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.

Summertime Blues for Your 401(k) Plan, P.2: Eligibility Failures

This is the second installment in five posts covering the most common 401(k) plan operational issues that arise during Form 5500 prep season for calendar year plans, which happens to be summertime: the season of outdoors fun and enjoyment for folks outside the ERISA bubble. This time around we will focus on a few selected errors related to eligibility under the plan – who gets to participate in the plan, and when. (More information on fixing eligibility errors in a 401(k) plan, courtesy of the IRS, is found here.) Note that the following discussion relates to plans in which participants must affirmatively enroll; a separate post will cover operational errors arising from auto-enrollment features.

Error No. 2: Eligibility Failures

Eligibility speaks to who gets to participate in a 401(k) plan, and entry dates signal when their participation must begin. These related areas can result in a host of plan errors.

The two main criteria of plan eligibility are age and service, and a minimum age of 21 and one Year of Service (defined below) are common eligibility criteria, especially for receiving employer contributions. The minimum service requirements to make salary deferrals are commonly reduced to, say, three months of service or even a shorter period. Also, commonly, plans exclude employees covered by a collective bargaining agreement, and employees earning no U.S.-source income. These criteria are all fairly straightforward, but complications sometimes arise when plans exclude employees based on schedule or job category, such as part-time employees, temporary employees, and per diem employees. Applicable law requires that employees in these categories be allowed to participate once they have worked 1,000 hours in a 12-consecutive month period (“Year of Service”). This requirement is part of preapproved plan documentation (adoption agreement), but plan sponsors not infrequently fail to adhere to it in actual fact. So, it is not uncommon to find that a plan has been excluding employees classified as per diem, or part-time, even after they have attained 1,000 hours in a given plan year.

The correction for this error is generally to put the improperly excluded participant in the position they would have been in had the error not occurred, by making qualified nonelective contributions (QNECs), plus earnings, to replace the salary deferrals and matching contributions that they failed to receive while improperly excluded from the plan. Generally plan sponsors only need to replace 50% of the missed elective deferrals (lost opportunity cost), but in some cases when the error is caught and corrected quickly and a disclosure is made to affected participants, the lost opportunity cost is reduced to 25% of the missed elective deferral (period of failure exceeds three months, but is less than two years), or even 0% (period of failure is less than three months). 100% of the missed matching contribution or nonelective contribution needs to be replace, plus earnings.

Note that under the SECURE Act, Section 401(k) plans (other than collectively bargained plans) must cover “long-term, part-time employees” who work at least 500 but less than 999 hours in each of the last three consecutive years. Employers must start counting hours of service towards this standard in 2021, such that the first coverage of long-term, part-time employees will occur in 2024. Proposed legislation would reduce the three year measurement period to two years. A plan sponsor can be more generous than the minimum requirement and allow entry into their plan sooner than the SECURE Act deadline.

Entry dates add another area of potential error. Entry dates may be semi-annual (e.g., January 1 and July 1, for a calendar year plan) or more frequent, such as quarterly (January 1, April 1, July 1, October 1), or even monthly. Errors often occur when plans are amended to adopt a more frequent entry date schedule, but plan operation lags behind and continues to follow the old entry date schedule. Errors also arise because of the time period for counting the 1,000 hours (the initial eligibility computation period) is often misunderstood and thus misapplied. In most plans, but not always – check your Adoption Agreement! – the 1,000 hours are counted from the date of hire to the first anniversary of hire, and then the counting period switches to the plan year (in these examples, the calendar year). Sometimes plan sponsors keep using the anniversary date cycle and therefore don’t catch the correct point at which 1,000 hours is attained, and thus miss the correct entry date.

Other eligibility errors arise from permitting employees to participate before they have met eligibility criteria. Sometimes these errors can be corrected with a retroactive amendment permitting early participation by the otherwise eligible employee. However this might not be the correct approach if, for instance, most of the affected participants are highly compensated employees. In that scenario, return of contributions plus earnings may be appropriate.

Correction of eligibility errors is relatively straightforward, as noted. The real goal, however, is to avoid these operational errors in the first place. I’ll come back to my favorite recommendation to avoid unneeded plan interpretation mishaps – design your plan as simply as possible. Of course, “simplicity” will depend upon the sector your business is in and the rate of employee turnover you experience. Immediate eligibility may be simple to administer for a small shop of engineering professionals, but a six-month or longer eligibility period may make sense for a restaurant or other business that experiences high turnover. If immediate eligibility works for your business, keep in mind that there are other ways to incentivize employees to stay with you long term, for instance by way of a vesting schedule imposed on employer contributions.

