Written by Kristina Kananen

There are so many rules and regulations associated with the administration of qualified retirement plans, that plan fiduciaries are hard pressed to operate an error-free plan, the requirement to maintain the qualified status of the plan.  In the early years after ERISA was passed, government agencies charged with overseeing qualified plans assumed plans would be error-free because, of course, that was the rule.  It did not take too long for them to realize that many plans had failures to comply.  Not failures caused by fraud or theft, but failures caused by math errors, absence of those employees trained in operating the plan due to vacation or illness with no trained back up or just failures caused by missing one step in payroll processing.  Disqualification of a plan with such failures seemed a bit extreme and counter to the government goal of helping Americans provide for their own retirement.

Then in the 1990’s the IRS issued the Employee Plan Compliance Resolution System (EPCRS) which provided correction methods for the most common failures found in qualified plans.  There are three main categories in EPCRS; Self-Correction Program (SCP), Voluntary Correction Program (VCP) and Audit Cap.  VCP (available for egregious failures and certain significant failures) and Audit Cap (applies when an IRS auditor finds the failures), require submission to the IRS for approval of the correction planned.  The SCP allows eligible plans to make corrections without involving the IRS and without paying penalties.

The basis for determining which program must be used can be based on whether the failure(s) are operational or document in nature and are considered to be significant or insignificant.  Operational failures occur when the provisions of the plan are not followed in the administration of the plan.  Document failures occur when a plan is not timely restated under the six-year cycle or required amendments due to law changes are not added to the plan document within the required timeframe.  The difficulty is in determining if the failure is significant or insignificant.

There is no rock-solid definition of significant versus insignificant.  You cannot ask the IRS to make a determination of whether your situation is significant or insignificant as they will not tell you.  They will expect you to make your own determination and follow through on the appropriate correction program.  The question becomes what criteria is needed to determine if your failure is significant or insignificant.  The IRS has provided a list they would consider in determining the significance of a failure:

Were there other failures at the time this failure occurred?

Were there several types of failures occurring in the same plan year or was there only one type of failure?

What is the percentage of assets and contributions involved to the total assets and contributions?

Was a large percentage of the plan assets or contributions involved in the failure or only a small percentage?

How many years has the failure occurred?

Did the failure occur in one plan year or was it repeated over several years?

What is the ratio of participants involved in the failure to the total participants in the plan?

In comparison with all the participants, was a large percentage affected by the failure?  Or were only a small percentage of participants affected?

What is the number of participants who were affected to the total participants who could have been affected?

For example, if there were 10 new participants eligible to make deferrals to the plan, did the Plan Sponsor fail to withhold deferrals for only a few of them, or for all of them.

Was the failure corrected within a reasonable timeframe?

Did the Plan Sponsor bring the plan back into compliance as soon as they discovered the problem, or did they leave it for several years?

Why did the failure occur?

Was there an error in the data used or were there math errors?

Who is eligible for SCP?  A Plan Sponsor of a Qualified Plan or a 403(b) Plan is eligible to use SCP to correct insignificant and significant Operational Failures as long as it meets the requirement to have Practices and Procedures in place to help ensure the plan complies with qualified plan laws and regulations.  Significant Operational Failure corrections must be completed or substantially completed by the last day of the 3rd plan year following the plan year of the failure to be eligible for SCP.  Document Failures can be corrected as long as there is a Letter of Determination for the plan document.  At one time, the letter of determination was issued to the Plan Sponsor, and still may be if the plan document is considered individually drafted.  Now, the Letter of Determination is issued to the Document Sponsor, which also covers the adopting Plan Sponsor.  All Document failures are considered Significant, those that are eligible for correction under SCP must also be corrected by the end of the 3rd plan year following the plan  year of the failure to use SCP.  However, failure to adopt the initial document or to timely adopt a written 403(b) document are not eligible for correction under SCP.

