Crime and Punishment-- The Theory, Evolution and Future of Alternatives to Plan Disqualification

by Marcia Beth Stairman Wagner, Esq.

Boston, Mass.

Footnotes in [ ] appear at the end of the article


As an incentive for employers to implement private retirement programs for their employees, Congress has provided munificent tax benefits with respect to qualified retirement plans, i.e., employers receive current deductions for plan contributions, participants defer taxation until their actual receipt of plan contributions (and any earnings thereon), and earnings on trust assets accumulate and compound on a tax-deferred basis.[1] However, Congress has not provided these benefits without cost; on the contrary, to enjoy this favorable tax treatment, a plan's terms and operation must comply with a long (and seemingly ever-expanding) array of qualification requirements, which are set forth in §401(a), et seq. [2] These qualification requirements effectively impose a code of ethics mirroring certain of Congress' social policy concerns. For example, the qualification requirements prohibit significant discrimination in contributions or other benefits provided to or on behalf of highly compensated employees,[3] specify participation rules containing the maximum age and years of service that may be required for plan eligibility[4], provide vesting rules containing the maximum years of service that may be required before a participant's benefits become non-forfeitable[5], and require that a certain percentage of non-highly compensated employees benefit under the plan[6], among many other requirements. Compliance with all of these requirements is necessary to preserve a plan's tax-qualified status. Thus, even relatively minor, hypertechnical and innocent violations of any of the myriad qualification requirements would, under a literal reading of the Code, result in disqualification of the affected plan.

Plan disqualification has severe consequences for the sponsoring employer, participating employees and the plan's trust. Indeed, plan disqualification is nothing less than the tax analogue of dropping a nuclear bomb. This article summarizes the effects of disqualification and describes and critiques the IRS' recently implemented programs to avert disqualification. The article concludes with the thought that maintenance of a set of tax laws and regulations as complex as those found in §401(a), et seq., necessitates a strong, working partnership among the IRS, employers and the ERISA practitioner community. Hopefully, the roots for such a partnership may be found in the Service's attempt to educate its field auditors and the public through its issuance of examination guidelines and the Service's implementation of alternatives to plan disqualification.


For an ERISA plan to be tax-qualified, it must comply in form and operation with the requirements contained in §401(a) et seq. The form of the plan document must contain certain language required by the Code provisions and the operation of the plan must comport with such required language. A plan with either a "form defect"[7] or an "operational defect,"[8] no matter how minor, technically subjects the plan to disqualification.

The IRS takes the position that disqualifying defects "carry over" from year to year, rendering a plan disqualified until the defect is completely corrected, both retroactively and prospectively. Hence, only correction can return a plan's qualified status, and correction must start with the year in which the operational defect first occurred, whether in an open or closed statutory year for audit purposes.[9] In Martin Fireproofing, the Tax Court upheld the Service's position, stating " . . . we read section 415 [compliance with which is a condition of qualification] to require disqualification until the section 415 violation is corrected, e.g., by reallocating the excess allocation or by placing it in a suspense account" (92 T.C. II 73, 1185-86) (emphasis added).

As demonstrated from the cases cited in this article, the Service has the power to seek and obtain disqualification of plans for their operational and form defects. Hence, the Service's position, which has been largely upheld by the judiciary, requires that a plan strictly comply with the qualification requirements or risk disqualification, regardless of the inadvertence, innocence or immateriality of the defect.


Tax Effects of Disqualification

A non-exempt trust is subject to income tax on its earnings for the open years in which the plan is disqualified. Such a trust would be taxed under the general rules for taxing trusts, specifically those concerning "complex" trusts.[10]

The employer-sponsor of a disqualified plan may take a contribution deduction only if a separate account is maintained for each participant in the disqualified plan,[11] a requirement that is automatically satisfied by defined contribution plans and almost never satisfied by defined benefit plans. Moreover, the employer may deduct its contributions to a disqualified plan only to the extent participants are vested in such contributions.[12] Therefore, if an employer contributes to a disqualified plan, and the participant on whose behalf the contribution is made is not fully vested, the employer cannot deduct the contribution to the extent that the participant is not vested. The rationale is that the participant will not include these amounts in his or her gross income until such amounts become vested, and only then would the employer be entitled to take the corresponding deduction.

A participant in a disqualified defined contribution plan must include in taxable income employer contributions made on his or her behalf for all open years in which the plan is disqualified, to the extent that the participant is vested therein (or his or her interest changes from nonvested to vested).[13] Similarly, a participant in a disqualified defined benefit plan must include in taxable income the increase in the present value of his or her accrued benefit to the extent vested.[14] Recognizing the illogic of penalizing non-highly compensated employees in situations where a plan is disqualified because it disproportionately covers highly compensated employees, in the Tax Reform Act of 1986 Congress amended §402(b) to provide that, if a plan is disqualified solely because it fails to satisfy the requirements of §410(b) (minimum coverage rules) or §401(a)(26) (minimum participation rules), this will not cause non-highly compensated employees to recognize as gross income employer contributions made on their behalf.[15] However, highly compensated employees must recognize as gross income the entire value of their vested account balances or vested accrued benefits,[16] not merely the vested portion of employer contributions made on their behalf for the year in issue. The Service applies the same rule with respect to discriminatory contributions made or benefits provided within the meaning of §401(a)(4).[17] Amounts included in a participant's gross income increase his or her basis in the pension benefit.[18]

