When a retirement plan is disqualified from section 401 (a) of the Internal Revenue Code, the plan's trust loses its tax-exempt status and becomes a non-exempt trust. Tax legislation and administrative details that may seem trivial or irrelevant can actually be critical to maintaining a plan's qualification. If a plan loses their eligibility status, each participant pays taxes on the value of their benefits acquired after the date of disqualification. This can result in large (and completely unexpected) tax obligations for participants.
For employers If your retirement plan is disqualified, your deductions for plan contributions may be restricted and delayed. Once a plan is disqualified, different rules apply to how much an employer can deduct for plan contributions and when deductions are allowed. Unlike contributions to a qualified plan, contributions to a trust for non-exempt employees cannot be deducted until the contributions are included in employee gross income. Employers that sponsor a defined benefit plan (or another plan that doesn't maintain separate accounts for each employee) can't deduct any contributions.
What happens if qualification status is lost? If the Internal Revenue Service (IRS) determines that a plan is disqualified, it's not just the employer who is affected. Employees who received contributions from the employer must report them as income, which could result in a modification in the filing of tax returns and due taxes. The Plan Trust that holds the assets owes income tax on the trust's profits. Plan renewals are no longer tax-exempt and are subject to taxation.
Employer contributions are subject to Social Security, Medicare and Federal Unemployment taxes, and employer deductions are limited. The IRS also has plan repair guides for 401 (k), SARSEP, SEP and IRA SIMPLE plans that help you fix the most common errors; find, correct and avoid errors; and a link to an overview of the Employee Plan Compliance Resolution System.