An eligible plan sponsor must have Practices and Procedures in place to promote and facilitate overall compliance in both form and operation with applicable requirements of the Internal Revenue Code (the Code).  These Practices and Procedures must have been in place and routinely followed and the operational failure or document failure occurred because of an oversight or mistake in applying them. Such Practices and Procedures:

  • Can be in formal or informal format (An all-encompassing handbook or a list of tasks for a specific function);
  • Must be routinely followed;
  • Need not be in place for a specific failure as long as some procedures exist that show an overall effort to comply;
  • Are in addition to the plan document. The document is not enough evidence of having Practices and Procedures; and
  • Can be a checklist that is routinely followed.

The IRS looks for an effort on the part of the Plan Sponsor to comply with the Code.  They make every attempt to apply their rules in a way to ensure small businesses are eligible to use the Self-Correction Program.  Having Practices and Procedures allows the Plan Sponsor to participate in the SCP without fees.

There are two categories of failures under the SCP; Operational Failures and Document Failures.  An Operational Failure is the failure to follow plan document provisions in the administration of plan duties.  An example would be failing to enroll a new participant in a 401(k) plan so they do not have the opportunity to make elective deferrals.  A Document Failure is the failure to timely adopt a required restatement or a required amendment.  All of these failures must follow Correction Principles under EPCRS:

  • A failure is not corrected unless full correction is made with respect to ALL Participants and Beneficiaries for all taxable years.
  • The correction method should restore the plan to the position it would have been in and restore current and former participants and beneficiaries to the benefits and rights they would have had if the failure not occurred.
  • The correction should be reasonable and appropriate. Appendix A and B of the EPCRS offers methods of corrections, but other particular correction methods can be considered reasonable and appropriate under the applicable facts and circumstances and the following principles.  The correction method should:
    • Resemble a correction method already provided for in the Code, regulations or other guidance;
    • Keep plan assets in the plan, except when the correction requires a distribution to participants or beneficiaries or return assets to the employer;
    • If related to nondiscrimination, provides benefits to non-highly compensated employees;
    • Not violate another specific requirement of 401(a) or 403(b); and
    • Allow Compliance with a correction method of another government agency with interpretive authority which the IRS will recognize.
  • If more than one correction method is available, the same method should be applied to failures of the same type that occurred in a plan year.
  • Corrective Allocations and corrective distributions under a defined contribution plan must use the following principles:
    • Defined Contribution Plans should apply the terms of the plan (including the compensation that would have been used under the plan for the period) and the corrective allocation must be adjusted for earnings and forfeitures that would have been allocated to the participant’s account if the failure had not occurred. A corrective allocation need not recognize losses but can.
    • A corrective allocation due to the failure to make a required allocation in a prior limitation year is not considered an annual addition for the participant for the year of correction. However, it is considered an annual addition for the limitation year in which it should have been made and may impact 404 deductions for the year of the failure.
    • Corrective allocations should come only from employer nonelective contributions and, if the plan permits their use to reduce employer contributions, forfeitures.
  • Full correction of a failure is required, but there are exceptions to this requirement as long as the correction method adopted does not have significant adverse effects on participants and beneficiaries or on the plan and does not discriminate in favor of highly compensated employees. These exceptions are:
    • If it is possible to make precise calculations but the probable difference between the approximation and the precise calculation is insignificant or the administrative cost of determining precise restoration significantly exceeds the probable difference OR if it is not possible to make a precise calculation, reasonable estimates may be used, such as using the Department of Labor’s VFCP Online Calculator to determine lost earnings.
    • If the total corrective distribution due to a participant or beneficiary is $75 or less, the Plan Sponsor is not required to make the corrective distribution if the costs of processing and delivering the distribution exceeds the distribution.
      • Corrective Contributions must be made regardless of the amount
    • If the correction calculation results in an overpayment to a participant or beneficiary of $250 or less, the Plan Sponsor is not required to seek the return of the overpayment and is not required to notify the participant or beneficiary that the overpay of $250 or less is not eligible for favorable tax treatment, such as tax-free rollover.
    • If a participant or beneficiary is lost and the Plan Sponsor has taken every action required to locate them, but has failed, the Plan Sponsor will not be considered to have failed to correct a failure, as long as the additional benefits are provided to the participant or beneficiary when they are found.
    • If the Excess Amount corrective distribution for a participant totals $250 or less, the Plan Sponsor is not required to distribute or forfeit such Excess Amount. However, if the Excess Amounts exceeds a statutory limit the participant or beneficiary must be notified that the Excess Amount and any gains are not eligible for favorable tax treatment.
  • A participant is generally responsible for paying the corrective amount for a plan loan failure, but the employer may have to pay a portion of the correction payment equal to the interest that accumulates as a result of the failure
  • Excluding employees with respect to elective deferrals or after-tax employee contributions is corrected with a contribution to the plan on behalf of the excluded employee an amount that makes up for the value of the lost opportunity for the employee to have a portion of his compensation contributed to the plan accumulated with earnings tax deferred in the future. (Using the wrong compensation is one of the most common failures.)
  • Plan Amendments can be used to correct an operational failure to conform the terms of the plan to the way the plan has been operated.
  • Any corrective distributions from the plan should be properly reported for tax purposes.
  • If spousal consent was not obtained at the time of a distribution, it should be obtained from the spouse, or
    • The participant can repay the distribution and receive a Qualified Joint and Survivor Annuity;
    • The plan is liable to pay the spouse a benefit equal to the portion of the qualified joint and survivor annuity that would have been payable to the spouse upon the death of the participant had a qualified joint and survivor benefit been provided to the participant under the plan at the annuity starting date for the prior distribution.
    • The Plan can offer the spouse a choice between a survivor annuity or a lump sum payment equal to the actuarial present value of that survivor annuity benefit.