Authorities are split as to whether distributions from the trust of a disqualified plan are eligible for favorable tax treatment (i.e., capital gains and forward averaging) or rollover treatment. According to the Fifth, Sixth and Seventh Circuits and, recently, in a reversal of position, the Tax Court, the statutory language requires that the status of the plan at the time of the distribution is controlling. In other words, the full amount of distributions from a plan that has been disqualified is ineligible for favorable tax treatment.[19] Not surprisingly, the Service agrees with this viewpoint.[20]

However, the Second Circuit and some district courts have held that distributions from non-exempt trusts are pro rated into amounts attributable to contributions (and income thereon) made when the plan was qualified and amounts attributable to contributions (and income thereon) made when the plan was not qualified. Amounts attributable to contributions made when the plan was qualified would be eligible for favorable tax treatment regardless of whether the trust is exempt at the time of distribution.[21]

Employers and employees would be obligated to pay Federal Insurance Contributions Act (FICA) and employers would be obligated to pay Federal Unemployment Tax Act (FUTA) taxes on all contributions made to disqualified plans.[22] Further, employers would have to withhold for income tax purposes an applicable portion of contributions to disqualified plans.[23]

Finally, although unclear, participants may well have a private right of action under ERISA §502 against plan fiduciaries who permitted or were responsible for the plan's disqualification.[24] Spokespersons for the Department of Labor have privately and unofficially agreed with this position and have expanded upon it by positing that it could well be a breach of fiduciary duty to allow a plan to become disqualified.

Statute of Limitations

The Service may retroactively disqualify a plan and assess taxes with respect to any open taxable year (i.e., a taxable year for which the statute of limitations has not run). The Service is generally allowed three years after the filing of the income tax return for the applicable year in which to assess taxes on an employer that sponsored, or an employee who participated in, a disqualified plan.[25] The statutory period during which the Service may assess taxes (other than taxes for unrelated business income)[26] against a previously exempt trust which becomes non-exempt as a result of the plan's disqualification expires three years after the employer or administrator files with the Service its Form 5500 series return with a Schedule P, Annual Return of Fiduciary of Employee Benefit Plan.[27] If the Schedule P is not filed, the statute of limitations does not start to run with respect to the non-exempt trust.

It is important to understand that the Service's 44 carry over position, discussed above, effectively obviates these statutes of limitations, in that disqualifying defects, no matter how "old and cold," render a plan disqualified, with all attendant adverse tax consequences being applicable to the open statutory years.


As discussed above, the results of plan disqualification are draconian and, more often than not harming rank and file employees, the very persons that ERISA was designed to protect and are not in the best interest of employees, employers or the U.S. government. Although the Service clearly has the power to do so, it is both illogical and counterproductive to deny employer deductions, tax the trust and deprive participants of the benefits of qualified plan participation due to technical violations of the qualification rules.

In practice, the unreasonably harsh sanction of disqualification had, before the Service's adoption of the programs discussed below, led to inconsistent and often arbitrary enforcement of the law, based on the individual field auditor's assessment of employer culpability, severity of the disqualifying defect, effect of disqualification on rank and file employees, and the like. Inconsistent enforcement of the law, based on such subjective factors, inevitably gives rise to inequities.(since similarly situated individuals are treated differently) and just as inevitably undermines the effectiveness of any system of sanctions or voluntary compliance.

By implementing and formalizing alternatives to disqualification, the Service implicitly acknowledged that overall tax compliance and, by extension, the continued viability of the voluntary pension system, could be better assured through the flexible treatment of "troubled" plans pursuant to written, uniform, and publicly available and discussed programs. Underlying these programs is the premise that there should be a sliding scale of penalties or sanctions tailored to fit the severity of the disqualifying defect at issue. At the far end of the spectrum, only the most egregious and abusive qualification violations should result in plan disqualification, while, at the other end, inadvertent, isolated and minor defects should merely be "fixed," with no attendant adverse tax consequences or sanctions. The vast majority of the situations fall in between these polar extremes. It is principally for such situations that the Service has, through its recently established alternatives to disqualification, attempted to create a continuum of proportionate sanctions, penalties and fees based on the severity of the defect. With the advent of these alternatives to disqualification, the Service has taken laudable steps -with many more steps necessary for the goal to be achieved - toward a reasonable and equitable system where the punishment fits the crime.

Internal Revenue Code Remedies

Section 401(b)

The Code provides only two remedies short of plan disqualification: relief under a §401(b) remedial amendment period, and relief under §7805(b) based on the taxpayer's detrimental reliance on the Service's prior determinations.

