Sometimes it’s difficult to get clients to understand that when Congress gives a tax break, they impose conditions that must be met to maintain that break. That’s especially true with items such as retirement plans where some or all of the funds in there are, in the client’s view, my money that can be dealt with just like any other of my property.

In the case of Family Chiropractic Sports Injury & Rehab Clinic, Inc. v. Commissioner, TC Memo 2016-10, the taxpayer’s failure to respect the requirements to maintain a qualified retirement plan proved fatal to the hoped for tax benefits.

One of the key protections provided to qualified retirement plans relates to the anti-alienation rules. The good news is that such rules effectively insulate the assets inside the plan from the claims of creditors. But the plan must have provisions that require such protections be applied and it must actually comply with such requirements in practice.

The plan in question was an employee stock ownership plan (ESOP) for the corporation. The corporation was wholly owned by a chiropractor and both he and his wife were employees of the corporation. Both were covered by the plan and had accounts in the plan.

The plan contained the following provisions regarding protecting employee’s benefits via the anti-alienation provisions:

11.2 ALIENATION

(a) Subject to the exceptions provided below, and as otherwise permitted by the Code and Act, no benefit which shall be payable out of the Trust Fund to any person (including a Participant or the Participant's Beneficiary) shall be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, or charge, and any attempt to anticipate, alienate, sell, transfer, assign, pledge, encumber, or charge the same shall be void; and no such benefit shall in any manner be liable for, or subject to, the debts, contracts, liabilities, engagements, or torts of any such person, nor shall it be subject to attachment or legal process for or against such person, and the same shall not be recognized by the Trustee, except to such extent as may be required by law.

(b) Subsection (a) shall not apply to a "qualified domestic relations order" defined in Code Section 414(p), and those other domestic relations orders permitted to be so treated by the Administrator under the provisions of the Retirement Equity Act of 1984. The Administrator shall establish a written procedure to determine the qualified status of domestic relations orders and to administer distributions under such qualified orders. Further, to the extent provided under a "qualified domestic relations order," a former spouse of a Participant shall be treated as the spouse or surviving spouse for all purposes under the Plan.

Eventually the marriage soured and the parties were divorced. One of the steps that has to be undertaken when unwinding a marriage is dividing up the property in question, and this is where the problems began for the plan.

As the above provision notes, the only way a participant’s benefit can be assigned to a former spouse is via a qualified domestic relations order which meets specific requirements. Unfortunately it does not appear that anyone involved with the plan or the parties’ divorce appeared to under that matter—and that was a major oversight.

The Tax Court describes the details of their divorce and how they dealt with the ESOP benefits of the non-chiropractor:

On April 5, 2007, Richard and Heidi divorced. Pursuant to the final divorce decree filed in the Seventh Judicial District Court, County of Muscatine, State of Iowa, each was awarded 50% of Family Chiropractic's shares of stock, ownership, and management. The decree is silent as to the ESOP.

As reflected in several corporate documents, on May 27, 2009, Heidi agreed to “relinquish her retirement value” in the ESOP “in accordance with the divorce decree” and resigned as Family Chiropractic's director, vice president, and secretary. As of June 30, 2009, the ESOP’s summary of participant accounts reflected that each ESOP account of Heidi and Richard included 14.95 class B stock shares at a total value of $286,904.53 and that all the shares were 100% vested. Heidi’s ESOP shares were subsequently reallocated to Richard's account, as recorded in the June 30, 2010, report, rendering her account with zero shares 0% vested. The June 30, 2010, report reflects that Richard had a $482,851.138 account balance with 29.9 class B stock shares. During its 2010 plan year the ESOP did not distribute any assets to Heidi.

The taking of the balance from Heidi and transferring it to Richard was the big problem here, since that transfer did not take place pursuant to a qualified domestic relations order—rather they just decided to transfer it over.

The IRS revoked the plan’s tax exempt status based on this transaction. The IRS justified this by noting:

The 2010 reallocation of shares from Heidi's ESOP account to Richard's ESOP account caused the ESOP to fail the section 401(a)(13) requirements for its 2010 plan year and for all subsequent plan years;
By transferring Heidi's ESOP benefit to Richard at her termination, the ESOP failed to follow its written terms in operation and therefore failed to be a qualified plan within the meaning of section 401(a) for its 2010 plan year and for all subsequent plan years

Retirement plans must both have proper documentation that provides it will meet the requirements (generally found in IRC §401(a)) to be a qualified plan and then it must actually operate in accordance with those documents. As the Court explains:

A qualified plan must meet the section 401(a) requirements in both form and operation. Ludden v. Commissioner, 620 F.2d 700, 702 (9th Cir. 1980), aff’g 68 T.C. 826 (1977); sec. 1.401-1(b)(3), Income Tax Regs. A form failure occurs when a plan document does not contain required language or terms. See Michael C. Hollen, D.D.S., P.C. v. Commissioner, T.C. Memo. 2011-2. An operational failure occurs when: (1) a plan, in operation, does not meet the section 401(a) requirements, see Martin Fireproofing Profit-Sharing Plan & Tr. v. Commissioner, 92 T.C. 1173 (1989), and (2) a plan fails to follow the terms of the plan document, see Michael C. Hollen, D.D.S., P.C. v. Commissioner, T.C. Memo. 2011-2. A plan that does not follow the terms of the plan document is not a “definite written program” as required by section 1.401-1(a)(2), Income Tax Regs.

As well, once a plan suffers a disqualification event, the impact goes forward into all future years. As the Court notes:

In general, a qualification failure pursuant to section 401(a) is a continuing failure because allowing a plan to requalify in subsequent years would be to allow a plan “to rise phoenix-like from the ashes of such disqualification and become qualified for that year.” Pulver Roofing Co. v. Commissioner, 70 T.C. 1001, 1015 (1978); see also Martin Fireproofing Profit-Sharing Plan & Tr. v. Commissioner, 92 T.C. at 1184-1189.

As the Court noted, the plan simply wasn’t operated in accordance with either the requirements of the law or the plan document:

Pursuant to the May 27, 2009, corporate documents, and relying upon the divorce decree, Heidi transferred 100% of her ESOP shares and relinquished any rights she had under the ESOP. The ESOP’s June 30, 2009 and 2010, reports reflect that 100% of the shares allocated to Heidi on June 30, 2009, were reallocated to Richard’s account as of June 30, 2010.

Before April 5, 2007, Richard and Heidi, husband and wife, were also Family Chiropractic’s sole employees and ESOP participants. Although the 2007 divorce decree dissolved the Leavitt marriage, it is insufficient to allow the transfer of plan assets that transpired in this case. See, e.g., Rodoni v. Commissioner, 105 T.C. 29 (1995). Transferring the vested shares from Heidi’s account to Richard’s caused Heidi’s ESOP account to become alienated from her after it became fully vested. By violating section 401(a)(13), the plan ceased to be qualified. Accordingly, we hold that respondent did not abuse his discretion in disqualifying the ESOP for its 2010 plan year and for subsequent plan years.

Clients may have a tough time understanding the result. After all, nowhere was it alleged that Heidi objected to the transfer of her interest to Richard—but that’s not the issue.

Rather the taxpayers availed themselves of a significant tax benefit by setting up the qualified plan where a deduction was allowed to the corporation for transfers made for their benefit, but they did not have to personally pay tax at the time of the transfer. In exchange for that benefit, Congress required strict compliance with the rules—and, in this case, that simply didn’t happen.