A plan that is under examination can still be eligible for SCP to correct insignificant failures, even if the IRS agent discovered the failure.

Section 8 of Revenue Procedure 2021-30 has several examples of insignificant failures.  Section 9 of the Revenue Procedure gives examples of significant failures as well as the timeframe within which the correction must be made to be eligible for SCP. The IRS plans to provide additional examples illustrating whether a failure is insignificant and to hopefully link the examples to their “Correcting Plan Errors” page.

Appendix A “Operational Failures and Correction Methods” provides safe harbors for correcting failures.  There may be several reasonable and appropriate correction of the failure and the Plan Sponsor can choose the one that best suits him as long as the basic principles of SCP are met. Correction methods are included for failure to:

  • Provide minimum top-heavy benefits to non-key employees;
  • Satisfy the ADP test or the ACP test;
  • Distribute elective deferrals in excess of the maximum allowable elective deferrals;
  • Include all employees eligible for contributions for one or more plan years;
  • Enroll participants for deferral and employer match purposes;
  • Allow participants to make designated Roth contributions;
  • Allow catch-up contributions by participants meeting the age requirements for the catch-up;
  • Implement a participant election for deferral elections in a timely manner;
  • Implement a participant election to make after-tax employee contributions in a timely manner;
  • Provide matching contributions that would have been provided under the plan, but for the failure to implement employee deferral elections;
  • Satisfy the universal availability requirement of a 403(b) plan;
  • Meet the requirements of an automatic contribution feature in 401(k) or 403(b) plans;
  • Pay required minimum distributions;
  • Obtain participant or spousal consent for a distribution;
  • Satisfy §415 limits on annual additions in a defined contribution plan; and
  • Provide for the proper handling of a qualified plan because the Plan Sponsor has ceased to exist making the plan an Orphan Plan.

Appendix B “Correction Methods and Examples, Earnings Adjustment Methods and Examples” provides additional information on the actual calculation needed to correct the failures.  As seen with Appendix A, there have been many failures over the years.  Appendix B consists of 43 pages of the how to’s to correct the failures listed in Appendix A.

While maintaining a qualified plan can be complicated and the Plan Sponsor may miss the mark in complying with the Code, regulations and procedures issued by the IRS, the IRS has provided a gateway to correcting the failures without the burden of fees.  The Plan Sponsor must prepare for the possibility of a failure by maintaining Practices and Procedures to ensure the plan’s compliance.  The Practices and Procedures keeps the door open to Self-Correction.

 

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