Section 401(b) generally provides that a plan with a form defect may, in certain instances, be cured by the adoption of a retroactive remedial amendment. A form defect is referred to as a "disqualifying provision" under the §401(b) regulations, and includes, generally, a plan provision (or the absence of a plan provision) that causes a plan to fail to satisfy the Code's qualification requirements because of certain changes made by the Tax Reform Act of 1986, and certain subsequent tax law changes (collectively referred to in this article as "TRA '86").[28] A disqualifying provision also includes any plan provision (or the absence of any plan provision) that results in the failure of the plan to satisfy the Code's qualification requirements by reason of a change in those requirements made by amendments to the Code that are designated by the Commissioner as disqualifying provisions.[29]

The period in which retroactive corrections are allowed is known as the "remedial amendment period."[30] During the remedial amendment period, the plan will be deemed to have satisfied the qualification requirements if, by the end of the period, the plan has been amended to conform with those requirements and the amended conforming provisions have been treated as retroactively effective throughout the whole remedial amendment period. In other words, in order for a plan to maintain its qualified status, it must be operated in accordance with the applicable legal requirements from the beginning of the remedial amendment period.

Section 7805(b)

Under traditional legal theory, interpretations of the law by administrative agencies apply retroactively. Agencies are said not to make the law, but rather to find the law and declare its meaning. This is so even when an agency interpretation overrides a prior interpretation. Thus, there is a presumption that the Service's interpretations of the Code are retroactive.

Section 7805(b), however, provides the Service with discretionary authority to prescribe the extent, if any, to which any ruling or regulation shall be applied without retroactive effect.[31]

In deciding whether to apply §7805(b) in a particular situation, the Service must balance competing considerations. On the one band, the law must be administered uniformly and consistently. If statements of the IRS' position are to provide uniformity and consistency to all taxpayers, they must be retroactive. On the other hand, to the extent that a valid basis for reliance has been created by the Service, fundamental considerations of fairness may require that a change in position be prospective only. Thus, the key is reliance. To the extent that considerations bearing on reliance outweigh the goals of uniformity and consistency, §7805(b) relief may be appropriate.

If a taxpayer has requested and received a favorable determination letter with respect to its plan or received a private letter ruling with respect to an issue relating to its plan, the taxpayer has a strong case that it has relied in good faith on the Service's interpretations of the law and, thus, retroactive application of a new interpretation by the Service would be not only detrimental to the taxpayer but unjust as well. The Service apparently agrees with this position and, despite its broad powers under §7805(b), the Service has voluntarily limited its authority to retroactively revoke determination letters and private letter rulings. Hence, except in rare or unusual circumstances, the revocation or modification of a letter ruling or determination letter will not be applied retroactively to the taxpayer for whom the letter ruling or determination letter is issued provided that: (i) there has been no misstatement or omission of material facts; (ii) the facts at the time of the transaction are not materially different from the facts on which the letter ruling or determination letter was based; (iii) there has been no change in the applicable law; (iv) the letter ruling or determination letter was originally issued for a proposed transaction; and (v) the taxpayer directly involved in the letter ruling or determination letter acted in good faith in relying on the letter ruling or determination letter, and revoking the letter ruling or determination letter retroactively would be to the taxpayer's detriment.[32]

Hence, if the taxpayer has provided all pertinent facts in its request for a determination letter, it can reasonably assume that such letter is not subject to retroactive revocation. Although neither the Code nor ERISA require that a plan receive a favorable determination letter to be tax-qualified, a significant advantage in obtaining such a letter is the §7805(b) relief or protection that comes with the letter, since neither a form defect overlooked by the Service, no any operational defect resulting from such form defect, will result in the retroactive disqualification for the plan.

Administrative Policy Regarding Sanctions

On March 26, 1991, the Service announced the Administrative Policy Regarding Sanction (APRS).[33] Under APRS, each Key District Office has the discretionary authority not to disqualify a plan for minor operational violations if certain criteria are met. With its establishment of APRS, the IRS acknowledged that letter-perfect adherence to all requirements of §401(a) is extremely difficult and that certain operational defects are so insignificant that, if fully corrected retroactively and prospectively, they should not result in plan disqualification, tax liability or sanctions.

Before the APRS Program was adopted, certain Key District Offices were not, in fact, imposing disqualification sanctions for minor operational violations. However, since no formal guidelines existed, there was no uniformity of treatment among Key District Offices or even within the same Key District Office; it was largely to address this lack of uniformity that the formal guidelines of APRS were published. APRS provided Key District Offices for the first time with formal direction about how minor operational violations could be treated without disqualifying the plan.

APRS imposes no penalties, excise taxes or sanction amounts for violations of the qualification rules. Rather, it requires that the plan and the affected participants be "made whole" for open and closed years so that they are in the same (or substantially the same) position they would have been in had the operational violation never occurred.

Under APRS, an IRS Key District Office may, in its sole discretion, treat an operational violation as nondisqualifying if all of the following criteria are satisfied:

(i) the operational violation must be an isolated, insignificant instance; as a rule of thumb, a plan may have no more than one defect in one plan year to be eligible for the APRS Program;

(ii) the plan must have either (a) a history of compliance with §401(a), both in form and operation (other than the nondisqualifying defect), or (b) if the plan does not have a history of compliance (such as a newly adopted plan), the violation must have been corrected before examination and there must be no evidence of noncompliance in other areas;

(iii) the plan sponsor or plan administrator must have established practices and procedures (formal or informal) to ensure compliance with §40 (a), including procedures involving the area in which the violation occurred;

(iv) established procedures must have been followed, but through an oversight or mistake in applying those procedures, an operational violation occurred;

(v) when dollar amounts are involved (as in excess contributions or excess allocations), the amounts must be insubstantial in view of the total facts of the case; and

(vi) the taxpayer must have made an immediate and complete correction to cure the violation once it was discovered so that no participant or beneficiary suffered substantial detriment.

