The Internal Revenue Service believes tens of thousands of small-business owners and sole proprietors may have invalid Keogh plans, and that a failure to fix the problem could prove to be very costly to them and to advisers.
“Under no circumstances should an accountant or a lawyer permit tax deductions for contributions to an illegal Keogh, or allow the Keogh owner’s survivors to do a rollover to an [individual retirement account],” said Seymour Goldberg, an estate lawyer and pension expert in the Jericho, N.Y., firm of Goldberg & Goldberg PC. “This is a malpractice issue, he said.”
WHEN A KEOGH EXPIRES
Keoghs become invalid when the plan documents aren’t amended to reflect periodic changes in federal law. This happens far more often than plan owners or their advisers realize, Mr. Goldberg said. When a Keogh is invalid, contributions and earnings become taxable, and plan rollovers into IRAs become illegal. Often, the problem surfaces when the client dies.
Technically, a one-person Keogh expires with its owner. In order to postpone income taxes on plan assets, the beneficiaries must roll them into IRAs. But rollovers aren’t permitted unless the Keogh is valid, said Mr. Goldberg.
“If the IRS catches a surviving spouse rolling an invalid plan into an IRA, she’ll owe income taxes on the entire amount, plus a 6% fine for making an illegal IRA contribution,” he said. “And she can turn around and sue her adviser.”
AMENDING INVALID PLANS
The good news is that the IRS has a streamlined procedure for amending invalid plans. If your client dies with an invalid Keogh, his or her executor should submit the plan to the IRS correction program, pay a $750 fine, and get it approved before distributing any assets to the beneficiaries, Mr. Goldberg said. To facilitate this process, he advised any client who acts as his own Keogh administrator to leave instructions that his executor is to become the administrator after his death, and make any necessary amendments to the plan.
A Keogh owner’s surviving spouse can transfer the assets into an IRA in his or her own name. But non-spouse beneficiaries can only do a rollover to an IRA if the plan documents have been amended to allow it — and even then, they can do only a rollover to an inherited IRA. This means the IRA must bear the name of the deceased Keogh owner. It cannot be titled in the beneficiary’s name.
MAKING SURE A KEOGH IS LEGAL
Responsibility for keeping a Keogh legal is shared by its owner/administrator and the financial firm that provided the prototype plan documents.
A special IRS unit called the Master & Prototype Plan is currently trying to determine whether banks, brokerages, insurers and other providers of prototype retirement plans are fulfilling their responsibility to ensure that clients update their plans.
“The IRS is asking to see the letters these firms have sent their clients alerting them to the fact that their plans must be updated,” Mr. Goldberg said.
In his opinion, plan providers are often more conscientious about sending out these reminders than their clients are about responding. “One major broker actually told me it has fired clients who don’t amend their plans — simply told them to take their money elsewhere,” Mr. Goldberg said. Keogh owners sometimes drag their feet about amending an invalid plan, he added, because the cost can include $2,000 or $3,000 in legal and accounting fees as well as the $750 IRS fine.
A COMPLIANCE CHECK-LIST
Tax accountants and estate attorneys are often unfamiliar with Keogh plan documents. To make sure your client’s plan complies with current law:
*Ask the American Society of Pension Actuaries in Arlington, Va., for a current list of Keogh amendments and compare it with the client’s plan document (visit www.asppa.org or call 703-516-9300).
*Ask the Keogh custodian (the sponsoring bank, brokerage, insurer or mutual fund company) for copies of the amendments in its files and compare them with your client’s plan document.
*Ask the client for a copy of his or her plan’s IRS approval letter. Make sure the letter covers amendments at least through 2002. “If the letter is dated prior to 2001, the plan is invalid and you should put the client into the IRS correction program,” Mr. Goldberg said.
It’s also wise to ask the Keogh custodian to confirm in writing whether the beneficiary can transfer the assets into an IRA on the plan owner’s death. “If you can’t get absolute confirmation of this, then your client needs to transfer the Keogh into an IRA while the [Keogh owner] still alive,” said Barry C. Picker, a tax accountant and financial planner at Brooklyn, N.Y.-based Picker Weinberg and Auerbach CPAs.
