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

Does Your Retirement Plan Incorporate State Law Into the Plan?  Check Your Spousal Benefit Obligations!

Retirement plan documents are contracts and generally they contain a “choice of law” provision.  The choice of law provision dictates what laws will govern interpretation of the contract, for instance in the event of a dispute over the contract’s application.  A recent, unpublished Ninth Circuit court opinion held that the Plan’s choice of California law required the plan to provide spousal survivor rights to registered domestic partners, because California law affords registered domestic partners the same legal status as spouses, and because doing so did not conflict with any provision of the plan document, ERISA or the Internal Revenue Code.  In light of the opinion, plan sponsors should examine their plan documents to determine whether or not choice of law provisions carry state domestic partner rights into their plan document, and if this is the case, should consult with counsel as to how that might impact their plan distribution and plan loan approval procedures, and QDRO procedures as well.

In Reed v. KRON/IBEW Local 45 Pension Plan, No. 4:16-cv-04471-JSW (9th Cir. May 16, 2019), plaintiff David Reed entered into a long-term relationship with Donald Gardner in 1998.  Gardner was an employee at KRON-TV and a participant in the KRON/IBEW Local 45 Pension Plan, a union-management sponsored defined benefit pension plan.  In addition to a choice of law provision that invoked California law, to the extent consistent with ERISA and the Internal Revenue Code, the KRON plan document did not limit the term “spouse” or “married” to opposite-sex spouses.

In 2004, Reed and Gardner registered as domestic partners under California law.  Registered domestic partners have had the same status under California law as legally married spouses since the California Domestic Partnership Rights and Responsibilities Act of 2003 went into effect on January 1, 2005.[1]

Gardner retired in 2009 and began receiving pension benefits under the plan.  Prior to retiring he attended meetings with KRON-TV’s human resources department together with Reed.  Although HR knew that the couple were registered domestic partners (Reed, for example, received benefits under the group health plan), the HR personnel did not mention the availability of a joint-and-survivor form of benefit under the Plan.  Gardner accordingly elected a single life annuity form of benefit.  He also designated Reed as his beneficiary under the Plan.

Gardner and Reed married in May 2014, five days before Gardner passed away.  Reed submitted a claim for survivor’s benefits under the plan.  Although the Pension Committee of the Plan never formally responded to Reed’s claim, Reed was deemed to have exhausted his administrative remedies and filed suit in federal court against the Plan, the Pension Committee, and the parent company of KRON-TV.  The federal trial court granted the Plan Committee’s motion for judgment on the pleadings, finding that it did not abuse its discretion in denying Reed’s benefit claim.

On appeal, a three-judge panel of the Ninth Circuit reversed the trial court and remanded the case with instructions to determine the payments owed to Reed.  The panel stated:

“The Committee abused its discretion by denying benefits to Reed. During either time the Committee evaluated the Plan’s benefits in this case—in 2009 or in 2016—California law afforded domestic partners the same rights, protections, and benefits as those granted to spouses. See Cal. Fam. Code § 297.5(a); see also Koebke v. Bernardo Heights Country Club, 36 Cal. 4th 824, 837-89 (2005). Neither ERISA nor the Code provided binding guidance inconsistent with applying this interpretation of spouse to the Plan. See United States v. Windsor, 570 U.S. 744 (2013) (striking down the Defense of Marriage Act’s definitions of “spouse” and “marriage” as unconstitutional); cf.26 C.F.R. § 301.7701-18(c) (as of September 2, 2016, the Code excludes registered domestic partners from the definition of “spouse, husband, and wife”). Therefore, because Reed and Gardner were domestic partners at the time of Gardner’s retirement, the Committee should have awarded Reed spousal benefits in accordance with California law, as was required by the Plan’s choice-of-law provision.”

Despite the fact that the Internal Revenue Code does not recognize domestic partners as equivalent to spouses, this did not limit the terms of the plan document; in this regard Reed successfully argued that federal law established a floor, but not a ceiling, for drafting the terms of the plan.  This case is of particular relevance to plan sponsors in California and Hawaii, as both states fall within the Ninth Circuit, and both states grant domestic partners the same rights as married couples.[2]  As mentioned, if domestic partner rights are imported into the plan document, they may be implicated even in the absence of joint and survivor annuity provisions.  For instance, if the plan document expressly requires spousal consent for a loan or hardship withdrawal, domestic partner approval in such instances may be required, and QDRO procedures may have to be expanded.