Further, to be eligible for APRS, a plan must have been timely amended for TEFRA, DEFRA and REA and must not have an exclusive benefit rule violation.

While APRS represents a step toward more realistic and equitable enforcement of the qualification requirements, the program is, in fact, available to very few plans with disqualifying defects because the criteria for relief are so narrow. Virtually all large plans and most small plans are effectively excluded from eligibility. For example, the requirement that the defect be an isolated event is impractical for large plans (and many smaller plans, as well) in that most large plans inevitably have clerical errors (e.g., transposition of numbers or other errors regarding dates of hire, termination or age) which repeat themselves not only within a single year, but subsequent years as well. Most practitioners would like to see an expansion of the APRS Program so that, for example, plans with more than one minor defect, such as a mere clerical error may be corrected without sanctions. In fact, certain IRS officials have stated informally that the IRS has begun to reevaluate the circumstances under which it will allow defective plans to participate in the APRS Program.

Voluntary Compliance Resolution Program


The Voluntary Compliance Resolution (VCR) Program was initially established on November 16, 1992, as a temporary and experimental program, conducted by the IRS National Office to enable the Service to quickly compile data to judge VCR's successes and shortcomings and determine appropriate modifications to the Program. The Program was initially only available until December 31, 1993, but was later extended until December 31, 1994.[34] The VCR Program was extended indefinitely on September 8, 1994,[35] due to its apparent success and popularity. Under the VCR Program, the plan sponsor pays only a fixed "user fee" based on the amount of plan assets and the number of plan participants, ranging in amount from $500 to $10,000. There are no other monetary sanctions or penalties - unlike the significant sanctions that may be imposed under the CAP Program (discussed below). This feature of VCR is intended to encourage plan sponsors to voluntarily approach the Service to correct disqualifying operational defects. The VCR Program generally permits employers to voluntarily correct operational defects in their plans and obtain from the Service a compliance statement which provides that the Service will not disqualify the plan with respect to the operational violations identified in the compliance statements

Eligibility for VCR Program

The VCR Program is available only for operational defects relating to qualification issues; it is not available for operational defects that give rise to income or excise tax issues. Therefore, for example, neither funding violations nor prohibited transactions can be addressed through the VCR Program; an exclusion made by the Service because the Code already provides specifically tailored sanctions (short of plan disqualification) for such defects.[36] However, if the disqualifying defect is the failure to satisfy the §401(a)(9) minimum distribution requirements, the Service may enter into a closing agreement, as part of the VCR Program, with respect to the §4974 excise tax.[37]

The VCR Program is also unavailable for exclusive benefit rule violations, plans (including recently adopted plans) without determination letters (or opinion or notification letters in the case of master and prototype plans and regional prototype plans, respectively) that take into account TEFRA, DEFRA and REA, plans under audit, plans for which required trusts were not maintained and terminated plans that no longer have trusts or plan assets.[38] A defect arising from the failure to satisfy a TRA '86 qualification requirement is not eligible for the VCR Program because the §401(b) remedial amendment period is still in effect; thus, the disqualifying defects may be retroactively corrected without the VCR Program. However, if a plan has been properly amended for these qualification requirements, and the operational defect arises after the amendments have become effective, the defect would be eligible for the VCR Program.

If a defect cannot be handled under the VCR Program because it is "egregious" in nature, the Service will provide the plan sponsor with a 60-day period in which to voluntarily approach the appropriate Key District Office under the CAP Program. As discussed below, voluntarily approaching the Service under CAP significantly reduces the sanctions which may be imposed thereunder. If the plan sponsor does not voluntarily enter into the CAP Program, the VCR application will be forwarded to the Key District Office for examination.[39] However, Service spokespersons have repeatedly and adamantly stated that this is the only instance in which a VCR application may give rise to an audit;[40] inasmuch as the Service wishes to encourage voluntary compliance and "self-policing" in the qualified plan area, to do otherwise would be shortsighted and self-defeating. Trust among the Service, employers, and the practitioner community is fundamental to any system of voluntary compliance and correction; in fact, the VCR Program got off to a , "slow start" because of mistrust of its "voluntary" nature; however, this problem appears to be fading.[41] The practitioner community can only hope the Service is sincere (as it so far seems to be) that the National Office has established a "fire wall" with the Key District Offices concerning VCR applications.

