Avoiding Top-Heavy Retirement Plans
Failing to timely file Form 5500, failing to advise clients about restrictions on types of distributions and adviser actions that cause a retirement plan to fail to operate within its terms are just a few reasons why those who provide services to retirement plans get sued.
BECOMING TOP HEAVY
Generally, a tax-qualified retirement plan top heavy when the benefits of certain company executives (called “key employees” in the Internal Revenue Code) account for more than 60 percent of the plan’s assets.
Once this happens, the company sponsoring the plan must make a minimum contribution to the accounts of “non-key” employees equal to 3 percent of their pay.
Claims are most often made against the administrative or actuarial firm that performed the top-heavy test. But these types of claims are not limited to those firms. Other advisers who have close relationships with the company also are targets. CPAs, who are often the frontline advisers to the company and act as liaisons between their clients and their retirement plan administration firms, need to be on the lookout for signs a retirement plan may be top-heavy – and know how to keep the balance.
CLAIM COMMONALITIES
While the circumstances of claims against professionals differ, there are commonalities to most claims. Generally, the claims are brought after the company has learned it has incurred a large top-heavy obligation. When the contribution is greater than anticipated (or when the company did not anticipate a contribution), the company looks for someone to share the blame and ease the cost of the 3 percent minimum payment.
The argument usually advanced by the company: Had it known the plan was going to be top heavy (or that the top-heavy obligation was going to be so great), it would have taken some action to avoid or reduce the liability.
The sponsor claims it either never would have adopted the plan, would have frozen the plan before it became top heavy or would not have permitted key employees to continue to defer income into the plan, thereby avoiding the top-heavy obligation.
Each of these arguments is subjected to attack. First, it may be a stretch for the company to argue that it would not have sponsored a plan – particularly when its competitors offer retirement plans – to avoid the top-heavy contribution. Moreover, since businesses depend heavily on their key employees, it may be unrealistic to contend that the company would have prevented them from deferring income to the retirement plan.
SOUND ADVICE
If you advise companies that sponsor qualified retirement plans, be prepared to deal with this rising trend of top-heavy based claims. At the outset, communicate with your clients about their goals and expectations in adopting a qualified plan.
For example, statements that suggest the sponsor only wants to provide a benefit for its employees and does not want to incur any unnecessary costs may be a sign that an unexpected top-heavy liability will be a problem. If so, talk with the sponsor about the top-heavy rules and their impact on the plan -– and put those conversations in writing. Your staff should also be trained to be sensitive to these issues.
Also, document all communications about the results of a top-heavy test, the plan’s current or prior top-heavy status and any related topics. For example, if the administrative firm hired to perform the top-heavy test cannot do so because the company has been slow in gathering the necessary census and ownership information.
If you are involved in plan administration, consider using an administrative service agreement that explains the top-heavy rules and consequences of a top-heavy plan. You can go a step farther and confirm that unless you are notified otherwise in writing, you will assume that the company intends to allow key employees to continue to defer, regardless of the plan's top-heavy status.
The agreement should be signed by the plan sponsor and make clear that any delay in providing requested information, which results in a delay in preparing test results, will be attributed to the sponsor.
Finally, advisers should make sure they are properly insured. Litigation is expensive -– even when you are not at fault -– and failing to have the proper level of coverage can significantly impact the profitability of your operation.
© 2004
Reprinted with permission from the California Society of Certified Public Accountants. Article was originally published in California CPA magazine, March/April 2004.
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