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CPA Dismay Over Form 5500 Changes May be Misplaced

Last week, final changes to Form 5500 reporting requirements were announced that are estimated to result in over 10,000 fewer retirement plans having to file independent qualified public accountant (IQPA) reports with their Form 5500 returns. The changes, which take effect for reporting for the 2023 plan year, were met with dismay by CPA firms that provide the IQPA reports, often referred to as audit reports. However, their concerns may be short-lived, as certain provisions of SECURE 2.0 will likely increase plan participation levels over the next few years and result in more plans that are of the size that must file as “large plans” and accompany their Form 5500 with an audit report. Below, we explain the change to the audit requirement, and briefly cover the SECURE 2.0 provisions that may be coming to the rescue.

Who Gets Counted?

The key issue here is the definition of a “large plan” for Form 5500 reporting purposes, including the requirement that a large plan submit an IQPA report with Form 5500.  A large plan is one with 100 or more participants on the first day of the plan year, although special rules apply to plans that cross over that threshold (the 80-120 rule).  As for who gets counted towards the 100 participants, the rule has been that you count any individual who has satisfied eligibility requirements under the plan, whether or not that individual actually participates (such as by contributing salary deferrals, in a 401(k) plan), or otherwise has an account under the plan.  This has often resulted in the anomaly that a plan that covered over 100 participants, but with only a handful of actual plan accounts, and only a few hundred thousand dollars in plan assets, was required to engage an IQPA each year, often for fees in excess of $5,000.

In new final regulations on Form 5500 requirements, the Department of Labor changed the participant counting methodology for defined contribution plans, including 401(k) plans, so that only individuals who actually have plan accounts are counted toward the 100 participants on the first day of the plan year.  This change is also reflected in a revised Form 5500 and instructions released by the Departments of Labor and the Treasury, as well as the PBGC.   The 80-120 rule is still in effect, but only individuals with plan accounts will be counted rather than those who are eligible.

SECURE 2.0 to the Rescue?

There is no question that in the short term there will be a reduced need for IQPA reports during coming Form 5500 seasons.  However CPAs need only to look to certain key provisions in SECURE 2.0 to realize that the stated goal of that legislation – to increase access to retirement plans – will eventually result in a broader base of plan participants in the US and growth in the number of larger plans requiring plan audits.

Specifically, the requirement that plans adopted on or after December 29, 2022 automatically enroll new participants starting in 2025, and auto-escalate their contributions, will be a likely source of plans crossing the 100 participant threshold earlier than would otherwise be the case.  As soon as someone is auto-enrolled at 3% of pay or higher, that person has a plan account and will be counted as a participant towards the 100 participant threshold.

Second, the rules for long-term, part-time employees that go into effect under SECURE 1.0 in 2024, and under SECURE 2.0 starting in 2025, means that a number of plans that are currently under the 100 participant threshold due to a 1,000 hour eligibility requirement may not retain that status with a new maximum deferral eligibility threshold of 500 hours of service in two consecutive years (under SECURE 2.0; three consecutive years under SECURE 1.0).

Think for instance of a plan that was adopted in 2023 and will be required to auto-enroll new participants starting in 2025, and that must also start covering long-term, part-time employees in that year.  That plan will begin with a significantly larger participant base than if it did not auto-enroll, and maintained a 1,000 hour eligibility requirement.

In sum, CPAs may lose some existing plan audit clients in the short term but likely will gain as many if not more back under the expanded coverage rules put in place under SECURE 2.0.

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. © 2023 Christine P. Roberts, all rights reserved.

Photo credit: Andre Hunter, Unsplash

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The Unsung Importance of Self-Correction Memos

Self-correction of operational errors arising in qualified retirement plans is a critical means for plan sponsors to retain their plans’ tax-qualified status. Self-correction has been promoted by the Internal Revenue Service as part of the Employee Plans Compliance Resolution System, or EPCRS, for approximately twenty years, but the rules for self-correction have evolved over that time period, and some essential requirements of self-correction are still little understood. One recommended component of self-correction that can tend to be overlooked is preparation of a self-correction memo. Below I describe what a self-correction memo is, and why preparing one is “best practices” – even if EPCRS does not mandate it.

