery.