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Multiple Employer Plans: IRS Takes a Big Bite Out of the “One Bad Apple” Rule

The DOL recently released new rules that expanded access to retirement plans for small businesses. In conjunction with these changes the IRS proposed rules that would largely take a bite out of the longstanding “one bad apple rule” for multiple employer plans (MEPs). As it stands today, under Internal Revenue Code (IRC) Section 413(c), one participating employer’s failure to satisfy any plan qualification requirement, even minor innocent plan operation errors, could cause the entire MEP to lose its tax-qualified status.

Unified plan rule.

For over 40 years, IRC Section 413(c) and Treas. Reg. Section 1.413-2(a)(3)(iv) have provided that if a single participating employer in an MEP is non-compliant with any tax-qualification rules, the entire plan and all the other participating employers are at risk of disqualification. This so-called “one bad apple,” or “unified plan,” rule has dissuaded many employers from joining an MEP. Although a legislative change would be needed to repeal the rule, the IRS has released a proposed regulation crafting an administrative procedure where a defined contribution MEP could isolate a “bad apple” from the rest of the bushel, thereby limiting the adverse consequences to the offending spun-off plan. The proposed regulation also includes a procedure for suspected plan qualification errors made by a bad apple employer similar to the procedure for known plan qualification failures committed by the offending employer.

Three strikes and you’re out.

Under the proposed rules, the process for dealing with a bad apple is lengthy and complicated. The MEP must give a bad apple employer three written notices following a specified time cadence. If the employer does not take prompt corrective action, the MEP must expel the employer from the plan by automatically spinning off the employer’s portion of the MEP into a stand-alone, single employer plan, and terminating the spun-off plan. The MEP also must notify participants in the problematic plan before the spin-off/termination, stop accepting contributions from that employer and notify the IRS on a form that the IRS will create for this purpose. All unvested participants of a bad apple employer will become vested due to plan termination and the MEP will process plan termination distributions to affected participants. Tossing the bad apple out could take a full year to implement.

Which MEPs are eligible?

To qualify for the relief, the defined contribution MEP must have good internal controls that facilitate overall compliance and cannot be “under examination”; these are some of the same requirements for participating in IRS’s Employee Plans Compliance Resolution System (EPCRS) self-correction program for tax-qualified retirement and 403(b) plans. The plan document must also include certain language describing the non-responsive bad apple spin off procedures – but the IRS intends to issue a model plan amendment setting out sample language. Finally, the problem must be caused by an unresponsive participating employer and cannot be an overall plan problem.

The proposal is unclear about whether the cost of sending the notices to the bad apple employer, along with isolating and terminating that portion of the plan, can be charged to that employer’s participants’ plan accounts or if it is an overall cost that the plan as a whole will need to bear.

Additionally, the proposal isn’t clear about whether distributions from the terminated bad apple plan are eligible for rollover, since the source of the funds is a plan that is known to have a qualification failure.

If you have questions about how this may affect your small business or whether an MEP makes sense for your business, contact a member of our Retirement Plan Advisory Team.

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