Voluntary Fiduciary Correction Program

June 6, 2022

The Slippery Slope of SEP and SIMPLE Notification Duties

As the June 30, 2022 CalSavers deadline bears down on employers with five or more California employees, many small employers may be giving thought to adopting a simplified retirement plan, whether a SEP or SIMPLE IRA. Establishment of one of these types of plans is a permissible alternative to participating in CalSavers. There are circumstances where these types of plans are a good fit. However, each of these types of plans imposes participation notification duties that employers often overlook, and noncompliance can put the tax-sanctioned status of the whole arrangement at risk. Below we summarize the relevant rules.

Simplified Employee Pension (SEP) Notification Duties

IRS Form 5305 is often used to establish a SEP. A plan set up via Form 5305 is considered adopted when eligible employees have been provided with:

a copy of the completed, signed, and dated Form 5305-SEP, including the Instructions to Employer and Information to Employee sections;
a statement to the effect that IRAs other than the IRA(s) into which employer contributions will be made may yield different rates of return and may have different terms concerning, among other things, transfers and withdrawals of funds from the IRA;
a statement that notice of any amendment to the SEP, a copy of the amendment and a written explanation of its effects, will be provided within 30 days of the effective date of any such amendment; and
a statement that the employer will provide written notice of contributions made to the plan, by the later of (a) January 31 of the year following the year in which the contribution is made, or (b) the date that is 30 days after the date the contribution is made. This notice duty may be met by reporting the SEP contribution on eligible employees’ Form W-2 for a given year. Failure to provide the notice of contribution may subject the employer to a $50 penalty per failure unless the failure is due to reasonable cause.

This information must be provided thereafter to each new employee who becomes eligible under the SEP.

Additional disclosure duties apply if you are using a prototype SEP arrangement, rather than Form 5305-SEP, including special disclosures for plans under which contributions are integrated with Social Security. Providing eligible employees with a copy of the SEP agreement will meet many of the disclosure requirements, but employers should check with the prototype SEP sponsor to confirm that they will timely supply your business with all necessary additional disclosures. Annual contribution reporting through Form W-2 is the same.

Savings Incentive Match Plan for Employees (SIMPLE IRAs)

Notification duties under a SIMPLE plan are more complicated than under a SEP due to the employee elective deferral feature. Also, there are two model SIMPLE forms in use, Form 5304-SIMPLE and Form 5305-SIMPLE. Form 5304-SIMPLE is used when all IRAs are established with a single designated financial institution, and Form 5305-SIMPLE is used when participants select their own IRA provider.

For an existing SIMPLE IRA plan, eligible employees must receive a Summary Description and Notification to Eligible Employees before the start of a 60-day election period. Since all SIMPLE plans must be on a calendar plan year, including those set up using Forms 5304- or 5305-SIMPLE, the plan year must be the calendar year. Therefore the 60-day election period runs from November 2 through December 31, and the notice must be provided before November 2 each year. Provision of a current copy of the completed Form 5304-SIMPLE or 5305-SIMPLE, with instructions, will satisfy both disclosure duties if Article VI – Procedures for Withdrawals, is completed. When Form 5304-SIMPLE is in use, the custodian or trustee may provide the Article VI information directly to the employees; employers should confirm that the custodian/trustee is timely meeting this disclosure duty, however.

For a new SIMPLE IRA plan or for a new hire who becomes eligible, the Model Salary Reduction Agreement that comprises part of Forms 5304- and 5305-SIMPLE must be provided prior to the 60-day period that includes either the date the employee becomes eligible or the day before. The employee must be able to commence elective deferrals as soon as they become eligible, regardless of whether the 60-day period has ended, but no earlier than the plan’s effective date. Certain special notification and election period rules apply when an employee becomes an eligible employee other than at the beginning of a calendar year, including when an employee is rehired during a plan year.

How to Deal with SEP and SIMPLE Mishaps

If you have not timely met your SEP notification duties as outlined above, you should consult an ERISA attorney.