For this to be the case, the plan’s choice of law provision must invoke the law of a state which grants to domestic partners rights equal to those of spouses, and the plan must also not define “spouse” in a more limiting way, for instance by limiting the term to legally married couples. These factors are more likely to be present in individually drafted retirement plans, whether in a “Taft-Hartley” plan such as the KRON plan, or in a document drafted specifically for a unique single employer.

The situation posed in the Reed case is not as likely to occur under a pre-approved plan document.  Fidelity’s Volume Submitter Defined Contribution Plan (Basic Plan Document No. 17), for instance, defines “spouse” as “the person to whom an individual is married for purposes of Federal income taxes.”  This, then, would include same-sex and opposite-sex spouses, but would exclude domestic partners, irrespective of the Fidelity plan document’s choice of law provision (which invokes the laws of the Commonwealth of Massachusetts).

By contrast, the Empower basic plan document (formally, the Great-West Trust Company Defined Contribution Prototype Plan and Trust (Basic Plan Document #11)) allows the plan sponsor to define “spouse” in Appendix B to the Adoption Agreement.  If the plan sponsor fails to specify a definition, the basic plan document choice of law clause (Section 7.10(H)) defaults to the law of the state of the principal place of business of the employer, to that of the corporate trustee, if any, or to that of the insurer (for a fully insured plan).  Plan sponsors using an Empower prototype document may want to consult benefits counsel as to the consequences of the default language as applied to their specific factual circumstances.

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.  © 2019 Christine P. Roberts, all rights reserved.

#10YearChallenge for 403(b) Plans

The #10YearChallenge on social media these days is to post a picture of yourself from 2019, next to one from 2009, hopefully illustrating how little has changed in the 10 year interim. For tax-exempt employers who sponsor Section 403(b) plans, however, 2019 brings a different #10YearChallenge – namely, to bring their plan documents – many of which date back to 2009 – into compliance with current law.

The actual deadline to restate your 403(b) plan (technically, the end of the “remedial amendment period”) falls on March 31, 2020, but vendors of 403(b) documents that have been pre-approved by the IRS will proactively be sending clients document restatement packages this year, in order to avoid the inevitable crunch just prior to the 2020 deadline. The restatement deadline is an opportunity to retroactively restate the plan document (generally, to January 1, 2010) to correct any defects in the terms of the plan documents, such as missed plan amendments. It is also the last chance for tax-exempt employers with individually designed plan documents to restate onto a pre-approved document, as the IRS does not now, and does not intend to, issue approval letters for individually designed 403(b) plans

There are significant differences in the 403(b) document landscape in 2019, as compared to 2009. Back in 2009, which was the year the IRS first required all 403(b) plan sponsors to have a plan document in place, there were no IRS pre-approved documents. Now, in 2019, numerous vendors offer pre-approved documents that individual tax-exempt employers can (somewhat) tailor to their needs (for instance, through Adoption Agreement selections). The IRS pre-approved documents are much lengthier than the documents that were adopted in 2009. For instance, the Fidelity Adoption Agreement from 2009 was approximately 6 pages long, including attachments, but the 2019 restatement version, with attachments, is approximately 49 pages long. This difference is down to changes in the laws governing retirement plans, as well as increased sophistication of plan administration and recordkeeping systems over that time.

Due to increasing complexity in plan design and administration, employers may want to take the restatement opportunity to self-audit their plan administration procedures and to confirm that they are consistent with the way the document, as restated, reads. For instance, does the payroll department, whether internal or outsourced, draw from the correct payroll code sources when processing employee salary deferrals and employer matching or nonelective contributions? Does the plan contain exclusions from the definition of compensation that are being ignored when payroll is processed? Are participant salary deferrals and loan repayments timely being remitted to the plan? The self-audit is a good opportunity to catch any operational errors and correct them under IRS or Department of Labor voluntary compliance programs (e.g. Employee Plans Compliance Resolution System, and Voluntary Fiduciary Correction Program).

Pre-approved document vendors (often also the investment providers) will assist employers in migrating their 2009 (or subsequent) plan document provisions over to the new version of the document, but employers should seek assistance from benefit counsel in this process to limit the chance of errors. Benefit counsel can also help conduct a self-audit, or take employers through the voluntary correction programs in the event any operational errors are uncovered.

