IRS Plays Musical Chairs With Voluntary Correction Programs

Section 401(k) and other retirement plans are notoriously complicated to operate and no plan sponsor gets it 100% correct, 100% of the time. When problems arise, plan sponsors may correct certain errors – technically “failures” — under an IRS program called the Employee Plans Compliance Resolution System, or EPCRS. Failures corrected this way cannot later be the basis for revoking the tax-qualified status of the plan, or imposing other tax penalties or interest. EPCRS is set forth in a Revenue Procedure that the IRS updates every few years. On July 16, 2021 the IRS published the latest EPCRS upgrade in Revenue Procedure 2021-30, in which, like musical chairs, some ground is gained while some is taken away. Below is a summary of some of the key changes.

Expansion of Self-Correction Period

Under the Self Correction Program, a plan sponsor may at any time, without IRS review or approval, correct “insignificant” failures in the way a plan has been operated (operational failures), and failures relating to plan documentation such as missed amendment deadlines (plan document failures). Further, a plan sponsor may self-correct “significant” failures of these types, provided that the significant failure is identified and fixed within a set “correction period.”

In the past, the correction period ended on the last day of the second plan year following the plan year for which the failure occurred. The EPCRS upgrade adds a whole additional year to the correction period. Now, self-correction of significant failures may be made by the end of the third plan year following the plan year in which the failure occurred. Thus, a plan sponsor with a calendar plan year and a significant operational error occurring in 2018 will have until the end of 2021 to correct the error.

There are two follow-on effects of this extension:

  • The three-year self-correction period for significant operational failures does not begin to run until after the statutory correction period for ADP and ACP testing failures, which is the 12-month period following the close of the plan year for which the test was failed. In effect there is four years to correct these errors – the original statutory period of 12 months, followed by the three plan year self-correction period.
  • For errors involving a failure to offer or implement elective deferrals, corrective contributions equal to 50% of what would have been deferred generally must be made to the plan. That percentage is reduced to 25% of what would have been contributed if certain requirements are met, including that the period during which the error occurred lasted more than three months, but not longer than the self-correction period for significant failures. That period has now been extended a year, from two to three plan years.

Plan sponsors wishing to use the Self-Correction Program should be mindful not just of the correction period deadline, but of several other pre-requisites. First, the plan sponsor must have established compliance practices and procedures in place, and the error must have arisen due to a lapse in their normal application. Plan document failures may only be self-corrected if a “favorable letter” for the plan exists. The plan sponsor must also assess a number of facts and circumstances in order to determine whether the failure is “insignificant” or “significant.” For those seeking more information, the IRS provides helpful online guidance on Self-Correction (but the two-year correction period had yet to be updated as of the date of this post), as well as Self-Correction FAQs.

Anonymous VCP Repealed after 2021

In addition to Self-Correction, EPCRS includes the Voluntary Compliance Program (VCP), which involves an online submission, IRS approval of the proposed correction method, and payment of a VCP fee. Normally the name of the plan sponsor and the plan involved are revealed in the VCP submission process. However the IRS has for some years maintained an Anonymous VCP process, particularly for plan sponsors whose proposed corrections do not fit within the preapproved or “safe harbor” methods outlined in EPCRS. In Anonymous VCP, a representative of the plan sponsor, such as a law firm, files the submission without identifying the plan sponsor or plan. If the IRS approves the proposed correction, the plan sponsor reveals is identity and the process converts to a conventional VCP submission. If the IRS rejects the proposed correction method, the plan sponsor remains anonymous and has the option of later participating in regular VCP with an alternative proposed correction.

For reasons that it does not explain, the IRS is retiring Anonymous VCP and will not accept any more Anonymous VCP submissions after December 31, 2021. In its place the IRS is introducing a new program effective January 1, 2022, which it refers to as an “anonymous, no-fee VCP pre-submission conference.” This new program is intended for proposed corrections that fall outside the safe-harbor correction methods set forth in Appendices A and B to the EPCRS Revenue Procedure. The VCP pre-submission conference is available only if the plan sponsor is eligible for and intends to submit a conventional VCP submission. Following a VCP pre-submission conference, the IRS will provide oral feedback on the failures and proposed correction method that is “advisory only, is not binding on the IRS.” The IRS will only confirm in writing that a VCP pre-submission conference took place but will not appear to provide anything substantive in writing about what was discussed.