If you have not timely met your SIMPLE-IRA plan notification duties as outlined above, you can fix the problem by following the steps outlined in the SIMPLE IRA Plan Fix-It Guide. Self-correction may be an option if you had practices and procedures in place to timely provide the notice but failed to follow them, and other pre-requisites to self-correction have been met. Otherwise, you may need to use the Voluntary Correction Program to fix the problem. This will generally require the involvement of an ERISA attorney.

In addition to notification duties, SIMPLE plans are subject to rules regarding timing of deposit of employees’ elective deferrals. Elective deferrals must be deposited with the IRA custodian or trustee within the 30-day period following the last day of the month in which the amounts otherwise would have been payable in cash to employees.

If elective deferrals are not timely deposited, the Department of Labor (DOL) may have to be contacted to correct the problem. Why is this necessary? To avoid potential employer liability for civil penalties, and in some cases involving missed or late elective deferrals, criminal penalties.

Special rules, not addressed above, may apply to plan documents not established using the IRS forms mentioned in this post.

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. © 2022 Christine P. Roberts, all rights reserved.

Photo credit: Nico Smit, Unsplash

April 4, 2022

Just Adopted a New 401(k) Plan? Beware These Common Pitfalls

By June 30, 2022, businesses with 5 or more California employees must either enroll in CalSavers, a state-managed system of Roth IRA accounts, or establish their exemption from CalSavers by adopting 401(k) or other retirement plans of their own. Other states have implemented or are rolling out similar auto-IRA programs. Below are some potential pitfalls for new plan adopters that business owners should be aware of, and, where possible, take steps to avoid.

Immediate top-heavy status. The “top-heavy” rules compare the combined plan account balances of certain owners and officers, called “key employees,” with the plan account balances of all other plan participants (non-key employees). If the key employee account balances make up 60% or more of the combined plan account balances of all participants, the plan is top-heavy and the plan sponsor is required to make minimum contributions (generally equal to 3% of compensation) to the accounts of all non-key employees. A plan can be top-heavy in its first year of operation, although it is more commonly a result of large account balances accumulated over time by long-term key employees, versus smaller accounts held by high-turnover, lower paid employees. Top-heavy status is particularly likely to arise in a family-owned business, as family members of owners count as key employees, but the problem is not limited to this scenario. Businesses that anticipate a potential top-heavy problem should consider adopting safe-harbor 401(k) plan designs, as a basic safe-harbor matching or non-elective contribution will satisfy minimum top-heavy contribution requirements. A SIMPLE-IRA plan is also exempt from top-heavy requirements, provided you have 100 or fewer employees.
ADP/ACP testing failure. A similar and more common problem, failure of the Actual Deferral Percentage or ADP test, occurs when the average rate of elective deferrals made by Highly Compensated Employees exceeds the average rate of elective deferrals made by non-Highly Compensated Employees by more than a permitted amount. (A related test, the Actual Contribution Percentage test, applies to matching contributions.) Highly Compensated Employees (HCEs) are persons who own more than 5% of the company sponsoring the plan at any time during the current or prior year, or who, for the prior year, earned above a set dollar amount. (For 2022, the amount is $135,000 and applies to 2021 earnings.) Correcting testing failures will involve refunding amounts to HCEs, or making additional contributions to non-HCEs. Fortunately there are a number of preventive measures to take, including using a safe harbor contribution formula, using a “top 20%” election to define HCEs, using automatic enrollment at a meaningful percentage of compensation (such as 5% or higher), and robust enrollment meetings and tools to engage employees with savings potentials under the plan.
Late deposit of elective deferrals. When you run payroll and pull employee elective deferrals from pay, you have a deadline within which to invest them under your 401(k) plan, which is the point at which they are considered to be “plan assets” under ERISA. Investment is generally is denoted as a “trade date” by your plan’s recordkeeper, whether Fidelity, Vanguard, or the like. If you have under 100 participants as of the beginning of your plan year (counting those who are eligible to participate even if they don’t actively do so) you have seven business days to get from pay date, to trade date. For larger plans, the normal deadline to invest is as soon as elective deferrals can reasonably be segregated from your general assets. (An outside deadline of 15 business days after the end of the month following the month in which the elective deferrals would have been payable in cash applies in the event of extraordinary circumstances interrupting normal payroll functioning.) If you fail to meet the seven business-day or “as soon as” deposit deadline, your retention of employee funds constitutes a “prohibited transaction” and an excise tax is payable to the IRS. Additionally, the Department of Labor views it as a fiduciary breach. It is possible to seek relief from the excise tax and from potential fiduciary liability by participating in the Department of Labor’s Voluntary Fiduciary Compliance Program or VFCP. Late deposits of employee elective deferrals (and loan repayments) must be disclosed each year on your Form 5500 Return/Report, which in turn could trigger further inquiry, so compliance with your applicable deposit deadline is important.
Plan audit requirement. As we covered in an earlier post, a business sponsoring a brand new 401(k) plan may be required to obtain an audit report on the plan’s operations and finances, prepared by an independent qualified public accountant or IQPA, at an annual expense of $5,000 – $15,000 or more. These reports generally are required for plans with 100 or more participants as of the first day of the plan year, counting those who are eligible to participate whether or not they actually do so. Proposed regulations for Form 5500 might change that rule, to count only those with plan account balances, but they have yet to be finalized and put into effect. Until that time, businesses sponsoring new plans that will cover 100 or more eligible participants need to prepare for the audit process, both in terms of budgeting dollars for the cost, and time to gather responses to the auditor’s questionnaires. New auditing standards going into effect this year put increased responsibilities on plan sponsors to account for plan operations and documentation.

