[Revision - February 5, 2016. At the request of the taxpayers involved we have removed the names of the individuals from the Tax Court opinion paragraph cited below.]

A number of bad consequences will follow from the IRS finding that a purportedly qualified retirement plan wasn’t actually qualified. In such a case the trust will generally be treated as a taxable entity rather than a tax exempt one. As such, the IRS does not often take this drastic step, but it did in the case of DNA Pro Ventures, Inc. v. Commissioner, TC Memo 2015-195.

The corporation argued that the IRS action was an abuse of discretion in this case, but the Tax Court did not agree.

The IRS asserted two separate problems in the operation of the retirement plan (which was structured as an ESOP) that justified disqualification.

The first problem was that the plan received shares of stock and allocated them to individuals for a year in which the corporation paid no compensation, violating the limitations on allocations to employees under the plan each year. The Tax Court noted:

Neither Dr. [name redacted] nor Mrs. [name redacted] received any compensation for his or her services as a DNA officer or employee during 2008. Accordingly, their contribution limits were zero. Because DNA improperly transferred to Dr. Prohaska's ESOP account 1,150 shares of DNA's class B common stock in 2008 (with a $10 par value per share), the annual addition to his account was $11,500 more than his contribution limit under section 415(c). Accordingly, because Dr. [name redacted]'s ESOP account received an annual addition in excess of the section 415(c) limitation, the ESOP failed the requirements of section 401(a)(16) and was not a qualified plan for 2008. Moreover, because the section 415 failure is a continuing failure, the ESOP failed section 401(a)(16) for 2008 and was not a section 401(a) qualified plan for all subsequent plan years.

As well, the plan failed to obtain appraisals from an independent appraisal of the value of the stock each year, as required by IRC §401(a)(28)(C) and the plan document itself. The Court opinion holds:

…[S]ection 6.2 of the plan document requires a good-faith valuation to determine the fair market value of the securities. Similarly, section 6.1 of the plan document requires that valuation of the trust fund be made on each valuation date. Despite these requirements, the ESOP did not obtain any annual appraisals in 2008, 2009, and 2010, resulting in an operational failure rendering the ESOP not a section 401(a) qualified plan because the ESOP was not a "definite written program". See sec. 1.401-1(a)(2), Income Tax Regs. Moreover, because the failure to follow the plan is a continuing failure, the ESOP was also not qualified for the plan years ending December 31, 2009 and 2010.