VCP pre-submission conferences are held only at the discretion of the IRS and “as time permits.” Given limited IRS funding and significant understaffing in recent years, one wonders how widely and promptly available this program will be. It is also unclear whether or not the introduction of the VCP pre-submission conference means that VCP coordinators at IRS will no longer informally discuss proposed corrections with attorneys and other practitioners, as has been the practice in the past.

Other Changes

  • EPCRS generally requires full correction of operational errors, but makes an exception for certain de minimis amounts. Effective July 16, 2021, the de minimis threshold increases from $100 to $250, and erroneous contributions (plus earnings) of $250 or less will not need to be pulled from a participant’s account or recouped after distribution to a participant.
  • In the past, when a participant received a lump sum distribution of a more than de minimis amount (“Overpayment”), the plan was required to seek recoupment in a lump sum repayment. Now, repayment in installments is also an option. For defined benefit plans, the Revenue Procedure describes certain conditions under which recoupment of Overpayments may be avoided altogether.
  • The Revenue Procedure restores a safe harbor correction method for failures arising from automatic contribution arrangements, which had expired on December 31, 2020. The new expiration date is December 31, 2023; until then no corrective contributions are required for certain automatic contribution failures that do not extend beyond 9 ½ months following the end of the plan year of the failure. Other correction criteria apply including provision of written notice to affected employees.
  • The Revenue Procedure substantially liberalizes self-correction of certain operational failures through a plan amendment that retroactively reflects how a plan has been operated. Such retroactive amendments must increase benefits, rights or features under the plan, rather than reduce them. In the past it has been required that the benefit increase or enhancement apply to all eligible participants under the plan, which made many proposed corrections unaffordable. The new Revenue Procedure lifts the universality requirement, so that a retroactive amendment may increase benefits only for those participants affected by the operational error. This will make this form of correction much more flexible and attainable for plan sponsors.

Photo credit: Federica Campanaro, Unsplash

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. © 2021 Christine P. Roberts, all rights reserved.

IRS Lists Solo 401(k) Plans as Audit Target

If your business sponsors a “solo 401(k)” plan, it may be in the crosshairs of the Internal Revenue Service.  The Service’s TE/GE (Tax Exempt and Government Entities) division has identified one-participant 401(k) plans as among its current audit initiatives.  In its web posting announcing the initiative, TE/GE states:  “[t]he focus of this strategy is to review one-participant 401(k) plans to determine if there are operational or qualification failures, income and excise tax adjustments, or plan document violations.”

By way of background, a solo 401(k) plan is a traditional 401(k) plan covering a 100% business owner with no employees, or that person and their spouse.  As this handy IRS info page describes, solo 401(k) plans are subject to the same rules and requirements as any other 401(k) plan, however because no common law employees participate, you do not have to worry about minimum coverage and nondiscrimination testing, top heavy rules, or most of the requirements of Title I of ERISA.  Solo 401(k) plans can be a great fit for some businesses, but those that stray outside the strict eligibility requirements for these plans have potentially high exposure to correction costs and sanctions in an audit setting.    

Below we list some common solo 401(k) compliance pitfalls.   If you are a solo 401(k) sponsor, check your plan design and operations to determine if these might be issues for you.  Take steps now to correct any compliance failures through use of EPCRS and other voluntary compliance programs, where applicable, so that, if an IRS audit does occur, it is resolved without incident.

