The term “qualified plan” refers to an employer sponsored retirement plan meeting the requirements of IRC Section 401. Section 401 not only provides for an extensive list of requirements incorporating additional IRC sections, but it also conveys uniquely favorable tax treatment to employers and covered employees and their beneficiaries as long as those requirements continue to be met. This section (Q 3837 to Q 3936) explains the basic qualification requirements that apply to all qualified plans. The additional plan-specific qualification requirements that apply only to certain types of plans are explained beginning at Q 3714.

Assuming the qualification requirements set forth in the IRC are met, the following tax advantages are available for qualified plans:

(1) An employer can take a current business expense deduction (within limits) for its contributions to the plan even though employees are not currently taxed on these contributions (Q 3937 to Q 3942);

(2) An employee pays no tax until benefits are distributed regardless of whether he or she has a forfeitable or non-forfeitable right to the contributions made on his or her behalf unless the plan offers a designated Roth account option and the employee makes contributions to that account (Q 3945);

(3) Distributions meeting certain requirements may be eligible for rollover or special tax treatment (Q 3968 to Q 3972);

(4) Annuity and installment payments are taxable only as received (Q 3968 to Q 3969, Q 3975);

(5) The fund within the plan earns and compounds income on a tax deferred basis (Q 3978); and

(6) Certain small employers (i.e., employers with fewer than 100 employees earning compensation over $5,000 per year ($500 prior to 2020)) may be able to claim a business tax credit equal to 50 percent of qualified start-up costs of up to $5,000 per year for three years of an eligible employer plan.¹

In addition, ERISA provides creditor protection to accounts, even in the case of bankruptcy, though levies and fines may be chargeable against a participant’s account.²

For owners of pass-through entities, the deduction for contributions to qualified plans passed through from the entity may assist in reducing taxable income below the $383,900 (joint returns)/$191,950 (other taxpayers) thresholds for 2024 (projected) to qualify for the qualified business income (QBI) deduction under section 199A.³ These thresholds in 2023 were $364,200 (joint filers)/$182,100 (other taxpayers). If an owner’s taxable income exceeds those limits, the QBI deduction may be subject to additional limits. For the owner of a specified service trade or business,⁴ no QBI deduction is available if the owner’s taxable income exceeds the annual threshold level for the year, plus $50,000 for single filers or $100,000 for joint returns.

Self-employed persons (i.e., sole proprietors and partners) (Q 3932) may participate in qualified plans as “employees.” There are special rules applicable to self-employed individuals (Q 3826 to Q 3829).

A retirement plan is tax qualified when the plan document complies with the requirements under IRC Section 401(a). The document must be updated periodically to meet this section’s changing requirements, and the plan must be operated in compliance with the IRC and the document. A plan that fails to meet these requirements, either in its document or operation, has a document failure or an operational failure, respectively. A plan that does not correct either failure could be disqualified by the IRS. An IRS disqualification strips the plan of its tax benefits. Most document or operational failures can be corrected through one of the IRS’ voluntary correction programs under the Employee Plans Compliance Resolution System (“EPCRS”).¹

To meet the basic qualification requirements of IRC Section 401(a), a plan must:

(1) Be established in the United States by an employer for the exclusive benefit of employees or their beneficiaries (Q 3839).

(2) Prohibit the use of plan assets for purposes other than the exclusive benefit of the employees or their beneficiaries until such time as all liabilities to employees and their beneficiaries have been satisfied (Q 3839).

(3) Meet minimum age and service standards (Q 3841), and minimum coverage requirements (Q 3842).

(4) Provide for contributions or benefits that are not discriminatory (Q 3848 to Q 3863 in general, and Q 3802 to Q 3804 with respect to 401(k) plans).

(5) Provide for contributions or benefits that do not exceed the IRC Section 415 limitations (Q 3868, Q 3719, and Q 3728).

(6) Meet minimum vesting standards (Q 3869 to Q 3876).

(7) Provide for distributions that satisfy both the commencement rules and the minimum distribution requirements (Q 3891 to Q 3910).

(8) Provide for automatic survivor benefits under certain circumstances (Q 3881 to Q 3890).

