Key District Office Schizophrenia

Notwithstanding the rigidity of the IRS National Office's Employee Plans Division in the mid-late 1980's, the KDOs were another story. There was almost schizophrenia within and between the KDOs. In practice the sanction of disqualification was not uniformly applied at all as the KDOs heeded National Office policy in varying degrees. The schizophrenia expressed itself in a lack of uniformity between the KDOs in enforcing -whether to, when to, why to, to what extent - the sanction of disqualification; and the inconsistency occurred within the same regional offices, within the same KDOs, within the same groups, and often by the same EP Agents from case-to-case.

This enforcement inconsistency in the KDOs resulted in the following types of actions. In those cases where the operational failures were truly minimal, 5/ EPAgents generally only required retroactive and prospective correction without plan disqualification. However, unless the failure was truly minimal, some EP Agents would disqualify plans outright without regard to the number, type, and effect of the failures. EP Agents in the same KDOs - often sitting at desks at adjacent cubicles - had different standards for enforcing disqualification. In all cases where plans were not disqualified, EP Agents required retroactive correction. Some EP Agents did not assess a tax sanction if they required correction. Others did impose a tax sanction roughly equivalent to the sanction as if the plan was disqualified and then adjusted down to some reasonable amount. To highlight this inconsistency some reviewers allowed the full range of actions against plans from different EP Agents whose work they were reviewing.

With retroactive correction, the KDOs uniformly required make-up contributions as well as plan amendments, but employers were always willing to make retroactive corrective in lieu of disqualification. In some cases - where the failures were more substantial in number and effect - an EP Agent might impose a sanction even though he did not disqualify the plan and would also require full correction. How this amount was arrived at varied, but it was the rough equivalent of the tax liability, discounted to some extent, that would have been imposed had the plan been disqualified.

There were several reasons why many EP Agents allowed plan sponsors to correct form or operational failures without disqualification or dollar sanctions. One was the pressing need to close cases where caseloads were large. Correction allowed EP Agents to close cases quickly. Also correction served the overall goal of getting retirement plans in compliance so that retirement benefits could be paid as prescribed by the terms of the plan. 6/

Several EP Agents told me that it was very difficult to face practitioners and plan sponsors at conferences day-after-day and tell them that an inadvertent top-heavy or ADP or 401(a)(17) violation would result in a disproportionate $50,000 disqualifying tax sanction where the effect of the violation was minimal and easily correctable. Many EP Agents simply required correction without any dollar sanction.

Key District Office Split Personality

This uneven enforcement of disqualifying failures was also due in part to the bifurcation of authority within the KDOs at the time. In the 1980's the EP/EO Division was responsible for determining plan qualification. The Examination Division (which was a Division within the Office of the Assistant Commissioner (Examination) and which was wholly separate from the EP/EO Division) was responsible in most KDOs for enforcing the income tax aspects of plan disqualification, plan distributions, and other qualified plan related tax issues that resulted from a 1040 or 1120 audit. 7/

Because a KDO Examination Division was not generally required to accept referrals to set up audits from the EP/EO Division, there was an inconsistent and uncoordinated enforcement of the income tax consequences of disqualification within the KDOs. For example if the EP/EO Division proposed to disqualify a plan, the EP Agent could not count on the Examination Division to set up an audit of the corporation that established the plan and made deductible contributions or of the plan participants (especially the highly compensated employees) on whose behalf nontaxable contributions were made. Without the Examination Division's concurrence, disqualification as a sanction had no teeth. And so for this reason too, EP Agents simply closed cases by full correction rather than simply going after the trust over which the EP/EO Division did have jurisdiction.

In retrospect, what EP Agents did made some sense. Why? It was simply too much of a hassle to get the Examination Division to accept an audit referral. Letter perfect operational qualification compliance was too much to expect from plan administrators. The dollar sanctions for disqualification were often wholly disproportionate to the nature and type of failures found on audit. Cases needed to be closed. In the real world EP Agents generally handled cases properly and fairly.

The unfortunate aspect of how EP Agents handled cases within KDOs and between KDOs was the extreme inconsistency of results. However - in part - it was this inconsistency that led to the decision in 1989 to develop voluntary compliance programs for qualified plans.

Failure of IRS National Office to Provide Guidance to KDOs

An unfortunate failing of the IRS National Office Employee Plans Division was the lack of any formal or even informal guidance to the KDOs beyond the statutory requirement that Code Sec. 401 operational failures required disqualification and disqualification meant loss of deductions, trust liability, and income tax liability to plan participants, as appropriate. The IRS acknowledged later that "there were instances of not applying the disqualification sanctions for a minor violation by our key district offices. Because there were no formal guidelines, there was a lack of uniformity between key district offices or even within the same key district office." 8/

IRS National Office Rigidity Turns to Realistic Flexibility

A whole different dynamic - from how KDO EP Agents were closing cases - was occurring in the IRS National Office Employee Plans Division in late amender and retroactive disqualification cases. In the mid-1980's, prior to the issuance of the Employee Plans Closing Agreement Program (Audit CAP) in 1990, practitioners at National Office conferences on cases involving potential retroactive disqualification often argued that KDO EP Agents would not disqualify these plans and only required retroactive correction in similar circumstances. The National Office response was uniformly that, as a technical matter, a form or operational failure results in plan disqualification; and the act of disqualification has adverse tax consequences that are required by the Internal Revenue Code. Case dismissed. That was our mantra and it did not matter what the ultimate tax consequences were to the adversely affected parties.

However, in the late 1980's, the attorneys in my Rulings Group and I came to understand how differently the KDOs and National Office were resolving the same types of cases. We also understood quite clearly that - after TEFRA in 1982, DEFRA in 1984, REA in 1984, and then TRA '86 - it was simply too much to expect plan administrators to maintain picture-perfect plans and also expect plan sponsors to foot the bill for the tax consequences of plan disqualification that were too often in excess of the proportionate plan failure. We simply thought it was time to stop disqualifying plans and that some other mechanism needed to be put into place.

We brought to Marty Slate, the Director of the Employee Plans Division, and Bill Posner, Assistant Director, the idea of using Delegation Order 97 to close technical advice cases by a formal closing agreement instead of issuing a formal technical advice memorandum. My proposal to Marty and Bill was that - instead of disqualifying plans retroactively - we would negotiate a tax sanction less than would be imposed if the plan lost its qualified status.

Most practitioners understand the dollar figures of disqualification. A minor failure for a defined contribution plan that had been in existence for several years with consistent contributions and positive earning could result in a combined tax sanction of over $100,000. That was truly crazy, we all knew it, and we all were growing tired of it. So we began to use DO 97 to close cases at 60 cents on the dollar//40 cents on the dollar// and somewhere above that, below that, and somewhere in between.

But even these reduced sanctions were disproportionate to most failures, which were inadvertent and easily correctable and without much adverse impact to the plan or its participants.

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