  1. Employees Eligible for Benefits: One of the most frequent errors with solo 401(k) plans is that they lose their solo status when the business sponsoring them acquires employees, and the employees work the necessary number of hours required for eligibility under the plan.  (These generally cannot exceed 1,000 hours in a year of service.)  This will trigger application of minimum coverage, nondiscrimination, and top heavy rules, as well as ERISA reporting and disclosure requirements (Summary Plan Description, Form 5500-SF, etc.).  Failure to meet requirements under any of these sets of rules will be fodder for the IRS in an audit setting.  Business owners who need employees should probably avoid solo 401(k) plans unless they can be certain that the employees’ work hours never reach or exceed 1,000 hours in a year.   
  2. Controlled Group/Affiliated Service Group: This issue is related to the first in that, if the business that sponsors the solo 401(k) plan is under common control with a business that has common law employees, the answer to the question “who is the employer” — and who has employees — will be both businesses under common control, not just the business that sponsors the solo 401(k).  Generally, solo 401(k) status will be lost as a result.  The same potential coverage, testing, and top-heavy issues listed above can apply. Potentially, employees of the other business could be eligible for benefits under the (formerly) solo plan.
  3. Form 5500 Filing Duties: Solo 401(k) plans are exempt from filing Form 5500-EZ so long as plan assets remain under $250,000.  If plan assets exceed this threshold and a Form 5500-EZ is not filed, significant penalties could be assessed by IRS and by Department of Labor.  Participation in the Department of Labor Penalty Relief Program for Form 5500-EZ Late Filers should be considered in such instances. 
  4. Exceeding Contribution and Deduction Limits: The contribution and deduction limits that apply to group 401(k) plans apply to a solo 401(k) plan.  Employee salary deferrals cannot exceed the applicable dollar limit under Internal Revenue Code (“Code”) § 402(g) ($19,500 in 2021, plus $6,500 for those 50 and older).  The 415(c) limit equal to the lesser of 100% of compensation or $58,000 (in 2021) applies (and is increased by the age 50 catch-up limit, for a total of $64,500).  The maximum Code § 404(a) deduction of 25% of eligible plan compensation also applies, but in general the 415(c) limit will be reached first.  Failure to observe any of these dollar limits could be picked up on audit.
  5. Plan Document Errors: Businesses that sponsor a solo 401(k) need to update their plan document periodically to comply with the law just like any plan sponsor, meeting the adoption deadlines for preapproved plan remedial amendment cycles (the next one falls on July 31, 2022). Voluntary plan amendments also have to be properly documented and timely adopted.  Failure to meet these document requirements may be able to be corrected under EPCRS. 

The above information is provided for general informational purposes only and does not create an attorney-client relationship between the author and the reader. Readers should not apply the information to any specific factual situation other than on the advice of an attorney engaged specifically for that or a related purpose. © 2021 Christine P. Roberts, all rights reserved.

Photo Credit:  Markus Spiske, Unsplash

FAQ on New 401(k) Coverage Rules for Long-Term, Part-Time Workers

With a stated goal of encouraging retirement savings, the Setting Every Community Up for Retirement Enhancement Act expands eligibility to make salary deferrals under a 401(k) plan to “long-term, part-time workers.” The new rules under the SECURE Act, which became law on December 20, 2019, ramp up between 2021 and 2024. However, some employer action is already required, as explained below. The following Frequently Asked Questions walks you through the new rules, including those contained in IRS Notice 2020-68, published on September 3, 2020.

Q.1: What are the current rules for excluding part-time, seasonal, and temporary employees under 401(k) and other retirement plans?

A.1: Even of you exclude these categories by name, you must still track their hours of service and include them in the plan on the entry date coinciding with or following their completion of 1,000 or more hours of service within a 12-month period (or, if later, upon also attaining a minimum age not exceeding 21). This is required under Section 401(a) of the Internal Revenue Code. Different rules applicable under Section 403(b) plans are outside the scope of this FAQ.

Q.2: Over what period do you count the 1,000 hours of service?

A.2: You count them over an “eligibility computation period.” The first eligibility computation generally starts upon the date of hire and ends on the first anniversary of that date. The plan may then continue to use the anniversary of hire, or switch to a plan year cycle.

Example – Switch to Plan Year Cycle: Kyle is hired on June 15, 2021 under a plan that follows a calendar year cycle and uses quarterly entry dates. Kyle works 700 hours between June 15, 2021 and June 14, 2022, the first anniversary of hire. Kyle does not enter the plan on July 1, 2022. Kyle completes 1,000 hours between January 1, 2022 and August 15, 2022 and enters the plan on October 1, 2022.

Q.3: What is a “long-term, part-time worker”?

A.3: Section 112 of the SECURE Act defines a long-term, part-time worker as an employee who has worked 500 or more hours in each of 3 consecutive 12-month periods, and who has attained a minimum age, not to exceed 21, as of the end of that 36-month period. The 12-month eligibility computation periods may be based on the anniversary of hire or may switch to the plan year cycle as described above.

Q.4: What eligibility rules apply to long-term, part-time workers?