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December 13, 2021

Five Good Reasons to Correct Retirement Plan Errors

If your business sponsors a Section 401(k) or other retirement plan, it is governed by a lengthy plan document, often a separate trust agreement or custodial account agreement, and multiple other documents (salary deferral agreements, loan policy statement, investment policy statement, etc.) Not surprisingly, most plan sponsors get something wrong somewhere along the way, whether with respect to the plan document, or operation of the plan. Below are five reasons why taking prompt action to correct plan errors is in the best interests of your business, and your employees.

To preserve the tax-qualified status of your plan.

Contributions to your plan are deductible to your business and excluded from your employees’ taxable compensation (i.e., are “tax-qualified”) because the plan document, and operation of the plan, conform to certain requirements under the Internal Revenue Code. Under the Employee Plans Compliance Resolution System or EPCRS, the Internal Revenue Service permits plan sponsors to voluntarily correct a wide range of errors that, if left uncorrected, could result in a loss of the plan’s tax-qualified status and subject plan assets to taxation. There are costs associated with participating in the EPCRS, including amounts that may be owed to the plan, attorneys’ fees, and program fees, but they are usually only a fraction of the potential expense of plan disqualification.

To correct prohibited transactions.

While the IRS monitors the tax-advantaged status of benefit plans, the Department of Labor policies the actions of plan fiduciaries, both with respect to plan assets, and in fulfilling reporting and disclosure duties. When salary deferrals and loan repayments are withheld from employees’ pay and not promptly deposited in the plan’s trust account, the Department of Labor essentially views this as an interest free loan, by the employer, of employee money. Technically speaking, it is a “prohibited transaction” that requires correction under the DOL’s Voluntary Fiduciary Correction Program. Uncorrected prohibited transactions, if discovered on audit, can result in civil monetary penalties to the fiduciaries, and also triggers excise taxes payable to the Internal Revenue Service. Prohibited transactions also must be disclosed on the annual Form 5500 Return/Report, potentially alerting the Department of Labor to initiate further inquiry or audit. Timely participation in VFCP eliminates the fiduciary penalties and offers alternatives to payment of the excise taxes in some circumstances (e.g., if the same amount is paid to the plan).

To minimize penalties in the event of a plan audit.