(9) Contain provisions that meet the requirements for “top-heavy” plans and provide that these provisions will become effective should the plan become top-heavy (Q 3916 to Q 3922).

(10) Prohibit the assignment or alienation of benefits (Q 3912 to Q 3915).

(11) Meet the miscellaneous requirements described in Q 3927.

(12) Meet the plan-specific requirements that are based on the type of plan (e.g., profit sharing) (Q 3714 to Q 3827).

(13) Provide that if the distributee of an eligible rollover distribution elects to have the distribution as permitted under IRC Section 401(a)(31)(A) paid as a direct rollover, the distribution will be made in the form of a direct rollover.

(14) Provide that if the plan uses the forced distribution provision of IRC Section 401(a)(31)(B) for distributions of vested benefits that do not exceed $5,000, the plan also must notify the distributee in writing of the rollover (Q 4001).²

(15) Provide to each recipient of a plan distribution a written explanation of his or her right to elect a direct rollover and the withholding consequences of not making the election prior to making the distribution (Q 3998).³

(16) Be established through a written plan document that is communicated to employees prior to the first day of the plan year for which it is to be effective. This document must satisfy the requirements of 401(b). In most cases, plan sponsors rely on either a determination letter or other IRS approval to confirm that the form of the document is in compliance. Prototype and volume submitter documents have a form or preapproval by the IRS.⁴

(17) If the plan holds assets in a custodial account, that account must be with a bank or other entity that demonstrates to the satisfaction of the IRS that assets will be properly held.

(18) If the plan covers employees who are covered under a collectively bargained plan, the requirements of IRC Section 413 must be met.

(19) If the plan covers self-employed individuals, it must meet the requirements discussed under Q 3826, Q 3827, and Q 3932.

Although a document must fully satisfy the provisions of 401(a) on the date of adoption, changing legislation and Treasury regulations may require amendments prior to the close of a specific plan year. Almost every plan needs some required plan amendments every year. The IRS regularly releases a list of required amendments for qualified retirement plans.⁵

Failure to timely amend a plan to meet newly enacted or modified qualification requirements can result in revocation of a plan’s qualified status,⁶ even if the plan has been terminated.⁷ Nonetheless, a terminated plan must meet the IRC’s qualification rules until such time as all the assets are distributed in satisfaction of its liabilities.

Planning Point: On June 3, 2022, the IRS released details about a new pilot pre-examination compliance program for qualified plan audits. Under the program, the IRS will send the plan sponsor a letter advising that it has been selected for an examination. The sponsor is then given 90 days to review the plan for compliance issues. If the sponsor uncovers any issues, it can correct the problem within the 90-day review period if the issue is one that can be corrected under self-correction procedures or can request that the IRS enter a favorable closing agreement. If the sponsor receives a letter, the sponsor should show that either (1) the plan is compliant with any issues raised in the letter, or (2) the plan was non-compliant but has (or will) correct the problem. The sponsor must also show whether any additional issues have been detected during the compliance review (and steps that are being taken to correct those issues). The IRS will then review that information and, if it agrees, issue a closing letter without additional contact. If the IRS disagrees, it will contact the sponsor and determine whether further audit/action is necessary.

A plan must be established in the United States by an employer for the exclusive benefit of employees or their beneficiaries.¹

A plan will not qualify if it includes participants who are not employees of the employer that established and maintains the plan except in the case of “leased employees” (Q 3929).² An individual generally is an employee for the purpose of participating in a qualified plan if he or she is an employee under common law rules (Q 3928); however, under IRC Section 3508, certain real estate agents and direct sellers of consumer products are specifically defined as non-employees. An individual is an employee under the common law rules if the person or organization for whom he or she performs services has the right to control and direct his or her work, not only as to the result to be accomplished but also as to the details and means by which the result is accomplished.³

Self-employed individuals are eligible to participate in their own qualified plans under the same rules applicable to common law employees, although some special rules apply (Q 3827, Q 3932). Participation by independent contractors who are not employees of a corporation in a corporation’s plan generally would be a violation of the exclusive benefit rule; however, the IRS has not been inclined to disqualify plans on this ground alone.⁴

