It's a well-known fact: If you want to receive tax benefits from the IRS, you must comply with a host of requirements. This is especially true when dealing with qualified retirement plans. To be considered tax-qualified and enjoy the tax benefits that go with that, retirement plans must adhere to a laundry list of regulations.
Therein lies the problem. Many retirement plans, especially those offered by small and midsized businesses, don't meet all the plan requirements. The IRS found, for example, that about half the qualified plans examined in 1997 were not in compliance, says Pat Navin, a principal in charge of the employee benefit specialty tax group for Deloitte & Touche.
If you know your plan has defects or you suspect it may have problems, beware. You are not only running the risk of being hit with a huge tax bill, but the IRS could disqualify the plan altogether. When the IRS disqualifies a plan, it no longer enjoys tax-favored status. For business owners, that means you lose the deduction you received for contributions made on behalf of your employees. Also, the tax-deferred earnings in the plan become taxable.
Take the case of a podiatrist in Long Island, New York, who was glad he could finally set up a profit-sharing retirement plan for himself and his employees. However, his satisfaction quickly turned to disgust when the IRS decided to audit the plan.
The plan's administrator was a large and reputable brokerage firm, but it didn't alert the podiatrist of changes, resulting in the plan not being amended to reflect changes in the law regarding eligibility and vesting rules. As a result, the IRS expected the podiatrist to pay taxes owed on the plan's earnings, says Seymour Goldberg, a CPA and senior partner in the law firm Goldberg & Goldberg PC in Garden City, New York, and author of Goldberg Reports, an online pension distribution plan information service. After lengthy negotiations with the IRS, in which Goldberg represented the individual, the podiatrist paid $12,000 instead of the $21,000 originally assessed.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.