The IRS targets small pension plans - Internal Revenue Service audits

Nation's Business, May, 1991 by Roger Thompson

The IRS Targets Small Pension Plans

When it came to compliance with federal pension laws, Fran Morgan played strictly by the book. He voluntarily sought, and obtained, Internal Revenue Service letters of approval when he set up his restaurant management company's four-person retirement plan in 1983 and again when he ended the plan in 1989.

Now Morgan, president of Morgan Restaurant Management, in Fullerton, Calif., can't understand why the IRS is throwing the book at him for allegedly pouring too much money into the plan. The IRS contends that he owes $80,000 in back taxes plus $50,000 in penalties and interest because he made excess plan contributions. The approval letters Morgan received, it seems, did not specifically address the issues raised by the IRS's later audit.

"The thing that bothers me most," says Morgan, whose company manages 11 restaurants, "is that I paid the IRS a fee to examine my plan and determine whether everything was all right. Twice they said it was fine. Then they come back and say that I owe $130,000. It just doesn't make any sense."

The same, or much worse, often is said of the IRS's audit program for small pension plans--the program that snared Morgan's retirement plan for scrutiny.

The program is "illegal and abusive," fumes Chester J. Salkind, executive director of the American Society of Pension Actuaries, in Washington, D.C.

"Arbitrary and driven by the need to raise revenue to fight the [federal budget] deficit," says Bruce Ashton, Morgan's attorney in Los Angeles.

"Highly unethical and immoral," complains E. William Berke, president of Benefit Associates Inc., in Orange, Calif., and a member of an IRS advisory committee on pensions.

The IRS declined to comment on any of these accusations.

Beginning in November 1989, the IRS targeted for special audits defined-benefit pension plans that covered one to five persons at any time during 1986 through 1988. The agency suspected that within those plans were thousands of highly paid professionals--such as doctors and lawyers--and successful business owners who were larding their pension plans with excessive tax-deductible contributions. These high-income individuals used their pension plans as illegal tax shelters, says the IRS.

The agency trained its sights on plans with the greatest potential for abuse--those with annual contributions exceeding $100,000 per participant. In effect, the IRS targeted very small plans, because few with more than five participants have annual contributions that large. By contrast, the average pension-plan contribution is about $5,000 a year per participant.

While there is nothing inherently illegal about six-figure payments to a pension plan, the IRS maintains that such large sums often reflect the use of unreasonably low interest-rate and retirement-age assumptions in computing plan contributions. The lower the assumed interest rate on plan investments and retirement age of plan participants, the greater the annual tax-deductible contribution needed to reach the plan's retirement-income goals. In the IRS's view, many small-plan sponsors pick unreasonably low interest and retirement assumptions to inflate their plan contributions.

The audits focus on the issue of reasonableness because Congress did not specify what interest rates and retirement ages should be used in designing pension plans. Lawmakers deliberately avoided picking specific numbers because plan sponsors need flexibility to tailor plans to their needs. Over the years, the IRS has attempted to interpret Congress' mandate of flexibility in terms of "reasonable" interest rate and retirement age assumptions.

Under the small-plan audit program, the IRS says it is unreasonable to assume an interest rate lower than 8 percent or retirement before age 65. Because it figured most small plans would flunk one or both of these tests of reasonableness, the IRS projected that he audits would rise $666 million in taxes, interest, and penalties.

To date, the IRS has completed some 3,000 small-plan audits and has disallowed tax deductions averaging $111,000 in about 80 percent of those cases, says an IRS official, who spoke on the condition that he not be identified. The remainder have been dismissed with no change. More than half of the audits involved plans covering a single participant. The IRS now says that about 14,000 plans will be audited, down from the initial estimate of 18,000.

Whatever the merits of the IRS audit program, it has touched off a storm of protest from those affected. The U.S. Tax Court has been flooded with challenges; the IRS has lost two Freedom of Information Act lawsuits and has been required to release internal documents relating to the audit plan; and there have been threats of legislation to halt the audits.

In a Feb. 6 letter to IRS Commissioner Fred T. Goldberg, Rep. Nancy Johnson, R-Conn., detailed her strong objections to the audit program and concluded: "Unless the small-plan actuarial audit program is substantially constrained administratively, I fully expect the [House] Ways and Means Committee, with my strong support, to address this matter legislatively."