Entering the VCR Program

A plan sponsor must submit its request for a compliance statement to the IRS National Office. Unlike the CAP Program, there is no, and never was there an, officially sanctioned "John Doe" (i.e., "no name") process under the VCR Program, although the Service has stated that it will entertain "brief and focused" questions through its taxpayer assistance program or by staff members who handle VCR requests. The procedures to be followed by plan sponsors in requesting a compliance statement are similar to those for requesting a private letter ruling.[42]

Full and Complete Correction

The Service requires that the disqualifying defect be fully corrected for all years, whether or not "open" for audit. The VCR Program requires the sponsor to describe its proposed or accomplished method of correcting the operational defect, and to provide specific information needed to support the validity of the correction method. Correction must be retroactive to the year in which the defect occurred, even if such year is closed by the tolling of the statute of limitations. The IRS has issued guidance regarding acceptable correction methods,[43] but plan sponsors might well prefer alternative methods and the Service's list of acceptable correction methods does not (nor could it) cover every factual situation or disqualifying defect that may arise. Hence, the plan sponsor should propose what it believes to be a reasonable method of correction or present the corrective steps which it has already undertaken. In this area, the burden is initially on the plan sponsor to set the agenda for VCR negotiations.

One of the Service's primary goals in establishing the VCR Program is moving plans into operational compliance with the §401(a) requirements. Since the IRS has discovered, in implementing the Administrative Policy Regarding Sanctions, that a strong correlation exists between operational defects and inadequate administrative procedures, one of the requirements for sponsors participating in VCR is a complete description of the plan's usual and customary administrative procedures, as well as any additional procedures established so that it is unlikely that the operational defect will recur. If the Service determines that administrative procedures are inadequate, it may require that such procedures be modified before a compliance statement is issued or it may issue a compliance statement which is conditioned upon the implementation of revised administrative procedures within a certain stated period of time. Adequate administrative procedures may be formal or informal and the standards may be different for small plans and large plans. For example, while a series of checksheets might be adequate to insure compliance with the requirements of §§415 and 416, it might be appropriate for other requirements (and especially for large plans) to be handled by computer.

Standardized VCR Program

In an apparent effort to streamline approval procedures and correction methods with respect to typical operational violations, the Service established the Standardized VCR Procedure (SVP). A plan sponsor may avail itself of SVP only if the plan satisfies the eligibility requirements for the VCR Program, the defect is one listed in Rev. Proc. 94-62 and the plan sponsor utilizes correction methods specified in that revenue procedure. The defects and correction methods available under SVP are among the most prevalent the Service has encountered under the VCR Program, including, among others:

(i) failure to make minimum top-heavy contributions (correction would entail the provision of full make-up contributions on behalf of all affected non-key employees);

(ii) ADP/ACP failure (correction would entail the provision of sufficient qualified non-elective of matching contributions on behalf of non-highly compensated employees); and

(iii) the exclusion of an eligible employee from plan participation (correction would entail the provision of sufficient make-up contributions on behalf of the participant so that the participant is in the same position that he or she would have been in had he or she been a participant at the appropriate time).[45]

These issues are straightforward, and may be resolved in summary fashion under SVP if a plan sponsor is willing to implement the Service's correction methods. The SVP Program may be preferable in certain cases as it provides a less expensive and quicker process than the regular VCR Program and the correction method is set and predictable.


The VCR Program has generally been quite favorably accepted. Paying a reasonable user fee (plus, of course, the sometimes quite significant cost of correction) with no sanction in order to maintain a plan's qualified status, is a policy whose time has come. Further, the SVP Program is a positive step toward the expeditious resolution of disqualifying defect issues. Hopefully, the forms of defect and methods of correction under SVP will be expanded over time once the Service has more experience with the VCR and SVP programs.

Many feel that the VCR Program should have a "John Doe" aspect to it, in that plan sponsors are understandably reluctant to voluntarily disclose defects with the uncertainties that exist regarding the Service's acceptance of their proposed (or implemented) correction methods. A John Doe program would remove this reluctance, resulting in more plans approaching the Service to voluntarily correct disqualifying defects.

Closing Agreement Program

The Employee Plans Closing Agreements Pilot Program (CAP) was announced on December 21, 1990, in a memorandum from the Director, Employee Plans Technical and Actuarial Division, and the Director, Employee Plans/Exempt Organizations Operations Division, to the Assistant Regional Commissioners (Examination). By memorandum dated October 9, 1991, to and from the same parties, CAP was established as a permanent program. CAP provides for the use of §7121 closing agreements to resolve certain issues which would otherwise result in plan disqualification. Under CAP, the IRS may agree not to revoke a plan's qualified status because of either form violations or operational violations if the defects are completely corrected and a sanction amount is paid to the government. The CAP Program is the only program by which TEFRA, DEFRA and REA nonamenders may bring their plans into compliance.

Eligibility for CAP

The taxpayer has no right to participate in CAP; rather, the IRS may determine in its sole discretion to enter into a closing agreement under CAP.[46] The Key District Offices have the discretionary authority to enter into closing agreements under CAP concerning any qualification issues, except that the Key District Offices do not have the authority to enter into closing agreements in the following circumstances:

(I) violations of the exclusive benefit rule;

(ii) situations in which there has been significant discrimination in favor of highly compensated employees; or

(iii) "repeated, deliberate or flagrant" violations.

