Given the complex
nature of administering qualified retirement plans in accordance
with ever-changing pension law, mistakes are inevitable. When the
IRS discovers plan mistakes through audit, the plan risks being
disqualified which results in severe consequences to the plan
sponsor and participants.
Fortunately, the IRS recognizes that mistakes are a fact of life
and has responded by developing voluntary error resolution programs.
It has also posted on its web site the top ten failures reported
through these resolution programs. Since the IRS recently announced
its intent to conduct more audits this year, plan sponsors should
become aware of the more common types of compliance problems and, if
found in their plans, voluntarily correct errors by using the IRS
correction programs rather than take a chance that an audit will
reveal the mistakes.
In order to reap tax advantages, qualified plans are responsible
for complying with complex IRS requirements. Failure to meet these
requirements can lead to plan disqualification which results in
severe consequences including:
- Prior corporate deductions are reversed;
- The plan trust becomes taxable;
- Participants are subject to immediate income taxation of
vested contributions made on their behalf and cannot roll over
these amounts into an IRA or another qualified plan; and
- Plan fiduciaries may face the risk of lawsuits by
participants who were forced to prematurely recognize income.
To create awareness of common errors that may result in plan
disqualification, the IRS has released the following list of the top
ten failures found in the Voluntary Correction Program.
Top 10 Plan Qualification Failures
- Failure to timely adopt amendments required by tax law
- Failure to follow the plan definition of compensation for
determining contributions. This error results when certain types
of compensation are incorrectly excluded or included (such as
bonuses, commission or overtime) which can result in
participants receiving either higher or lower contributions than
the amount they should have received.
- Failure to include eligible employees in the plan or failure
to exclude ineligible employees from the plan. By making this
mistake, eligible employees may not receive contributions they
are entitled to receive. Conversely, the employer may be making
contributions for employees who are not entitled to receive
- Failure to satisfy loan provisions. Errors regarding loan
provisions include failure to withhold loan payments which
results in a defaulted loan, issuing loans that exceed the
maximum dollar amount (generally the lesser of 50% of the vested
account balance or $50,000) and loans with non-compliant payment
- Impermissible in-service withdrawals. This failure can occur
when a distribution is made to a participant and the law or plan
terms do not permit a distribution. For example, making a
hardship distribution even though the plan does not permit
- Failure to satisfy the minimum distribution rules. In
general, participants who fall into the following two categories
must begin receiving minimum distributions: (1) more than 5%
owners who have reached age 70½, even if they are still actively
employed; and (2) non-owner employees who have terminated
employment and have reached age 70½.
- Employer eligibility failure. In this failure an employer
adopts a plan that it legally is not permitted to adopt. For
example, the adoption of a Code Section 403(b) plan by an
employer that is not a tax-exempt organization.
- Failure to pass ADP/ACP nondiscrimination tests. This
failure can occur for a variety of reasons including incorrectly
classifying employees as either Highly Compensated or non-Highly
Compensated employees, using incorrect compensation for testing
purposes or excluding from the test eligible employees who
elected not to participate in the 401(k) plan.
- Failure to properly provide top heavy contributions to
non-Key employees. In general, a plan is considered to be top
heavy if more than 60% of the plan assets are for Key employees.
If the plan is top heavy, non-Key employees are entitled to
receive minimum contributions. One error that can occur is not
using total compensation to calculate the minimum
contribution--total compensation must be used even if the plan
has a different definition of compensation for allocation
purposes. Also, a 1,000 hour requirement cannot be imposed even
if it is required by the plan for allocation purposes.
- Exceeding the annual contribution limits. The law limits the
annual amount of contributions a participant can receive in a
defined contribution plan. The annual limit is the lesser of
100% of compensation or an indexed dollar amount ($49,000 for
2009). If not monitored correctly, this limit can be exceeded
when taking into account the total of all employer
contributions, employee deferrals and forfeitures allocated to
the participant's account (all plans sponsored by the employer
and related employers must be aggregated for purposes of this
Plan sponsors who uncover plan qualification failures, such as
those listed above, should promptly take advantage of the IRS's
Employee Plans Compliance Resolution System.
