- Practice Does Not Always Make Perfect: Top Ten Qualified Plan Errors
- July 13, 2011 | Authors: Jeffery R. Banish; Laura S. McAlister
- Law Firm: Troutman Sanders LLP - Atlanta Office
Mistakes happen. Even with the most vigilant plan sponsor, errors can occur when administering a qualified retirement plan. These mistakes often are unintentional and may seem minor, but they can have serious consequences (including plan disqualification), which can result in adverse tax consequences for both the employer and the employees.
However, there is good news. Recognizing that plan administration errors occur, the Internal Revenue Service (the IRS) has established a voluntary correction program that permits plan sponsors to correct plan errors on their own, at much less cost, before they are discovered in an audit. This article discusses the IRS’s voluntary correction program and identifies ten common errors for which plan administrators should be on the lookout.
Mistakes Happen: What to Do if a Failure Occurs
A qualified plan is a retirement plan, which meets requirements under the Internal Revenue Code (the Code) and, therefore, receives certain tax benefits. For example, a 401(k) plan is a qualified plan that, if it meets the Code’s requirements, permits participants to defer income tax on salary deferrals made to the 401(k) plan. If a qualified plan becomes disqualified, the IRS unwinds the tax benefits provided to the plan sponsor and the participants, resulting in extreme adverse tax consequences for both the employer and the employee.
Because of the harsh consequences of disqualification, the IRS created a correction program known as the “Employee Plans Compliance Resolution System” or “EPCRS.” Under EPCRS, the IRS provides model correction methods for certain common failures. If correction is completed by the end of the second plan year after the plan year in which the failure occurred or if the failure qualifies as “insignificant” based on IRS criteria, the plan sponsor can self-correct the error without IRS involvement (with certain exceptions). Otherwise, an application explaining the failures and the proposed correction methods must be submitted to the IRS. The plan must also pay an application fee based on the number of participants in the affected plan. If, after reviewing the application, the IRS approves the correction methods, a Compliance Statement will be issued that will preclude the IRS from disqualifying the plan based on the failures addressed in the application.
Top Ten Qualified Plan Errors
Listed below are ten of the most common plan errors, which if not properly corrected, could result in plan disqualification. For many of these failures, correction is available under EPCRS.
1. Failure to follow the plan’s definition of compensation when determining contributions
The amount of contributions an employee receives and the limitation applied to an employee’s benefit are often based on the amount of compensation received by the employee. A common error is to exclude (or include) certain types of compensation from the plan’s definition in calculating contributions or benefit limitations. The result is that the employee then receives either too much or too little in benefits, resulting in a violation of the plan’s terms, which generally constitutes a qualification failure.
2. Failure to amend the plan for changes in the tax law within the required amendment period
If a plan is not timely amended for legal changes, the plan fails to operate in accordance with the current law. The most recent laws requiring plan amendments were the Pension Protection Act of 2006, which for most plans required amendments on or before the last day of the plan year beginning on or after January 1, 2009, and The Heroes Earnings Assistance and Relief Tax Act of 2008, which for most plans required plan amendments by the end of the 2010 plan year. If a plan fails to timely amend for necessary amendments and that is the plan’s only failure, the employer might be able to correct the failure under EPCRS using an abbreviated correction method and a reduced fee.
3. Failure to follow the plan’s eligibility requirements
Qualified plans oftentimes have eligibility requirements (such as age and service requirements) that employees must meet to become participants in the plan. Plan sponsors may accidentally include in the plan participants who did not meet the eligibility requirements or, conversely, exclude from the plan participants who meet the eligibility requirements.
4. Failure to follow plan loan provisions and IRS loan requirements
Qualified plans are permitted to make loans to plan participants from the participant’s own account, subject to certain restrictions, including restrictions on how loans should be repaid and the maximum amount for which a loan can be issued. Failure to follow these restrictions could result in taxation on the amount of the loan.
5. Impermissible in-service withdrawals
The law restricts when distributions can be made from the plan and often prohibits in-service withdrawals unless certain criteria are met. If in-service withdrawals are permitted in contravention of the law or the plan document, the distributions could be taxed and participants subject to additional excise taxes.
6. Failure to satisfy the minimum distribution rules of Section 401(a)(9) of the Code
Participants are required to receive a distribution upon attainment of a certain age. If such distributions are not made, the participant must pay a tax of 50% on the amount of the required distribution.
7. Failure to timely remit plan contributions
Participant contributions, such as elective deferrals and loan repayments, must be remitted to the plan on the earliest date on which the contributions and repayments can reasonably be segregated from the employer’s general assets, but generally no later than the 15th business day of the month following the month in which the contributions and repayments are withheld by the employer from the employee’s wages. Failure to timely remit employee contributions can result in personal liability for plan fiduciaries.
8. Failure to pass the ADP/ACP nondiscrimination test under Code Section 401(k) and 401(m)
The Code restricts highly-compensated employees from receiving benefits that greatly exceed the average level of benefits of non-highly compensated employees. This includes the level of contributions highly-compensated employees are allowed to make on their own behalf. These requirements are measured through the “ADP/ACP” nondiscrimination tests. The Code provides a method for correcting ADP/ACP failures; however, if the failure is not corrected within certain specified time limits, the plan could risk disqualification.
9. Failure to properly provide the minimum top-heavy benefit or contribution under Code Section 416 to non-key employees
The law requires certain minimum contributions for non-highly compensated employees if the aggregate account balances of key employees in the plan exceed 60% of the aggregate account balances of all employees in the plan. If such a top-heavy failure is not corrected through a top-heavy contribution on behalf of non-key employees within the amount of time prescribed by law, the plan could risk disqualification.
10. Failure to satisfy the limits of Code Section 415
The law imposes limitations on the aggregate contributions (for a defined contribution plan) and the aggregate benefits (for a defined benefit plan) that an employee may receive through one or more qualified plans in a single year. If a plan sponsor does not closely monitor contribution and benefit accruals, these limits can be violated resulting in potential disqualification of the plan.
IRS Compliance Statement: Plan Disqualification Insurance
The administration of qualified plans is very complex and, even with best efforts, failures can occur. If a plan sponsor discovers a plan error, the best solution is often to correct the error through the EPCRS program if available. A fee may be involved if a filing is required; however, a final Compliance Statement can serve as a valuable insurance policy against a future IRS audit with respect to the disclosed failures.