The Service considers these three types of violation to be egregious and, therefore, as a matter of policy, such violations are not considered to merit the option of a closing agreement under CAP.[47]

In addition, employee plan issues other than qualification issues are not eligible for CAP. Therefore, prohibited transaction issues, funding issues and unrelated business taxable income issues may not be negotiated under CAP. If, for example, a case contains both a qualification issue and a prohibited transaction issue, only the qualification portion of the case might be eligible for negotiation under CAP. However, although he or she would be under no obligation to do so, the employee plans agent might work with the plan sponsor to reach a settlement with respect to the issue that does not involve plan qualification, which would then be reviewed by the District Director. If the District Director agreed with the proposed settlement, he or she could exercise authority to enter into a closing agreement with the plan sponsor with respect to the issue not involving qualification.

Procedure for Entering into CAP Negotiations

As mentioned above, CAP negotiations occur at the discretion of the IRS and the taxpayer has no right to participate in CAP. CAP negotiations may be commenced in either of the following ways:

(i) upon the completion of an audit, the Service may advise the plan sponsor that it proposes to disqualify the plan and may propose participation in CAP; or

(ii) a plan sponsor may voluntarily approach the Key District Office, either openly or, in the past, on a "John Doe" basis, to request negotiation of a closing agreement.

Some Key District Offices still allow John Doe inquiries where the cloak of anonymity may be retained during the early stages of the negotiation process, but at later stages the Service will need to review plan records and other specific documentation.

If a plan sponsor voluntarily seeks to participate in CAP (the so-called "Walk-in CAP") to correct a disqualifying defect, as distinguished from being required to participate on the conclusion of an audit of a Form 5500 series return, the monetary sanction imposed under CAP (discussed in more detail below) will range from 5% to 40% of the maximum payment amount, whereas the maximum payment amount may be much higher (up to100%) in other CAP cases.[48]

Requirements for Maintaining Qualified Status

The premise of CAP is that a defective plan may be allowed to maintain its qualified status if:

(I) the employer completely corrects the defect(s);

(ii) the employer pays a sanction amount based on the tax liability which would have existed if the plan were disqualified; and

(iii) the Service determines that the equities of a case merit the plan being allowed to retain its qualified status.

The concept of the Service's "weighing the equities" of a situation is key; the Service's decision whether or not to enter into a closing agreement, and the sanction amount imposed, will be affected by the equities of a case.

Complete Correction of Defect

As in VCR and APRS, the plan sponsor must fully correct all form or operational defect(s), both retroactively and prospectively. All affected parties must be made "whole" for any loss which resulted from the plan defect.


Under CAP, the party or parties to the closing agreement must pay a nondeductible sanction amount to maintain the plan's qualified status. The starting point for determining the sanction amount is the tax liability that would result from the disqualification of the plan, including loss of the employer's tax deductions, tax on trust earnings and inclusion of contributions in employees' income. As previously mentioned, if the sponsor voluntarily enters negotiations under CAP before an audit has commenced, the negotiations start at 40% of such amount and the ultimate sanction may be as small as 5% of such amount. The sanction amount is calculated based only on open years (although, as discussed above, correction must have been made for both open and closed years).

This so-called "maximum payment figure" may then be negotiated downward based on the facts and circumstances of a particular case. In general, the IRS will take into account the following equitable factors in determining the amount of the sanction:

(i) the number and percentage of employees who are non-highly compensated and who participate in the plan;

(ii) the inadvertence of the error;

(iii) the significance of the defect;

(iv) whether there was good faith administration of the plan;

(v) whether there was any denial of plan benefits;

(vi) whether there was any discrimination against non-highly compensated employees;

(vii) the frequency, duration and nature of the plan violation;

(viii) whether the taxpayer has voluntarily approached the Service to resolve the matter;

(ix) whether correction was made immediately upon discovery of the violation;

(x) whether highly compensated employees disproportionately benefited from the defect; and

(xi) the plan's overall compliance history and on going procedures for assuring compliance.

The IRS has stated that in imposing a sanction amount it may take into account the employer' financial situation and may impose a lower sanction amount than it would otherwise if the employer can demonstrate financial hardship.

There is no minimum percentage of the maximum payment figure which must be collected in each case, and IRS spokespersons have repeatedly stated that CAP is not intended to be a revenue-raising program. In two sample closing agreements published by the Service, however, the sanction amounts imposed were 68% and 73% of the maximum payment figure. Since the tax liabilities for plan disqualification can be tremendous, 68% or 73% of the maximum payment figure would usually be a very large sum, even for relatively minor violations. If the IRS intends, as it appears by its examples, to impose sanctions equal to a high percentage of the maximum payment figure, many employers may be discouraged from coming forward to voluntarily correct plan defects through CAP negotiations.

The criticism most frequently leveled at CAP involves the sanction amounts. A great many practitioners feel that the IRS has used CAP to impose sanctions that are disproportionate to the violations at issue. The IRS is aware of this weakness in the Program and IRS spokespersons have stated their intention to align the sanction with the severity of the defect, based on the equities of the particular case.