In addition to a simple plan design, I also recommend the all-hands meeting among human resource and payroll personnel, whether in-house or outsourced, at which every attendee has a copy of the plan adoption agreement, and a description of employment categories such as full-time, part-time, temporary, per diem, etc. It may also be helpful to have a representative of the plan recordkeeper at the meeting. At this meeting, the key sections of the plan document are those on eligibility, hours of service, and entry dates. The attendees should review the age and service criteria for eligibility, the method of crediting hours of service (whether actual hours or elapsed time.), any exclusion categories, whether any exclusion categories are subject to the 1,000 hour exception, and how the eligibility computation period works. Walking through hypothetical new hires and whether and when they enter the plan is one way to make sure everyone is on the same page and to reduce the chances for misinterpretation of the plan documents. After the meeting, drinks with umbrellas in them may be in order!

Photo credit: A.J. Garcia, 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.

Summertime Blues for Your 401(k) Plan, Pt. 1

Summertime is for fun, relaxation and a break from work, but it is also a crucial period for calendar year 401(k) plans. Form 5500 Annual Return/Reports are due July 31 for these plans, and even if an extension to October 15 is obtained, the summer months are when plan operations and finances are under scrutiny.  This is particularly true for “large” plans – those with 100 or more participants on the first day of your last plan year. (Note that special transition rules apply when switching from small plan to large plan Form 5500 filing status and back again, under the “80/120 rule.”  A good explanation of the rule is found here.)   Sponsors of large plans must engage an independent qualified public accountant (IQPA) and attach the auditor’s report to their Form 5500. 

As a benefits attorney, I associate summer with calls from plan sponsors whose auditing CPAs have identified operational failures and other plan errors that require correction under Internal Revenue Service and Department of Labor voluntary compliance programs, including self-correction, when available.  This is the first in a series of five posts covering the 401(k) mishaps that are as reliable a feature of my summers as are the 4th of July, outdoor barbecues and sunscreen.

Error No. 1:  Mismatching Definitions of Compensation

Disconnects between payroll procedures, and the way that your 401(k) plan defines “compensation” for purposes of salary deferrals and employer contributions, generate a significant number of plan operational failures that I see. 

Examples include adding payroll codes to your system without applying participants’ deferral elections and employer contribution to those new payroll amounts, or carving out categories such as bonuses, commissions, and overtime from your plan’s definition of compensation, without stopping deferrals and employer contributions from those amounts.  Whole categories of pay – for instance, tips recorded on credit cards – can sometimes be overlooked in plan operations, as well.  These errors can be corrected fairly simply but the corrections can be expensive and/or time consuming if the errors cover multiple years. 

The best recommendation I can make to avoid compensation-based errors in operating your 401(k) plan is to use Form W-2, Box 1 as your plan’s definition of compensation, with no exclusions (other than gift cards or cash rewards, if your company uses them) and to regularly revisit your payroll codes and procedures to make sure that all pay items that appear in Box 1 are counted for purposes of participants’ salary deferrals and loan repayments. 

Specifically, you should consider holding a meeting each year, or more frequently, among human resources and payroll personnel (in-house or out-sourced) to review the definition of compensation in the Adoption Agreement, on the one hand, and a list of all payroll codes, on the other. Revisit this exercise every time you modify payroll practices, your payroll vendor or software, or of course any time you change the plan’s definition of compensation. 

If your plan defines compensation in a way that involves carve-outs, be especially careful to ensure that the salary deferrals and employer contributions are not applied to the payroll code amounts that correspond to the exclusions, whether bonuses, commissions, overtime, or other items. 

Be mindful, as well, that certain pay items may be excluded from “safe harbor” definitions of compensation, such as cash and/or non-cash fringe benefits, reimbursements or other expense allowances, and moving expenses, but that other exclusions, such as overtime, will trigger the need for annual testing of the definition of compensation under nondiscrimination rules. 

Lastly, there is a good bit of confusion over the scope of certain categories referenced in the safe harbor definitions of compensation, such as nontaxable fringe benefits, and differential wage payments.  As used in an adoption agreement, differential wage payments generally will relate to military service and are not the same as shift differentials.    When in doubt about any definition of compensation issue, check with your third party administrator, ERISA attorney or other benefits professional.  You want your only headache next summer to be from an ice cream cone, not your 401(k) plan.

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.

Photo credit:  Krissara Lertnimanorladee, Unsplash

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.