The IRS, on audit, may assess penalties for uncorrected errors in plan documentation and operation, that can reach many thousands of dollars, on top of the amounts owed to the plan in order to correct operational errors. And, as mentioned, prohibited transactions trigger potential civil monetary penalties. Participation in IRS and DOL voluntary correction programs protects plan sponsors from these potential large assessments. Whatever the cost of taking part in the voluntary program, whether it be costs of corrective contributions and earnings, attorneys fees, and the program fee, it is a quantifiable cost and one that is much smaller than the cost of correcting under the supervision of the IRS or DOL.

To ensure the saleability of your business.

Plan sponsors sometimes think that their uncorrected plan errors are only at risk of discovery if they are audited, and point to low levels of IRS and DOL audit activity as proof that they can safely play “audit roulette.” However they are forgetting that, if they want to sell their business – particularly stock sales – or merge with another business, the due diligence process preceding the transaction will likely require them to identify any errors in plan documentation or operation within a 3 year or longer period. An unresolved plan error could derail the transaction, or at best require correction under terms and conditions that are not as favorable, to the plan sponsor, as self-correction would have been. If you envision your business as a purchase target or merger partner in the future you owe it to yourself to make sure that plan errors are corrected promptly and in advance of any due diligence inquiries.

Because it’s the right thing to do.

Your retirement plan document is a contract you have entered into for the benefit of plan participants and beneficiaries and you should take it as seriously as any contract you enter into with a third party. It spells out the right way to do things, for the most part, and the IRS and DOL self-correction programs are there to minimize the downside when plan documentation or operation falls short of perfection. Whether your goal is to sell your business without a hitch, or glide through an IRS or DOL audit with a minimum of fuss, fixing plan errors promptly is the right choice every time.

The above information is a brief summary of legal issues 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: Sasun Bughdaryan, Unsplash

August 11, 2021

Summertime Blues for Your 401(k) Plan, Pt 3

The third in our series of posts on common plan errors that are discovered when plan audits are underway each summer, is the failure to timely deposit plan assets consisting of employee elective deferrals and loan repayments. Unlike the operational errors we discussed in the prior two posts, which are corrected under the IRS Employee Plans Compliance Resolution System or EPCRS, this particular error of late deposits is corrected under a Department of Labor program called the Voluntary Fiduciary Correction Program or VFCP. There is an IRS piece that must be attended to, however, discussed below.

First – to identify the problem. Money taken out of employee pay in the form of elective deferrals, whether pre-tax or Roth, and loan repayments, becomes ERISA plan assets as of a certain point in time. Once they become plan assets, they must be invested in the Plan “trust” – meaning they must be documented as having been deposited with the plan recordkeeper. If they have not been deposited by the magic “plan asset” hour, then the Employee Benefits Security Administration of DOL (EBSA) views the situation as an illegal, interest-free loan of plan assets, by the plan sponsor. In formal terms, this is a “prohibited transaction” or misuse of plan assets by a fiduciary, and it has adverse consequences with DOL. It also triggers excise taxes with IRS, described below.

Thus, there are several parts to this inquiry – first, what is the magic hour at which employee funds become plan assets, and second, what relief from adverse consequences with DOL and IRS is available under VFCP? Lastly there is how this issue is reported on the Form 5500 Return/Report series. We discuss each in turn below. And – no surprise, there is a COVID-19 angle to consider, as well.

When Do Employee Funds Become Plan Assets?

The magic “plan assets” hour depends upon the size of the plan in question. If the plan has fewer than 100 participants as of the first day of the plan year, employee funds are timely deposited if they are deposited with the recordkeeper no later than the 7th business day following the day on which the amounts would otherwise have been payable in cash (i.e., the applicable pay date). Recordkeepers often refer to the deposit event as the “trade date.” If employee funds are not deposited by the end of that 7th business day, they are plan assets improperly held by the plan sponsor.

