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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.

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Lender Beware:  IRS Issue Snapshot on Third Party Loans

The IRS recently published an Issue Snapshot meant to guide examiners who encounter third party loans among the investments of plans they are auditing.   Third party loans occur when a qualified plan trustee elects to loan plan funds to someone other than a plan participant, at a designated rate of return, in exchange for a promissory note, deed of trust, or other form of security. Below I summarize some of the key points in the IRS Snapshot and add some insights gleaned from third party loan issues I have encountered in my practice.   Note: this post is not intended as a “how to” for these risky investments, but as a roadmap for plan sponsors who may have entered into such transactions in the past and could find themselves in an audit setting.

  1. Don’t Assume Your Trust Agreement Permits Third Party Loans.   The Issue Snapshot notes that a plan document may limit the ability of a plan trustee or plan participant to invest in third party loans, and this is absolutely the case.  It is necessary to check plan trust language before making any such investment.   In my examination of plan trust agreements, I have seen language expressly permitting third party loans (e.g., allowing investments in “notes or other property of any kind, real or personal,” and I have seen language that cannot, even in broad “general powers” provisions, be construed to permit third party loans.  A loan made in the absence of plan language permitting the investment is a fiduciary breach.
  2. Avoid Prohibited Transactions.  The third party loan will be a prohibited transaction if the loan is either made directly to a “disqualified person” or indirectly benefits a disqualified person, for instance through rerouting the loan proceeds to them.  A disqualified person includes the employer, fiduciaries, persons providing services to the plan (the IRS gives the example of accountants and attorneys), and persons and corporations who own a 50% or more interest in the employer.   I sometimes see this issue arise in family-owned businesses, where the borrower is a family member who owns more than half of the plan sponsor entity.  The Issue Snapshot encourages auditors to be on the lookout for plan loan terms that disadvantage the plan, such as little or no interest rate or unsecured loans, as indicators that the loan may have been made for the benefit of a disqualified person.  I would add to that list, failure of the plan to enforce timely loan repayment, or frequent re-amortization of the loans on terms that are favorable to the borrower.  Prohibited transactions are subject to excise taxes under Code § 4975(a) and (b).
  3. Avoid Self-Dealing.  Self-dealing by a fiduciary violates the exclusive benefit rule articulated in both the Code and ERISA.   With regard to the Code, the Issue Snapshot notes that others may benefit from a transaction with a plan as long as the “primary purpose” of the investment is to benefit employees or their beneficiaries.  (Citing Shedco Inc. v. Commissioner, T.C. Memo. 1998-295.)  An IRS examiner who concludes that a third party loan fails the primary purpose test must refer the matter to the Department of Labor.  On the Department of Labor side, ERISA Section 406(b) prohibits a plan fiduciary from dealing with the assets of a plan “in their own interest of for their own account.”   In my experience, self-dealing types of third party loans arise more often than direct loans to disqualified persons.  It is not uncommon for there to be a pre-existing relationship between the plan sponsor or trustee, on the one hand, and the borrower, on the other hand, whether that of a business partner, friend, or family member, such that the loan benefits the fiduciary by assisting someone of importance to them.   If identified in an IRS audit and referred to the Department of Labor, or identified in a DOL audit, a loan of this type may result in civil penalties.
  4. Value Your Asset.  The Issue Snapshot cites Revenue Ruling 80-155 as requiring annual valuation of defined contribution plan assets and states that this rule applies to third party loans just like any other plan investment.  It also notes that plan documentation may also expressly mandate annual asset valuations, making failure to obtain them a breach of the plan’s written terms.  The Issue Snapshot does not specify that a professional valuation must be obtained but suggests that a fresh value must be assigned to the loan each year based on a number of factors including the discount/interest rate and the probability of collection.    One thing not to do is to report a static value for the loan across multiple years’ Form 5500 Return/Reports as this will indicate to the Service “that payments under the loan contract are not being made and/or that the true fair market value of the loan is not being appraised or reported.”
  5. Documentation Is Key.  This is not explicitly addressed in the Issue Snapshot but is something I observed in practice.  In one matter I was involved with, the Department of Labor audited a 401(k) plan and observed a portfolio of about a dozen third party loans.  All charged substantial rates of interest, resulting in returns that exceeded those realized by the Plan’s more conventional investments.  All were secured by deeds of trust on real property held by the borrowers.  Third party valuations of the real property parcels had been obtained at the time of the loan, and periodically updated.  Amortization and repayment schedules were up to date on all loans.  The borrowers had no relationship with the business that sponsored the plan or with the fiduciaries themselves.  The Department of Labor scrutinized the loan files and were unable to find any ERISA violations in the loans as an asset class or individually.   The plan sponsor had discontinued the practice of extending new third party loans even in advance of the audit, but by essentially operating with the procedural rigor of a commercial lender, it had maintained third party loans as successful plan investments for a number of years.

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.

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    Will New IRS Funding Increase Plan Audits?

    The Inflation Reduction Act, H.R. 5376 stands poised for passage in the House and includes almost $80 billion in new funding for the Internal Revenue Service, of which almost $46 billion is allocated to “enforcement,” including determination and collection of taxes, legal and litigation support. What is not clear at this juncture is how much of that massive amount of new funding will trickle down to the Tax Exempt and Government Entities Division, which has oversight over retirement plans, the employers that sponsor retirement plans, and IRAs. IRS Commissioner Chuck Rettig has stated in letters to both houses of Congress that the rates of auditing households making under $400,000 per year will not increase despite the new funding, but that the resources will enable “meaningful, impactful examinations of large corporate and high-net-worth taxpayers.” Whether this includes examinations of large corporate and high-net-worth taxpayer retirement plans and IRAs is uncertain.

    A breakdown of the new IRS funding, which is set forth in Title I, Subtitle A, Part 3 of the Act, is set forth below.

    Section 10301. Enhancement of Internal Revenue Service Resources.

    It seems hard to imagine that some portion of the enforcement budget won’t ultimately increase plan audit activity. The IRS only recently announced a new plan enforcement initiative in the form of a 90-day Pre-Examination Compliance Pilot program (click on June 3, 2022 to display the program announcement). Under this new program, IRS will send a letter to a plan sponsor notifying them that their retirement plan has been selected for an examination. The letter gives the plan sponsor a 90-day window of time to review their plan’s documentation, and operations, for compliance with applicable law. If errors are noted, they may be eligible for self-correction under the terms of Revenue Procedure 2021-30. Errors that are not eligible for self-correction can be corrected under a closing agreement, with the Voluntary Correction Program fee structure forming a basis to determine the sanction amount that the IRS will impose. If the plan sponsor fails to respond to the IRS within 90 days of the letter, the IRS will contact the sponsor to schedule an exam. Since this audit initiative starts with a simple letter, there would now seem to be ample funds at IRS to pursue this agenda – in fact, postage is one of the expressly sanctioned expenses under Operations Support. Even without a specific funding line-item for TE/GE, plan sponsors should be on their guard in this new era of IRS funding.

    The author thanks Peter Gulia, Fiduciary Guidance Counsel, and other colleagues at the Benefitslink Message Boards for sharing their thoughts about the new IRS funding.

    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:  Mathieu Stern, 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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    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

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    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