Employee Plans Compliance Resolution System
EPCRS is a series of correction programs that can be used by plan
sponsors to correct common plan failures and bring the plan back in
compliance. "I'm from the government and I'm here to help" is
actually true in this case! These programs may be used to correct
qualification failures which generally fall into three categories:
- Plan Document Failures: Failure of the document to conform
to the Internal Revenue Code and IRS regulations. Plan sponsors
who fail to timely adopt required plan amendments fall within
- Operational Failures: Includes failure to follow the terms
of the plan document, such as failure to cover eligible
employees, failing to satisfy the top heavy requirements and
failing the ADP and ACP tests for 401(k) plans.
- Demographic Failures: Failure to meet minimum participation,
minimum coverage or nondiscrimination requirements.
The IRS has provided pre-approved methods for correcting many
types of common failures. The typical correction method is to put
the plan and participants in the position they would have been had
the plan been administered correctly. This may require additional
contributions (plus earnings) for certain participants. In some
cases, the failure can be corrected by a retroactive amendment to
the plan. Below is an overview of the three EPCRS programs.
Self Correction Program (SCP)
SCP allows qualified plan sponsors to correct operational
failures without filing with the IRS or paying a penalty tax. The
program allows the correction of both insignificant defects as well
as, in limited circumstances, significant defects. SCP cannot be
utilized for demographic and plan document failures or if the
failure is egregious. The plan must have established practices and
procedures (formal or informal) designed to promote overall plan
Plan sponsors should document the steps that were taken for
fixing the failure in case they are later asked to justify their
actions and should also put administrative procedures in place so
the mistake does not happen again.
Generally, in order for a correction to be considered
insignificant, it must be an isolated incident, and the plan must
otherwise have a history of compliance in all other areas. Several
factors need to be analyzed to determine if the correction is deemed
insignificant including the number of errors that occurred, the
percentage of plan assets and contributions involved in the error
and the number of plan participants affected.
Insignificant defects can be corrected at any time following
discovery. Also, SCP can be utilized for insignificant defects even
if the plan is already under examination by the IRS.
To be eligible to utilize SCP for a significant operational
failure, the plan must have a current determination letter or, in
the case of a pre-approved plan, an opinion letter. For significant
corrections, SCP is not available if the plan is already under
examination by the IRS.
Significant failure correction must be completed, or
substantially completed, by the end of the second plan year
following the plan year in which the error occurred.
Voluntary Correction Program (VCP)
Defects that are not eligible for SCP, such as significant
operational defects beyond the two-year correction period, plan
document failures or demographic failures, may be corrected using
VCP. This program is not available if the plan is already under
examination by the IRS.
The plan sponsor submits an application to the IRS outlining the
failures and proposed correction methods and also pays a fee based
on the number of participants. The IRS reviews the application and
issues a Compliance Statement setting forth the agreed terms of
If a plan sponsor is hesitant about disclosing plan failures to
the IRS, a John Doe submission can be filed which allows the plan
sponsor to propose a correction to the IRS anonymously. After a
correction method is agreed upon in writing, the plan and plan
sponsor are then identified.
Audit Closing Agreement Program (Audit CAP)
Audit CAP is available for problems that were not corrected
voluntarily but instead were discovered during an IRS audit. By
utilizing Audit CAP, the plan avoids the consequences of
disqualification. In addition to correcting plan defects, the plan
sponsor must pay a penalty equal to a percentage of the amount of
tax that would have been due if the plan were disqualified. The fee
is generally negotiated based on the severity of the failure.
Because of the severe penalties associated with plan
disqualification, plan sponsors should be aware of and on the
lookout for common plan failures. Frequent internal audits of all
aspects of plan administration can quite possibly prevent
insignificant defects from becoming significant.
If the plan sponsor discovers any instance of noncompliance, the
plan's advisors should be consulted to help determine the
appropriate correction method. Fortunately, there are several EPCRS
programs available for voluntarily correcting plan failures. The
least expensive way to correct defects is to discover them early and
before the IRS.
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