If the plan has 100 or more participants as of the first day of the plan year, employee funds are timely deposited if they are deposited with the recordkeeper as of the earliest date on which such amounts can reasonably be segregated from the employer’s general assets. In some cases, EBSA has asserted that, if payroll taxes can be segregated from general assets, so can employee contributions, making pay date the earliest segregation date. More commonly, the earliest reasonable segregation date can be determined by looking at payroll processing history and identifying the shortest amount of time that generally elapses between a pay date, and the recordkeeper trade date. Very often nowadays this is a period of only one or two business days. If employee funds are not deposited by the end of that period, they are plan assets improperly held directly by the plan sponsor.

Holidays may be taken into account in calculating the earliest reasonable segregation date, thus the deposit date would be the first business day after a holiday Monday, for example. For unusual events that are out of the plan sponsor’s control, the “drop dead” deposit deadline is the 15^th day of the month following the month containing the normal earliest reasonable segregation date.

What about the impact of COVID-19? In EBSA Disaster Relief Notice 2020-01, issued on April 29, 2020, relief is granted only if a timely deposit cannot be made “solely on the basis of a failure attributable to the COVID-19 outbreak.” This is a very fact-specific inquiry; each situation will be different. At the early stages of the pandemic, such a failure might have included a staff furlough that included payroll personnel or personnel at a third party payroll provider. Now that the pandemic is almost eighteen months along, even taking into account setbacks like the Delta variant, deposit delays that can be demonstrated to be exclusively due to the virus are unlikely to be common. That said, the Disaster Relief Notice 2020-01 remains in effect from March 1, 2020 through the 60^th day following the announced end of the COVID-19 National Emergency.

What Relief is Offered under VFCP?

Through timely participation in the VFCP program, which includes preparation of a written submission with proof of payment of earnings on late deposited elective deferrals and loan repayments, a plan sponsor may avoid potential civil actions, penalties, and the assessment of civil penalties under Section 502(i) of ERISA. Successful participants receive a “no action letter” from EBSA that is useful to demonstrate plan compliance in the event of a later plan audit or in a due diligence process related to a corporate merger or acquisition.

Importantly, participation in VFCP must precede the point at which a plan is “under investigation” by EBSA meaning an EBSA audit of the plan in question. Other circumstances can give rise to a plan being “under investigation” such that VFCP is unavailable.

A prohibited transaction consisting of late deposited ERISA assets gives rise to a first-tier excise tax under Internal Revenue Code Section 4975 that is equal to 15% of the amount involved, with the amount involved equal to the time value of the money that was untimely deposited in a plan. The excise tax is payable by the plan sponsor and reported on Form 5330. The VFCP offers a limited relief from this excise tax. VFCP can be used for multiple years (but a plan sponsor should ask itself why its timely deposit problems are persisting), but the excise tax relief can only be used once every three years.

Information on VFCP is found here – but keep an eye on that location as the program, which dates in its current form back to 2006, is under a rewrite and overhaul. It is anticipated that the new version will streamline some of the correction methods currently described under VFCP (late deposits is only one of a number of other transactions that the program covers).

How Are Delinquencies Reported on Form 5500/5500 S-F?

Form 5500 and Form 5500 S-F require a plan sponsor to disclose whether there was a failure to transmit any participant contributions to the plan during the plan year in question, and to disclose the aggregate amount that was not deposited timely. Even if the late deposits were corrected under VFCP, you must report them. If you report late deposits on Form 5500 without adding an attachment explaining that they were corrected under VFCP, you may get a letter from EBSA that politely “invites” you to participate in VFCP by a firm deadline. You are recommended to submit your VFCP application by that date, or risk further action that may result in penalties.

One question that comes up around late deposited employee funds is whether it is necessary to participate in VFCP for delinquent deposits that are small in amount and/or short in duration. The answer is that, until EBSA announces a self-correction version of VFCP, participation in VFCP is recommended in order to avoid adverse consequences when the uncorrected delinquencies must be reported on Form 5500 or 5500 S-F. If you have questions about a possible need for correction under VFCP, contact your plan’s third party administrator or ERISA attorney.

Photo credit: Inna Kapturevska, Unsplash