Anyone who has ever
watched late night television is familiar with the ubiquitous Top 10
List, counting down humorous examples of whatever is in the news.
Not to be upstaged, the IRS has its own Top 10 List—the top 10 plan
compliance failures found in voluntary correction filings.
While not nearly as entertaining, the IRS list is much more
instructive. Due to the frequency of these errors, the IRS makes a
point to look into these items when auditing plans. Taking steps to
prevent or correct these problems can save quite a bit of time,
money and frustration. So, without further ado here are the top 10
failures the IRS has identified in voluntary correction filings.
1. Failure to timely adopt amendments required
by tax law changes
All qualified plans are required to have written plan documents
describing their provisions. From time to time, Congress or a
government agency, e.g., IRS or Department of Labor, will issue new
rules or change existing ones. If these changes impact the language
in the plan document, the plan must be amended to reflect the law
change. Since these amendments do not follow a set schedule and
deadlines vary, it is easy to overlook a deadline.
Quite often, the service provider that prepared your plan
document will notify you when one of these so-called interim
amendments is required. Depending on the type of plan document you
use (prototype, volume submitter or custom), you may be required to
sign the amendment; other times, your document provider can sign on
your behalf. Regardless of these details, the IRS considers it to be
your responsibility to maintain timely adopted copies of all interim
The interim amendment rules can be counter-intuitive, so it is a
good idea to work with your service providers to clarify
responsibilities. This is especially important when you change
service providers. Taking a few minutes to identify roles and
responsibilities can save hours of consternation down the road.
2. Failure to follow the plan's definition of
compensation when determining benefits
There are many variations on this theme, but the gist is that
plan contributions must be based on compensation as defined in the
written plan document. A common definition is the amount reported in
box #1 of Form W-2, grossed up for any pre-tax deferrals to a 401(k)
plan and/or a cafeteria plan. That is essentially gross
compensation, so failure to consider that cash bonus handed out at
the company holiday party or the commissions paid to those sales
people would run afoul of this definition.
Another common oversight is to calculate contributions based on
an incorrect time frame. For example, many employers calculate their
matching contribution each pay period; however, if the terms of the
plan indicate the match should be based on activity for the entire
year, it is necessary to perform a true-up calculation at the end of
the year to make sure all employees receive the full match to which
they are entitled.
One possible way to minimize compensation errors is to work with
your payroll provider to confirm that the various pay codes they use
in their system are consistent with your plan document.
3. Failure to include eligible employees or
exclude ineligible employees
This one probably seems self-explanatory, but there are a number
of details that can complicate matters. These errors often arise due
to a misunderstanding of the plan's eligibility provisions. For
example, if a plan provides for immediate eligibility, your
employees' high school and college kids who come to work part time
over the summer are eligible for the plan. Although they probably
wouldn't make contributions anyway, if they are not given the
opportunity to enroll, they are treated as being improperly
excluded, and the company must contribute on their behalf to correct
It is also a problem to include someone the plan or the law says
should be excluded. A newly hired executive cannot be allowed to
join the plan right away if the eligibility requirements specify a
one-year waiting period.
4. Failure to follow the rules related to
The loan rules are complex and rigid. Regulations limit the
amount, duration and payment terms for participant loans and even
the slightest misstep creates a compliance failure. Even worse, loan
errors cannot be self-corrected; any corrections must be submitted
to the IRS for formal review and approval which can be a costly
undertaking. Examples of loan errors include failing to timely set
up payroll to withhold payments for a new loan, allowing a
participant who has fallen on hard times to suspend payments and
approving a loan for too much or too long.
A loan that does not follow the rules or remain within the
prescribed limits is treated as a taxable distribution to the
participant in question. Although it may be tempting to "help" an
employee who is having trouble making payments or needs a few extra
dollars, that favor can do more harm than good.
5. Failure to follow rules related to in-service
A plan document will specify whether and under what conditions
in-service withdrawals are permitted. For example, a plan may offer
hardship distributions and/or other in-service distributions on
attainment of age 59½. However, there are additional restrictions.
IRS rules provide a "safe harbor" definition of what constitutes a
financial hardship and many plans incorporate that definition. If an
employee needs money for a car repair so that he can get to work, it
might sound like a hardship; but it does not fit within the IRS
definition. A plan sponsor that does this employee a favor puts the
entire plan in jeopardy.