IRS Plan Correction Program Goes Digital

The IRS maintains a voluntary correction program for retirement plan sponsors, called the Employee Plans Compliance Resolution Program, or EPCRS. Plan errors that have occurred within 2 years generally may be eligible for self-correction, whereas older plan errors that are “significant” must be corrected with IRS approval through the Voluntary Compliance Program, or VCP. EPCRS is a very popular way for plan sponsors to resolve plan problems on their own schedule, and without suffering the monetary penalties that likely would apply in the event of a plan audit.

On September 28, 2018, the IRS announced that, effective April 1, 2019, VCP submissions, including payment of “user fees,” must be made electronically through the www.pay.gov website, per the instructions set forth in Revenue Procedure 2018-52. Plan sponsors, or their authorized representatives, may voluntarily use the electronic submission method starting January 1, 2019, but it will be mandatory starting April 1, 2019 and the IRS will reject hard copy VCP submissions postmarked on or after that date.

Revenue Procedure 2018-52 makes extensive revisions to Sections 2, 10 and 11 of Revenue Procedure 2016-51 (and otherwise generally supersedes it) to describe the new electronic user fee payment and VCP submission methods.  Under the new methods, a plan sponsor must either itself submit the VCP application electronically, or authorize a representative to do so via Form 2848, Power of Attorney.  Only third parties designated via Form 2848, such as attorneys, CPAs, or enrolled agents, can sign and file the VCP application on the plan sponsor’s behalf.  (A plan sponsor may use Form 8821 to designate other representatives (such as unenrolled return preparers) to inspect or receive confidential information from IRS about the submission.)

Under the new procedures, the VCP submission process will be as follows (note that links to IRS forms are not provided as they may be changing as a result of the new Revenue Procedure):

  1. Create an account at www.pay.gov, if one does not already exist. If using an authorized representative (AR), confirm that the AR has a www.pay.gov account.
  2. Using www.pay.gov, complete Form 8950, Application for Voluntary Correction Program (VCP).  If using an AR, the AR will complete the form.
  3. Assemble, into a single PDF file not exceeding 15 MB, the following:
  • Plan Sponsor’s signed Penalty of Perjury Statement. (This used to be part of IRS Form 8950 but now will be a separate statement.
  • Form 2848, Power of Attorney, or Form 8821, Tax Information Authorization. If using an AR, you must check line 5a for “Other acts authorized” on Form 2848 and include as a description “signing and filing of the Form 8950 and accompanying documents as part of a VCP submission.”
  • Form 14568, Model VCP Compliance Statement, and any/all applicable Schedules to same (Forms 14568-A through 14568-I), and required enclosures.  Alternatively, a cover letter and separate written narrative could be used.
  • Sample earnings calculations and earnings computations.
  • Relevant plan document language or full plan document when applicable (e.g., non-amender failures).
  • Copy of opinion, advisory, or determination letter, if applicable, pertaining to the plan document.
  • Any other required information, such as statement required for 403(b) plans re: cooperation of all investment providers.

4.  Upload the PDF file at www.pay.gov. If information supporting the submission exceeds the size limit, follow special fax instructions set forth in Section 11.03(7) of the Revenue Procedure.

5.  Use www.pay.gov to pay the user fee, as set forth in Appendix A of Revenue Procedure 2018-4 (and successor Revenue Procedures issued at the beginning of each year). The user fees are now based on plan assets rather than the number of plan participants.

6.  Keep the “Payment Confirmation – Application for Voluntary Correction Program” that is generated on successful filing through pay.gov; the Tracking ID on this receipt serves as the IRS control number for your submission and is official acknowledgement of the submission; if no confirmation is generated call (877) 829-5500 for assistance.

If you discover additional operational errors after submitting your VCP materials, but before the submission has been assigned to an IRS representative, you are directed to call the VCP Status Inquiry Line at (626) 927-2011 (not toll-free) for further information. Although it is currently customary for the IRS to contact the filer once a submission is assigned to an IRS representative, this may not be the case in the future; in the Revenue Procedure the IRS reserves the right to process submissions and issue compliance statements without any prior contact with the filer.  If the IRS gets the jump on you in this manner, you will likely have to pay a new user fee and address the later-discovered errors under a new VCP submission.

Even before the recent increase in VCP user fees, EPCRS was a consistently strong revenue source for the IRS and the new digital streamlining of the program will likely increase its use by plan sponsors over time.

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.

