Minimum Required Distribution Failures: Is there any way to get relief from the potentially severe excise tax?

By Stephanie Bennett

A client recently approached us for advice because they failed to make the required minimum distribution under their 401(k) plan to an owner-employee. In accordance with long-standing IRS correction guidance, we suggested that the client file a Voluntary Correction Program (VCP) application with the IRS to correct the tax-qualification defect of failing to operate the plan in accordance with its minimum required distribution provisions. This client welcomed this advice as to correction of the qualification defect; however, they related to us the owner-employee’s serious concerns about potentially having to pay a 50% excise tax on the missed distribution, and asked us what could be done about this.

By way of background, Code section 401(a)(9) requires that participants begin withdrawing at least a minimum amount from tax-qualified retirement plans by April 1 of the year following the year the participant reaches age 70 1/2. These minimum withdrawals are referred to as required minimum distributions. If required minimum distributions are not made in accordance with Code section 401(a)(9), Code section 4974 imposes for each year, on each participant who should have received such distributions, an excise tax in the amount of 50% of the unpaid minimum amount.

Naturally, correcting the failure to pay the required minimum distribution is important to plan sponsors, since that failure could result in disqualification of the plan and the loss of all tax advantages. And, the method of correction is straightforward and relatively simple. That is to currently distribute the required minimum distribution to the participant, which our client did shortly after contacting us. However, what is most important to the affected plan participant is relief from the potential severe and burdensome 50% excise tax, which the relevant participant is subject to under Code section 4974.

Fortunately, the Employee Plans Compliance Resolution System (EPCRS) (as currently described in Rev. Proc. 2006-27) provides for a waiver of the excise tax under Code section 4974. EPCRS, however, limits this relief to “appropriate cases” in which the plan sponsor has specifically requested it in the VCP application. Furthermore, in cases where the participant subject to the excise tax is an owner-employee, the plan sponsor must provide an explanation justifying the waiver request.

In this case, since the participant at issue was an owner-employee, we had to include an explanation supporting the excise tax waiver request. To accomplish this, our application described all of the relevant facts and circumstances that lead to the defect, and emphasized the lack of fault on the part of the employer or the plan participant. Specifically, we highlighted the fact that the employer was not sophisticated in the qualified plan rules and, for that reason, acted prudently in engaging the services of a professional third-party administrator (“TPA”) to ensure the plan’s compliance with the qualified plan rules. Unfortunately, the TPA in this instance breached its duty to the employer, by failing to properly take note of information that should have alerted it to the fact that the owner-employee had attained age 70 ½ and, therefore, was due to receive minimum required distributions beginning in the following plan year. By outlining these critical facts in detail in our application, we were able to obtain a waiver of the excise tax on behalf of our client. This case is important to you beyond the simple fact that the substantial excise tax under Code section 4974 can be waived as part of a VCP application. The true value of this case is that it highlights the importance of understanding what the IRS is looking for when it comes to establishing “reasonable cause,” and the ability to work with the facts to achieve the desired result.

© 2007 Reish Luftman Reicher & Cohen. All rights reserved. The ERISA Audit Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.

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