Letter-perfect adherence to the myriad qualification rules is nearly impossible; virtually all plans have or have had a disqualifying defect. The sanction of disqualification is much too severe and inequitable for the vast majority of qualification violations. The Service has so acknowledged and has implemented three creative programs as alternatives to disqualification. The underlying premise of the programs is that full correction should be undertaken with either no additional cost, a user fee or a sanction applicable to the plan sponsor, depending on the severity of the defect and whether the plan sponsor voluntarily approached the Service to correct the defect.

The qualified plan rules are so complicated and the Service examination resources so (relatively) meager that the only way of maintaining a private pension system in compliance with applicable law is through a finely tailored program balancing deterrence and voluntary compliance. It is in this spirit that the Service imposes severe sanctions on egregious, intentional or "bad faith" qualification violations, with lesser (or no) sanctions for innocent, inadvertent or merely clerical violations. Voluntary compliance requires a "level playing field," where practitioners and IRS field auditors are educated about and understand the nature of disqualifying defects, and the results thereof. For this reason, the Service has:

(i) released to news services its newly issued examination guidelines; and

(ii) provided guidelines for correction through the APRS, VCR and CAP programs.

Voluntary compliance requires a partnership based on trust and good faith among the Service, plan sponsors and practitioner community, which can occur only if sanctions, penalties and user fees are proportionate to the disqualifying defect at issue. The Service has made strides in this area but has not yet established a continuum of APRS, VCR and CAP in which the penalties assessed are truly proportionate to the seriousness of the violation. Over time, one would expect to see this resolved through, among other things, the expansion of APRS, the implementation of user fees under CAP where plans that "just miss" eligibility under APRS or VCR merely pay a proportionate user fee (similar to that under VCR) as opposed to a sanction, and moving the VCR Program from the National Office to the Key District Offices to provide for consistency of treatment.

The concept of tailoring penalties to fit violations should also be applicable to §403(b) plans, and the Service is currently developing such a program.[49] Interestingly, the Department of Labor seeks to implement a permanent, voluntary program for employers that are delinquent in filing their annual Form 5500 reports.[50]

Pension plan administration and maintenance is moving in the direction of voluntary compliance through self-audit, correction of defects and approaching the Service where necessary. This process is encouraged through the Service's "carrot and stick approach" where small violations that are voluntarily rectified are subject to small (or no) sanctions, and where egregious or deliberate violations result in large sanctions and even, as a last resort, disqualification. The goal of voluntary compliance (to the extent attainable) will be hastened when the continuum of alternatives to disqualification has been implemented and coordinated so that the punishment truly fits the crime.

In concluding, the author would be remiss if it were not mentioned that the Service has undertaken to develop and expand these creative alternatives to disqualification with little or no statutory authority to do so. With the exception of §§401(b) and 7805(b), the Code provides that disqualification is the result of failing to satisfy the §401(a) qualification requirements. The closing agreement authority provided to the Service under §7121 is intended to be used principally in unusual circumstances, where the existing sanctions and penalties are inappropriate; it is at best unclear whether §7121 was intended to or should be the basis of a comprehensive sanction system, such as the CAP Program. Moreover, there is no statutory authority for the APRS or VCR Programs. The Service might consider approaching Congress to amend the Code to provide a basis for the continuum concept of proportionate sanctions, dependent on the severity of the disqualifying defect. After such amendment to the Code, the Service would have appropriate rule-making authority to promulgate regulations incorporating the APRS, VCR and CAP programs and further (and likely more effectively) develop such disqualification alternatives. Thus, the Service would not be in the tenuous position of, on its own and arguably without appropriate authority, replacing or modifying the Code's disqualification sanction system.

1 As with other tax-exempt entities, qualified plan trusts are taxable on their unrelated business income.

2 All section references herein are to the Internal Revenue Code of 1986, as amended (the "Code"), and the

regulations promulgated thereunder, unless otherwise specified

3 §401(a)(4) and regulations promulgated thereunder; see §414(q) for a definition of "highly compensated employee".

4 §410(a).

5 §411.

6 § §40 1 (a)(26) and 4 10(b).

7 See, eg., Basch Engineering, Inc. v. Comr., T.C. Memo 1990-212, where a plan was disqualified for not being timely amended to comply with the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"), the Deficit Reduction Act of 1984 ("DEFRA") and the Retirement Equity Act of 1984 ("REA"), even though the plan in operation satisfied those laws; see, also, Stark Truss Co., Inc. v. Comr., T.C. Memo 1991-329; Mortenson Roofing Co., Inc. v. Comr., T.C. Memo 1992-112; Hamlin Dev. Co., Inc. v. Comr.,T.C. Memo 1993-89; and Fazi v. Comr., 102 T.C. No. 31 (May 19,1994).

8 See, eg., Halligan v. Comr., T.C. Memo 1986-243, where the Tax Court held that the good faith of the taxpayer was not relevant where the plan had an operational defect; Forsyth Emergency Services, P.A. v. Comr., 68 T.C. 881 (1977); Quality Brands, Inc. v. Comr., 67 T.C. 167 (1976); Oakton Distributors, Inc. v. Comr., 73 T.C. 182 (1979); Buzetta Construction Corp. v. Comr., 92 T.C. 641 (1989); and Martin Fireproofing Profit Sharing Plan Trust v. Comr., 92 T.C. 1173 (1989).