IRS Questionnaire Sent to College, University Plans Does Not Put Plans “Under Examination” but EPCRS Availability Remains Unclear

The IRS Employee Plans Compliance Unit (“EPCU”) is in the process of sending over 300 written questionnaires to a random sample of small, medium, and large institutes of higher education, including private and public colleges, universities, and trade and vocational schools. The questionnaire – on IRS Form 886-A – contains 18 separate questions but mainly focuses on one issue: whether the organization’s Section 403(b) plan satisfies the “universal availability” requirement. Under that rule, if one employee has the opportunity to defer a portion of salary under the plan, then generally all employees must be offered the same opportunity. (Very limited exceptions apply.) The questionnaire seeks to identify plans that are not making the deferral opportunity universally available, either because the limited exceptions are misapplied, or the employer imposes additional conditions on deferring that are not permitted under law. A number of the questions refer specifically to exclusion of groups of employees unique to educational organizations, such as medical residents, and different categories of instructors, professors or lecturers. An IRS announcement on the project as well as links to the questionnaire, instructions for filling out same, and a glossary of terms, can be found here.

Organizations have 25 days to complete and return the questionnaire by fax, mail or e-mail. Upon review of the questionnaire, the IRS will either deem a plan to be compliant and issue a “closing letter,” or will request additional information from the organization. If a problem is found the IRS will work with the organization to correct it, for instance by making fully vested employer contributions to restore the lost opportunity to make tax deferrals in prior plan years. (Generally the employer contribution requirement is equal to half of the deferral the employee would have made (the “lost opportunity” cost), but specific correction methods are not set forth in the questionnaire or in the IRS announcement of the program. Correction methods will be specified in a follow-up letter sent to organizations whose initial responses require follow-up.

Receipt of the questionnaire will not mean that a plan sponsor is “Under Examination” and thus barred from using the Voluntary Correction Program under the Employee Plans Compliance Resolution System (“EPCRS”) to correct 403(b) operational errors currently identified in EPCRS (for instance, failure timely to implement an employee’s salary deferral election). This was confirmed by the IRS, with regard to a similar 401(k) questionnaire project, in a recent issue of Employee Plans News. That said, the current version of EPCRS, set forth in Revenue Procedure 2008-50, does not provide as many corrections for Section 403(b) plans as are available to other types of qualified plans, largely because Rev. Proc. 2008-50 was drafted before Section 403(b) plans were required to be set forth in writing. For instance, VCP is not available for sponsors that lack a written Section 403(b) plan document or that have failed to operate the plan in accordance with its written terms, nor is it available for employer eligibility failures. The IRS is expected later this year to release an updated version of EPCRS that covers Section 403(b) corrections in greater detail. However, it is not known whether or not the new Revenue Procedure will contain relief for sponsors that failed to timely put a plan document in place or failed to operate a plan in accordance with its written terms.

Tax-exempt employers who receive a questionnaire strongly are advised to consult with their professional tax advisors before submitting a response to the IRS. An incorrect response – or an accurate response – could trigger potential contribution and tax liability on a significant scale, and the availability of EPCRS is uncertain. Such discoveries are better made – and resolutions discussed – with private advisors before the IRS is part of the conversation. If additional time to complete the questionnaire is necessary, employers should request it of the IRS before reaching the 25-day deadline.

DOMA Repeal Bill Introduced by House Democrats

Only a few weeks after the Justice Department announced withdrawal of its support for the federal Defense of Marriage Act, legislation to repeal it was introduced in the House of Representatives. Specifically, on March 16, 2011 Rep. Jerrold Nadler (D. N.Y.) re-introduced the Respect for Marriage Act, which he first sponsored in 2009. The legislation has the support of over 100 co-sponsors in the House, including four openly gay members of Congress. A version of the bill shortly is expected to be introduced in the Senate by Sen. Dianne Feinstein (D. California). This will be the first time that the Senate has entertained a bill to repeal DOMA, which since 1996 has limited the rights and protections of federal laws to legally married, opposite sex spouses.

Prior to DOMA, marital status was decided at the state level, and if the Respect for Marriage Act becomes law this again will be the case. If a same-sex couple legally was married in a state that permits such unions, such as Massachusetts, the couple would have equal treatment under federal law as an opposite-sex married couple. Couples who are registered domestic partners or in civil unions would not have spousal status for federal purposes unless they also legally were married under state law. Lamda Legal prepared a concise summary of the likely impact of the Respect for Marriage Act; you can read that summary here.