United States

Retirement plan disqualified for an improper transfer of assets after divorce

TAX ALERT  | 

In Family Chiropractic Sports Injury & Rehab Clinic, Inc., TC Memo 2016-10, the Tax Court agreed with the IRS that the taxpayer’s employee stock ownership plan (ESOP) became disqualified in 2010 after violating section 401(a) and failing to follow the plan’s terms. The ESOP had transferred an employee’s vested account balance to her ex-husband’s account in the same ESOP pursuant to corporate documents which indicated the wife had agreed to relinquish her ESOP account as part of a divorce.

Section 401(a)(13) prohibits the assignment or alienation of benefits in a qualified retirement plan. Although the taxpayer’s ESOP plan document contained this language, when the vested balance was transferred, the terms were violated in operation. In addition, pursuant to plan terms, the wife had been due a distribution of her ESOP account after terminating service with the employer, and no distribution had been made.

A qualified plan must meet all of the requirements of section 401(a) to remain qualified. In addition to meeting the requirements in form in the plan document, when a plan fails to follow its own terms, it is not considered a “definite written program” and is no longer qualified. Once disqualified under section 401(a), the trust holding the retirement plan assets is no longer tax-exempt. In addition, participants in the plan no longer receive the protection of deferring income tax on their account balances until they receive distributions. Also, once disqualified, the plan is disqualified for all future years so the consequences are underpaid taxes for multiple years which will include interest and penalties.

It is important to note that these rules apply to all qualified retirement plans, even though the plan in this case happened to be an ESOP. ESOPs represent a small portion of all qualified retirement plans but many employers today have 401(k) plans or other retirement plans which follow the same rules for qualification, and thus also prevent the assignment or alienation of benefits.

In addition, section 414(p) generally creates an exception to the assignment or alienation prohibition in section 401(a) (13) for qualified domestic relations orders. Under this exception, courts may assign benefits to an alternate payee if the court enters a Qualified Domestic Relations Order (QDRO). A QDRO must contain certain statutorily required facts related to the plan, the participant, and  the alternate payee (the participant’s former spouse or potentially a child or other dependent of the participant), as well as the amount the plan is to transfer to from the participant’s account, etc. Accordingly, plans should have processes in place to review domestic relations orders and to comply with them.

In this case, the ESOP transferred the account balance under what it believed was stated in a legally binding divorce decree. However, the plan did not undertake any processes to determine whether the transfer was pursuant to a QDRO and, in fact, it was not. Thus, the transfer violated qualified plan requirements in general as well as its own specific plan terms. That failure to follow the tax rules even though the plan document clearly stated those rules led to the disqualification of the plan.

Trustees and corporate sponsors of qualified retirement plans must fully understand the qualification requirements and plans’ terms. If appropriate care is not taken to adhere to the rules, a disqualification such as this may inadvertently occur and lead to onerous financial consequences for the employer and the employees.

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