A.4: An employee who qualifies as a long-term, part-time worker must be allowed to make employee salary deferrals under a Section 401(k) plan as of the first applicable entry date following completion of the 36-month period. A plan is allowed to use 6-month entry dates for long-term, part-time workers (e.g., January 1 and July for a calendar year plan) or may use regular quarterly, monthly, or other entry dates for this group.

Q.5: When do you begin tracking hours of service for long-term, part-time workers?

A.5: You begin tracking on January 1, 2021. That means the first point at which an employee will qualify for participation in a 401(k) plan as a long-term, part-time worker is January 1, 2024.

Q.6: Must long-term, part-time workers receive matching contributions or other employer contributions?

A.6: No, only eligibility to make salary deferral contributions is required. However, an employer may voluntarily make long-term, part-time workers eligible for matching and other employer contributions.

Q.7: If we choose not to, does that mean we don’t have to track hours of service towards vesting, for long-term, part-time workers?

A.7: No, you must track hours of service towards vesting, even if you don’t make employer contributions for this group. That is because, if a long-term, part-time worker later meets the plan’s conventional eligibility requirements, the worker joins the plan as a “regular” participant as of the first subsequent plan year, and may become eligible for matching and other employer contributions at that point. All of the worker’s hours of service must be counted towards vesting at that point. If these are hourly workers, you may be tracking their hours of service automatically, as it is.

Q.8: Do special rules apply to tracking vesting service for long-term, part-time workers?

A.8: Yes. Notice 2020-68 provides that you count each year in which an employee has at worked least 500 hours of service as a year of service counted towards vesting. Further, you count all years of service with the company in which they reach that threshold, not just years of service worked from January 1, 2021 and onward (as you do for eligibility purposes). If the plan language allows, you may disregard only years worked before attaining age 18, years worked before the plan was adopted, or years that may be disregarded under specially modified break in service rules.

Q.9: Are the break in service rules modified for long-term, part-time employees?

A.9: Yes. Normally, a break in service is defined as a year in which an employee has not completed more than 500 hours of service. For long-term, part-time workers, it is defined as a year in which the employee did not complete at least 500 hours of service.

Q.10: Can a plan still exclude employees based on job function or job location, such as “employees at Location B,” without violating the long-term, part-time worker coverage rules?

A.10: Presumably, reasonable, job-based exclusion criteria that pass minimum coverage testing are still permissible and are not preempted by the long-term, part-time worker coverage rules, but more guidance from the IRS would be appreciated. Employers with specific questions should consult benefit counsel for individualized guidance.

Q.11: Are long-term, part-time workers counted towards nondiscrimination testing, including ADP/ACP, and minimum coverage testing?

A.11: No, you are not required to count them under these tests.

Q.12: Are you required to make minimum top-heavy contributions on behalf of long-term, part-time workers?

A.12: No, you are not required to do so.

Q.13: Do the long-term, part-time worker coverage rules apply to employees subject to a collective bargaining agreement?

A.13: No, they do not apply to collectively bargained employees.

Q.14: Instead of tracking new hires over 3 years, should I just allow all employees who complete 500 hours of service to participate in the salary deferral portion of my 401(k) plan as of the next entry date?

A.14: That is certainly a simplified alternative to the minimum requirements, and presumably the exceptions from nondiscrimination testing and top-heavy contributions would continue to apply to employees meeting these reduced eligibility criteria. However this route could bring its own complications, by increasing your plan participant headcount over the 100 participant threshold sooner than is required. See Q&A 17.

Q.15: How will the long-term, part-time worker rules apply to plans with automatic enrollment?

A.15: The SECURE Act currently only refers to the minimum semi-annual entry dates for long-term, part-time workers, so it would appear that the automatic enrollment provisions would not apply to them. More guidance would on this topic would be appreciated, however.

Q.16: What if my plan doesn’t use actual hours to track service, but instead uses the equivalency method (e.g., 45 hours credited per week, if any service is performed in the week)?

A.16: It would appear that you can continue to use this method of tracking service for employees who meet conventional eligibility criteria, and use actual hours to track eligibility of long-term, part-time workers. Nothing in the SECURE Act prohibits use of the equivalency method for tracking service of long-term, part-time workers.

