Recent guidance issued by the Internal Revenue Service (IRS) highlights the importance of employer diligence in the operation of tax-qualified retirement plans. In light of this guidance, employers sponsoring qualified plans may wish to review the benefits offered to their employees to avoid disqualification or compliance obstacles.

In Private Letter Ruling 201722014 (the Letter), the IRS explained that a particular defined benefit plan for state government employees could face disqualification based on a proposed separation pay arrangement. Legislation proposed in the state would have provided employees, in lieu of exercising certain reduction-in-force rights, the option to elect either (1) a one-time lump sum severance benefit, or (2) a subsidized early retirement benefit under the state's defined benefit pension plan.

While generally, there are no formal requirements or filings necessary to establish a plan under the Employee Retirement Income Security Act (ERISA), when an employer provides employee benefits, the employer generally must comply with both ERISA and the Internal Revenue Code (the Code) to avoid potential liabilities or unfavorable tax treatment. Thus, without proper diligence, employers may unintentionally subject themselves to the myriad responsibilities and obligations for maintaining qualified plans under both ERISA and the Code.

In the Letter, the IRS concluded that by offering the employees an election, the plan would include a cash or deferred arrangement (CODA), which is something that, under the Internal Revenue Code, may not be offered under a defined benefit pension plan. Broadly, because the employees would have the option to elect either the lump sum payment (cash) or a subsidized early retirement benefit (deferral of compensation), the proposed offer would constitute a CODA, and offering a CODA would disqualify the defined benefit plan.

Although this IRS guidance comes in the form of a Private Letter Ruling, which binds only the IRS and the requesting taxpayer, it allows plan sponsors to gain a better understanding of the IRS's views regarding the inadvertent creation of CODAs.