Stockholders, even sole owners of corporations, who are bona fide employees of corporations (including professional corporations and associations and S corporations) are eligible to participate in a qualified plan of the corporation as regular employees, not as self-employed individuals.⁵ A full-time life insurance salesperson who is an employee for Social Security purposes can participate in a qualified plan as a regular employee.⁶ He or she cannot set up a plan as a self-employed individual.⁷

The primary purpose of benefiting employees or their beneficiaries must be maintained with respect to investment of trust funds as well as with respect to other activities of the trust.⁸

The use of the exclusive benefit rule to disqualify a plan where trust funds have been misappropriated generally occurs only under egregious circumstances. For example, the Tax Court held that where a plan loaned out almost all of its assets to the company president without seeking adequate security, a fair return, or prompt repayment, the plan was not operated for the exclusive benefit of the employees and the plan was disqualified.⁹

Likewise, where a corporation’s sole shareholder and plan trustee caused the plan to make 22 unsecured loans to himself and none of the loans bore a reasonable rate of interest or were adequately secured, the exclusive benefit rule was violated and the plan disqualified.¹⁰

A loan made by a plan to an employer from excess funds that would have been returned to the employer did not violate the exclusive benefit requirement despite the imposition of the excise tax on prohibited transactions.¹¹

The Tax Court has held that a violation of the prudent investor rule (i.e., a failure to diversify) did not violate the exclusive benefit rule.¹²

The IRS has decided that where an ESOP trust contained a provision permitting the trustee to consider nonfinancial, employment-related factors in evaluating tender offers for company stock, the exclusive benefit rule was violated.¹³

The garnishment of an individual’s plan interest under the Federal Debt Collections Procedures Act (“FDCPA”) to pay a judgment for restitution or fines will not violate the exclusive benefit rule.¹⁴

It must be impossible under a plan at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries for any part of the funds to be used for or diverted to purposes other than for the exclusive benefit of the employees or their beneficiaries.¹ (See Q 3839.)

As a rule, therefore, no sums may be refunded to the employer. A plan may provide for the return of a contribution (and any earnings) where the contribution is conditioned on the initial qualification of the plan, the plan receives an adverse determination with respect to its qualification, and the application for determination is made within the time prescribed by law for filing the employer’s return for the taxable year in which the plan was adopted or a later date as the Secretary of Treasury may prescribe.²

A plan also may provide for return to the employer of contributions made on a good faith mistake of fact and of contributions conditioned on deductibility where there has been a good faith mistake in determining deductibility.³ Earnings attributable to any excess contribution based on a good faith mistake may not be returned to the employer, but losses attributable to such contributions must reduce the amount returned.⁴

Employer contributions made to satisfy the quarterly contribution requirements (Q 3724) may revert to the employer if the contribution depends on its deductibility, a requested letter ruling disallows the deduction, and the contribution is returned to the employer within one year from the date of the disallowance of the deduction.⁵ Documentation must be provided showing that the contribution was conditioned on deductibility at the time it was made; board resolutions dated after the contribution is made are not sufficient.⁶ A letter ruling request may not be needed if the employer contribution is less than $25,000 and certain other requirements are met.⁷

If, on termination of a pension plan (other than a profit sharing plan), all fixed and contingent liabilities to employees and their beneficiaries have been satisfied, the employer may recover any surplus existing because of actuarial “error.”⁸ The plan must specifically provide for such a reversion.⁹ Thus, where a plan had no such provision, the employer was required to distribute surplus assets to the former employees (or their surviving spouses) covered by the plan.¹⁰ Furthermore, the calculation of the employees’ share of residual assets must result in an equitable distribution before the surplus assets may revert to the employer.¹¹ An excise tax may apply to any employer reversion (Q 3979).

If a pension or annuity plan maintains a separate account that provides for the payment of medical benefits to retired employees, their spouses, and their dependents, any amount remaining in such an account following the satisfaction of all liabilities to provide the benefits must be returned to the employer even though liabilities exist with respect to other portions of the plan.¹²