Q.17: Should we just create a new, separate 401(k) plan for long-term, part-time workers?

A.17: That depends. As it stands, it appears that employees who meet the criteria of long-term, part-time workers – whether or not they actively defer under the plan – will be included in the plan participant headcount on the first day of a plan year. This headcount is used to determine whether or not the plan has 100 or more participants and must include an independent qualified auditor’s report with its 5500 for a given year. If inclusion of your long-term, part-time workers will push your existing plan over the 100 participant threshold, you might give thought to separating them out in a separate plan, such that both of your plans will be under the audit threshold. Both plans would still have to file a Form 5500-SF each year, of course.

The above information is a brief summary of legal developments that is provided for general guidance only and does not create an attorney-client relationship between the author and the reader. Readers are encouraged to seek individualized legal advice in regard to any particular factual situation. (c) 2020 Christine P. Roberts, all rights reserved.

Photo Credit: Gabriella Clare Marino, Unsplash

Using Forfeitures for Corrective Contributions: Look Before You Leap

When a 401(k) plan fails nondiscrimination testing that applies to employee salary deferrals, one way to correct the failure is for the plan sponsor to make qualified nonelective contributions (QNECs) on behalf of non-highly compensated employees. The same approach may apply to matching contribution failures, but in that instance the corrective contributions are called qualified matching contributions or QMACs.   QNECs and QMACs must satisfy the same vesting and distribution restrictions that apply to employee salary deferrals – they must always be 100% vested and must not be allowed to be distributed prior to death, disability, severance from employment, attainment of age 59.5, or plan termination (i.e., they may not be used for hardship distributions).

Existing Treasury Regulations provide that QNEC and QMAC contributions must be 100% vested at when they are contributed to the plan, not just when they are allocated to an account.

Forfeitures are unvested employer contributions when originally contributed to the plan, and for this reason the IRS has taken the position that a plan sponsor may not use forfeitures to fund QNECs or QMACs. And in fact, the prohibition on using forfeitures to make QNECs or QMACs is reflected in the Internal Revenue Manual, and the IRS Employee Plans Compliance Resolution System (EPCRS) which outlines voluntary correction methods for plan sponsors.

On January 18, 2017, the IRS changed course by publishing a proposed regulation requiring that QNECs and QMACs be 100% vested only when they are allocated to an account, and need not be 100% vested when originally contributed to a plan. This means that forfeitures may be used to make QNECs and QMACs if the underlying plan document permits.  It would logically follow that other employer contributions that are not fully vested when made may be re-designated as QNECs to satisfy ADP testing for a plan year.

The proposed regulation is applicable for plan years beginning on or after January 18, 2017 (January 1, 2018 for calendar year plans) but may be relied upon prior to that date.

Caution is advised, however, for plan sponsors wanting to make immediate use of forfeiture accounts for QNECs and QMACs. First, they must confirm that their plan document does not prohibit use of forfeitures for this purpose.  In the author’s experience, master and prototype and volume submitter basic plan documents may expressly prohibit use of forfeitures for QNECs and QMACs.  The language below was taken from a master and prototype basic plan document:

7) Limitation on forfeiture uses. Effective for plan years beginning after the adoption of the 2010 Cumulative List (Notice 2010-90) restatement, forfeitures cannot be used as QNECs, QMACs, Elective Deferrals, or Safe Harbor Contributions (Code §401(k)(12)) other than QACA Safe Harbor Contributions (Code §401(k)(13)). However, forfeitures can be used to reduce Fixed Additional Matching Contributions which satisfy the ACP test safe harbor or as Discretionary Additional Matching Contributions.

Plan sponsors that locate a similar prohibition in their plan document should contact the prototype plan sponsor to determine whether they will be amending their plan document to permit use of forfeitures for QNECs and QMACs and when such an amendment will take effect.

In instances where there is no express plan prohibition, plan sponsors that are making use of EPCRS to correct plan failures should try to ascertain from the IRS whether or not they may use forfeitures to fund QNECs or QMACs as part of a self-correction or VCP application, as the most recently updated EPCRS Revenue Procedure (Revenue Procedure 2016-51, 2016-41 I.R.B. 465), expressly disallows this at Section §6.02(4)(c) and Appendix A §.03. Hopefully, the IRS will issue some guidance on this point without too much delay.