In its March 20, 2012 Employee Plans Newsletter, the IRS reviewed the five tax effects of plan disqualification. When a tax-qualified retirement plan is disqualified, the plan's trust loses its tax-exempt status. The corresponding effects of disqualification are as follows:

  • Employees Include Contributions in Gross Income. Generally, employees would include in their incomes any employer contributions made for the employee's benefit in and after the calendar year in which the plan is disqualified, to the extent the employee is vested in those contributions.
  • Employer Deductions are Limited. If an employer contributes to a nonexempt trust, it cannot deduct the contribution until the contribution is includible in the employee's gross income.
  • Plan Trust Owes Income Taxes on Trust's Earnings. The plan's trust must file a Form 1041 and pay income taxes on its earnings.
  • Rollovers Are Disallowed. A distribution from a disqualified plan cannot be rolled over to another plan or IRA, subjecting the distribution to taxation.
  • Contributions Subject to Social Security, Medicare and Federal Unemployment Taxes. An employer's contribution to a nonexempt trust on behalf of an employee can be subject to FICA and FUTA taxation if the employee's interest in the contribution is vested at the time of the contribution. Contributions are also subject to taxes when the employees become vested in such contributions.

Plans that have lost their tax-exempt status must correct the error(s) that caused the plan to become disqualified through the IRS's Voluntary Correction Program before the IRS will re-qualify the Plan.