By way of background, the Self-Correction Program or SCP is one of three component programs of EPCRS available to sponsors of qualified plans, 403(b) plans, SEP or SIMPLE IRA plans. (EPCRS is set forth in a Revenue Procedure that is updated periodically; the current version is Revenue Procedure 2021-30. The other component programs are Voluntary Correction Program or VCP, and the Audit Closing Agreement or Audit CAP.) SCP is available for operational failures (failure to operate a plan in accordance with its written terms) and plan document failures (such as failure to timely adopt a required plan amendment). With regard to operational failures, SCP divides them into two categories: “significant” operational failures, and “insignificant” operational failures. Plan document failures are always treated as significant. Insignificant operational failures are eligible for self-correction at any time. Significant operational failures are eligible for self-correction only if the corrections are both discovered and substantially completed by the last day of the third plan year following the plan year for which the failure occurred. Whether or not an operational failure is significant depends upon a number of criteria that are set forth in Revenue Procedure 2021-30, Section 8.02, including the number of affected participants, versus the total number of participants in the plan as of the Plan’s last filed Form 5500, and the amount involved in the operational failure, versus the total assets in the plan per the last-filed Form 5500. SEP and SIMPLE IRA plans may only self-correct insignificant operational errors.

Other requirements of SCP are as follows:

  • To correct a document failure or a significant operational failure, the qualified plan in question must be the subject of a favorable determination letter (for an individually designed plan) or must be a pre-approved plan that is the subject of a favorable opinion or advisory letter.
  • In addition, the plan sponsor or plan administrator must have established practices and procedure (formal or informal) that are reasonably designed to promote and facilitate overall compliance with Internal Revenue Code requirements, both in form and operation. This may take the form of annual plan administration procedures or guidelines; the plan document alone will not suffice. For SCP to be available, the procedures must have been in place and routinely followed, and the error must have occurred through an oversight or mistake in applying them. This component of SCP is also often overlooked.

What is a Self-Correction Memo?

A self-correction memo is a written memorandum, ideally signed and dated by a representative of the plan sponsor, that does all of the following: (a) describes a plan sponsor’s eligibility to use SCP; (b) describes the operational or document failure(s) and the method(s) of correction; (c) addresses whether or not the error was significant and if so whether it was substantially corrected within the necessary time period; and (d) assembles, as exhibits, all documentation of the error and its correction. Paragraph headings for a self-correction memo for an operational failure may include the following:

  • A description of the operational failure
  • The date that the plan sponsor discovered the operational failure
  • The fact that a favorable letter is in place
  • A description of the plan sponsor’s established practices and procedures for compliance with the Internal Revenue Code
  • A summary of any changes to the plan’s administrative practices designed to prevent the failure from reoccurring
  • A determination that operational errors were insignificant, or significant, following the criteria set forth in Revenue Procedure 2021-30, Section 8.02
  • The correction methodology, with citations to approved EPCRS correction methods, if appropriate
  • The number of affected participants relevant to the number of total participants
  • The manner in which affected participants were notified of the correction
  • A recitation of the actual corrections, including dates and amounts, or attached documentation proving same
  • The bases on which the plan sponsor determined the operational failure to be insignificant, if applicable
  • If the operational error was significant, the dates on which the correction period began and ended
  • If the correction involved transferred assets (which increases the time available for correction), the date of the merger, acquisition, or other similar transaction in which the assets were transferred.

Confirming that your operational failure is eligible for self-correction — and preparing the self-correction memo itself – will often require the guiding hand of an ERISA attorney.

Why is a Self-Correction Memo “Best Practices”?

That is a good question, and there is a common-sense answer. There is nothing in the Revenue Procedure 2021-30 specifically requiring that a self-correction memo be created, but it is best practices because it provides ready proof that the plan sponsor qualified for self-correction and completed all correction steps in accordance with EPCRS. Operational and document failures must be disclosed in a plan audit or during due diligence related to a merger or acquisition involving the plan sponsor. Having a self-correction memo and exhibits to hand in such an event is vastly preferable to simply asserting that self-correction was pursued, without being able to prove that SCP was both available to the plan sponsor, and properly completed within the necessary time period. The listing of recommended topics to cover, above, indicates the volume and specificity of information that is required to take advantage of self-correction. Trying to compile this information under the time pressures of a plan audit or due diligence process, when the information may be difficult to locate or reproduce, is a recipe for failure. It is far preferable to document your self-correction process with a memo as you go along, not unlike cleaning up the kitchen as you cook. You’ll thank yourself later.

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: Dimitri Karastelev, Unsplash


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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. 

  1. 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.
  2. 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. 
  3. 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.
  4. 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.

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:  Goh Rhy Yan, Unsplash

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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.   

  1. 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. 

  1. 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). 

  1. 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.

  1. 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. 

  1. 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

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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 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