In addition, there are legal restrictions on money types that are
available for in-service distributions. Safe harbor 401(k)
contributions cannot be withdrawn during employment prior to age 59½
even if the plan otherwise permits hardship distributions. Amounts
attributed to money purchase pension plans or defined benefit plans
are not available before age 62.
6. Failure to satisfy the rules related to
required minimum distributions (RMDs)
Once a participant reaches age 70½, he is required to take a
distribution of a portion of his account each year. The amount is
based on the participant's account balance and IRS life expectancy
tables. Participants who are not owners of the company that sponsors
the plan can generally postpone their RMDs until they retire.
Failure to timely take an RMD subjects the participant to an excise
tax equal to 50% of the RMD.
Since RMDs are based on account balances at the end of the
preceding year, it is a good idea to notify participants early in
the year if they are required to take a distribution. This gives
them adequate time to submit any necessary paperwork so that the RMD
can be processed well before the deadline.
7. Failure to satisfy the rules related to
eligibility to sponsor a certain type of plan
Certain types of businesses are eligible to sponsor certain types
of plans. Perhaps the most obvious example is that only
not-for-profit organizations and certain governmental entities (such
as public schools) can sponsor 403(b) plans while for-profit
organizations cannot. Similarly, many government entities cannot
sponsor 401(k) plans.
8. Failure to pass the ADP and/or ACP test
It is actually not a problem to fail the ADP/ACP test as long as
that failure is corrected by the end of the following year. In other
words, a calendar year plan that fails the ADP test for 2012 has
until December 31, 2013, to correct the failure by refunding
contributions to highly compensated employees, making additional
contributions to non-highly compensated employees or some
combination of the two.
If the failure is not corrected within the one-year time frame,
the plan's tax-favored status is in jeopardy. It is still possible
to correct, but the options become much more restrictive and
expensive. One way to minimize the likelihood of this eventuality is
to provide your employee census information to the service provider
that prepares your testing as soon as possible after the end of the
year. This gives them time to review your information, perform the
tests and advise you of any corrective actions while there is still
plenty of time to implement them.
9. Failure to provide top-heavy minimum benefits
to non-key employees
When more than 60% of plan assets are in the accounts of certain
owners and officers (known as key employees), the plan is top heavy.
Top-heavy plans must provide contributions to non-key employees,
generally up to 3% of their compensation, no later than the end of
the following year.
Sometimes plan sponsors will fail to provide these contributions
because they do not realize they are required to do so. Safe harbor
401(k) plans can be particularly vulnerable. Such plans are
generally deemed to satisfy the top-heavy requirements. However, if
the company makes contributions beyond the safe harbor
contributions, the top-heavy exemption is lost. In addition, there
can be misunderstanding in plans that do not otherwise provide for
any company contributions. However, even deferral-only plans can
become top heavy, triggering the required company contribution.
10. Failure to cap benefits at the annual
In a defined contribution plan, a participant's total
contributions for a given year are limited to the lesser of $51,000
(2013 indexed limit) or 100% of compensation. Due to the higher
limits, this failure is less common that it used to be. However, it
does still arise occasionally, especially when the goal of a plan is
to maximize contributions for one or a group of employees. Although
there are mechanisms in place to correct excess annual additions,
plan sponsors should avoid the temptation to intentionally "force"
an excess allocation, knowing it can be corrected, to accomplish
some other objective.
While it is unlikely to make the rounds amongst late night talk
shows, paying attention to the items on this list will help ensure
you are sleeping soundly rather than lying awake worrying about your
IRS and Social Security Annual Limits
Each year the U.S. government adjusts the limits for qualified
plans and social security to reflect cost of living adjustments and
changes in the law. Many of these limits are based on the "plan
year." The elective deferral and catch-up limits are always based on
the calendar year. Here are the 2013 limits as well as the 2012
limits for comparative purposes:
|Maximum compensation limit
|Defined contribution plan maximum
|Defined benefit plan maximum benefit
|401(k), 403(b) and 457 plan maximum elective
| Catch-up contributions
|SIMPLE plan maximum elective deferrals
| Catch-up contributions
|IRA maximum contributions
| Catch-up contributions
|Highly compensated employee threshold
|Key employee (officer) threshold
|Social security taxable wage base