September, 1998 Vol III, No.1

Keogh Panic (Forbes 10 August 1998)

A doctor forgot to sign some apparently meaningless mumbo jumbo. The IRS said "Gotcha!" and threatened to hit him up for $45,000.

There's a big mess out there having to do with retirement plans for small businesses and self-employed people. If you have a Keogh, 401(k) or other non-IRA plan, beware: One small paperwork error from the past may cost you $2,000.

The mess is that more than 100,000 of such plans don't comply with current law, estimates Seymour Goldberg, an attorney in Garden City, N.Y. Compounding it is the fact that owners may be eyeing a rollover of assets into a regular IRA and then to a Roth IRA. But if the plans are illegal, the rollovers will be tainted, causing even bigger headaches.

Defects in retirement plans can be either matters of substance (an ophthalmologist neglects to include her nurse) or matters of form (you didn't sign the right documents). For some reason the Internal Revenue Service is fixated on matters of form. Auditors love the rituals.

But you can blame Congress, not the IRS, for creating the mess. According to Marcia Wagner, a pension attorney in Boston, lawmakers have changed the pension rules a stupefying 21 times since they were enacted in 1974. "There's no way the average person could keep up with the changes, and neither could his accountant," says Goldberg.

Even the simplest plans (one participant, less than $100,000 of assets) have been affected by changes on spousal rights, contribution formulas and distribution rules. At a bare minimum, all plans in existence since 1986 should have been amended once, and those dating to 1982 should have been amended twice.

What's an amendment? It might be a few pages of gobbedly gook sent to you by your plan sponsor, such as Fidelity or Merrill Lynch. Maybe you thought it was a proxy and tossed the paperwork. Big mistake. Faced with the huge population of nonconforming pension plans, the IRS has-sort of- done what it can to ease things. Earlier this spring the taxman issued Rev. Proc. 98 22 (available at www.irs.ustreas.gov). For screwed-up plans, it is in effect an amnesty, although the IRS is allergic to that term.

For substantive errors,including mistakes in who is covered and what's paid in or out, the amnesty is pretty generous. But for an error of form-for example, you didn't sign those amendments on time-the punishment is draconian.

Carol Gold, IRS director of employee plans, explained for FORBES how all this works. She's talking about Keoghs, 401(k)s and other small plans, but not IRAs. And she's talking to business owners and the self -employed, not employees.

1. Check your plan. If you find a mistake in how your plan is run (in IRS lingo, "operational mistake") and correct it within two years, you don't even have to tell the IRS. Simply be able to show, if you are ever audited, that the mistake was found and corrected.

2. If any operational mistake is "insignificant" you may correct it without telling the IRS, no matter when it happened. Again, be ready to demonstrate all this on audit.

Say that for estate planning reasons you made your children the heirs of your Keogh several years age, under a 1984 law change, you can't do this without written consent from your spouse. Get your husband or wife to sign right now.

Unfortunately, few matters involving forms are insignificant. In particular, if you missed a deadline for amending your plan, that's "significant" and brings a stiff penalty, even if your plan has no other problems.

3. If your mistake doesn't fall into one of the above categories, you must got to the IRS. For operational problems that aren't egregious, there's the 'voluntary compliance resolution" program. Then you would correct it and pay any taxes, interest, penalties due, plus a fee of $500 or more.

If the operational mistake is worse or your plan document has a defect, turn to the IRS' " walk-in closing agreement" program. You confess your sins and pay a fee. For plans covering one to ten persons, the penalty ranges from $1,500 to $4,000, with a probable amount of $2,000. And, of course, you undo the damage to innocent parties. A loyal employee may be due a boost in his profit-sharing account.

A $2,000 fine is one thing for a business owner who stiffed a worker. But why stick it to law-abiding plan owners who forgot to fill out papers? Here the IRS is adamant, because, in its bureaucratic eyes, without proper forms there's no accountablilty. Gold confirms that for most taxpayers with form problems, the penalty will be $2,000 (plus lawyer's fees) to get a clean slate.

Next problem: How do you know if your plan is in good shape? Well, operational defects are always your responsibility, and if your plan was custom designed, the forms are your problem too, so check with a lawyer.

If you used a prototype plan from a bank, broker or mutual fund, the sponsor was responsible for updating the plan, which all of them did. However, the IRS says you must have signed copies agreeing to certain changes, and they must be in your own files or the sponsors.

We queried several sponsors about this issue for small plans. Four of them- Putnam, Schwab, Vanguard, T. Rowe Price - said they keep the forms in their own files, so they can tell shareholders if they are up to date. Two others - Merrill Lynch and Fidelity - don't, for most owners.

If you're in doubt, here's a suggestion put forth by several experts: Call your sponsor and ask for an up-to -date adoption agreement. Sign it. If it later turns out you didn't do so the first time around, at least the new documents stop the penalty clock on your mistake. And maybe the IRS won't notice.

If it does, however, beware: You can't then use the amnesty. Goldberg cites the recent case of a suburban New York doctor with $1 million-plus in his Keogh who forgot to amend but otherwise had no problems. The agent proposed settling for $45,000, the later reduced that to $5,000.

Sick of all this? You could always clean up your plan, the roll it into an IRA and switch to something simpler, though maybe less flexible.

Yes, our tax system is an atrocity. But until the public gets mad enough to demand changes, you'd better make darned sure you dot your i's and cross your t's. - L.S.