An IRS plan audit uniquely focuses an employer’s mind on the core identity of its qualified retirement plan, which is that of a tax exempt organization, but one whose exemption (or “qualification”) requirements are far pickier than those applicable to one’s favorite charity. Any single material operational violation or non-conforming written plan provision risks disqualification and loss of the related special tax benefits.

And disqualification was in fact the Tax Court’s ruling in Family Chiropractic Sports Injury & Rehab Clinic, Inc. v. Commissioner, decided January 19, 2016. The plan victim was an Employee Stock Ownership Plan (“ESOP”), a type of qualified plan primarily designed to invest in the stock of the employer and whose sole participants were a divorced chiropractor and his ex-wife. Without acknowledging the ESOP’s ownership of virtually all of the stock of the company sponsor, the couple’s divorce decree awarded each one-half of the plan sponsor’s outstanding stock. By later documents the ex-wife transferred all of her ESOP share account to her former husband’s ESOP account. Plan disqualification was held effective as of the date of that transfer principally because: (1) it was not pursuant to a properly approved qualified domestic relations order (“QDRO”) and, therefore, violated the anti-alienation rules of the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code — which generally prohibit assignment of a participant’s plan benefit before it is properly distributed under the plan, and, independently, (2) the transfer violated the terms of the ESOP plan document regarding the distribution rights of participants.

In addition to ERISA fiduciary liability, the consequences of disqualification include for open tax assessment years (generally three years back): taxes on the income of the plan’s trust, taxation of participants on vested undistributed benefits, taxation of otherwise tax-free rollovers from the plan, and disallowance or deferral of the plan sponsor’s deductions for contributions to the plan. In an IRS plan audit, a plan sponsor can avoid disqualification by not only fixing the mistake financially, but also paying as a sanction a negotiated percentage of the income tax amounts described above — potentially quite expensive, but normally far preferable to actual disqualification, which occurs only rarely.

Fortunately, the IRS’s Voluntary Correction Program (“VCP”) and other IRS Employee Plans Compliance Resolution System (“EPCRS”) correction procedures can reduce exposure resulting from the inevitable plan failures. But these procedures are most attractive when the employer discovers the failures and can voluntarily propose correction before the IRS announces an audit. Also, no standard IRS correction procedure exists to remedy a transfer of a plan benefit by a participant outside of the QDRO rules. In Family Chiropractic, undoing the illegal assignment of the ex-wife’s ESOP account may have simply been unacceptable to the IRS and/or the parties under the circumstances.

Disqualification exposure is reduced through regular administrative and legal review of plan operations in order to discover and deal with failures before the IRS does. IRS officials have stated that an employer’s probability of plan audit is reduced if the annual Form 5500 does not contain blank fields, internal inconsistencies, large unvested benefits for terminated participants (a partial termination risk) or substantial amounts of hard-to-value “other” assets.