9 Rev. Rul. 73-79, 1973-1 C.B. 194; Pension Plan Guide - Voluntary Compliance Resolution Program,Report 926, Issue No. 984 (CCH), p. 18, Q/A-48. 10 § 64 1, et seq.

11 §404(a)(5); Regs. § 1.404(a)- I 2(b)(3).

12§404(a)(5); Regs. §1.404(a)-12(b)(1).

13 §402(b)(1); Regs. 1.402(b)-I(a)(1).

14 Regs. 1.402(b)-l(a)(2).

15 §402(b)(4)(B).

16 §402(b)(4)(A).

17 Preamble to final §401(a)(4) regulations, T.D. 8360, 1991-2 C.B. 98, 110.

18 Regs. 1.402(b)-I(b)(5).

19 See Woodson v. Comr., 73 T.C. 779 (1980), rev'd, 651 F.2d 1094 (5th Cir. 1981); Baetens v. Comr., 82 T.C. 152 (1984), rev'd, 777 F.2d 1160 (6th Cir. 1985); Benbow v. Comr., 82 T.C. 941 (1984), rev'd, 774 F.2d 740 (7th Cir. 1985); and Fazi v. Comr., 102 T.C. No. 31 (May 19, 1994).

20 Regs. § 1.402(a)- I (a)(6) and Regs. § 1.402(b)- I (b).

21 Greenwald v. Comr., 44 T.C. 137 (1965), rev'd, 366 F.2d 538 (2d Cir. 1966); Pitt v. U.S., 75-1 USTC paragraph 9472 (M.D. Fla. 1975); Dudinsky v. U.S., 78-2 USTC paragraph 9688 (M.D. Fla. 1978); and Hesse v. U.S., 81-1 USTC T9153 (E.D. Mo. 1980).

22 §§3121(a) and 3306(b) do not exclude from the definition of taxable "wages" contributions made to non-exempt trusts.

23 §3402(a)(1).

24 See discussion in Wagner, 374 T.M., Plan Disqualification and ERISA Litigation, page A-4.

25 §6501(a).

26 This statute of limitations begins to run when the Form 990-T, Exempt Organization Business Income Tax Return, is filed.

27Announcement 80-45, 1980-15 I.R.B. 17.

28 Regs. §1.401(b)-I(b)(2)(ii).

29 Regs. § 1.401 (b)- I (b)(2)(iii).

30 Regs. §1.401(b)-l(c)(1).

31 For an illuminating article on this subject, refer to Slate, Martin I.," The IRS'Use of Section 7805(b) in the Employee Plan Area: An Analysis," Tax Mgmt., Special Report, February 13, 1989, reprinted in Wagner, 374 T.M. Plan Disqualification and ERISA Litigation, Worksheet 7.

32 Rev. Proc. 94-4, 1994-1 I.R.B. 90.

33 See Internal Revenue Manual, 7(10) 54, Employee Plans Examination Guidelines Handbook.

34 Rev. Proc. 92-89, 1992-46 I.R.B. 27, as modified by Rev. Proc. 93-36, 1993-29 I.R.B. 73.

35 Rev. Proc. 94-62, 1994-39 I.R.B. 11.

36 Specifically, with respect to violations of the minimum funding standards, §412(m)(1) provides that interest shall be charged to the funding standard account with respect to underpayments; §412(n) imposes, in certain instances, an automatic lien in favor of the plan upon the employer's property; §497 1 (a) imposes a 10% excise tax on the employer on the amount of the accumulated funding deficiency, which, under §497 1 (b), can increase to a 100% excise tax in certain instances. With respect to prohibited transactions, §4975(a) imposes on the disqualified person an excise tax equal to 5% of the amount involved in the prohibited transaction; §4975(b) increases this to a 100% excise tax in certain instances.

37 Rev. Proc. 94-62, §4.05.

38 Rev. Proc. 94-62, §4.

39 Rev. Proc. 94-62, §3.17.

40 However, the Service explicitly reserves the right to verify that the proposed corrections and any required administrative procedures have, in fact, been implemented (Rev. Proc. 94-62, §3.12).

41 See comments of Jill Rubin, Coordinator of the VCR Program, in BNA Daily Tax Report, October 11,1994, page G-5.

42 Rev. Proc. 94-62, §13.04.

43 Rev. Proc. 94-62, §5.02.

44 Rev. Proc. 93-36, as superseded by Rev. Proc. 94-62.

45 Rev. Proc. 94-62, §8.

46 See Mills, Mitchell & Tumer v. Comr., T.C. Memo 1993-99.

47 Pension Plan Guide - Extra Edition - IRS Procedures for Resolving Plan Qualification Defects, Rep. No. 843, Apr. 17, 1991 (CCH), page 8.

48 Rev. Proc. 94-16, 1994-5 I.R.B. 22.

49 Pension Plan Guide No. 1023 (CCH), page 5; BNA Daily Tax Report September 9, 1994, page G-6.

50 BNA Daily Tax Report, September 30, 1994, page G-5.