The Employee Plans Compliance Resolution System - Updated And Improved
The latest IRS updates to EPCRS (Rev. Proc. 2008‑50) became effective January 1, 2009, and result in some very real improvements to the retirement plan correction system. This article analyzes three of those changes:
- The guidance for correcting specific qualification failures.
- Correction principles applicable to all types of failures.
- Procedures for using EPCRS.
Guidance For Correcting Specific Qualification Failures
Correcting Failures To Allow Catch-Up Contributions
Rev. Proc. 2008-50 provides a method to correct a failure relating to catch-up contributions for eligible employees who have reached age 50. The correction method is to provide a qualified nonelective contribution (QNEC) equal to 50% of the "missed deferral." However, for this purpose, the "missed deferral" is defined as one-half of the catch-up contribution limit for the affected plan year. For example, if an employee is excluded from the ability to make a catch-up contribution for 2009 ($5,500 catch-up contribution limit), the "missed deferral" is equal to $2,750 and the QNEC is 50% x $2,750 = $1,375.
Failure To Implement An Employee's Deferral Election
Although EPCRS had in the past provided a way to correct the failure of improperly excluding an otherwise eligible employee from participating in a 401(k) plan, it did not address how to handle the failures when an employee elected to defer wages to the plan but the employer failed to implement the election. Now it does.
Under previous versions of EPCRS, the plan sponsor was required to contribute a QNEC on behalf of each improperly excluded employee equal to the average deferral percentage (ADP) for the employee's compensation group (either highly compensated or nonhighly compensated) multiplied by the participant's compensation. Now, the missed deferral is based on the deferral percentage that the employee attempted to elect, rather than on the compensation group average.
Although Rev. Proc. 2008-50 does not specifically address situations where the deferral election is not implemented for only certain forms of compensation, such as bonus compensation, we have discussed with the IRS using these same correction principles in these situations. The IRS has indicated that such corrections are appropriate.
Improper Exclusions Of Roth Contributions From 401(k) Plan
Previously, EPCRS provided that the methods to correct the failure of improperly excluding an employee from participation in a 401(k) plan did not apply with respect to Roth after-tax contributions. However, Rev. Proc. 2008-50 specifically addresses this issue, allowing the same correction principles that apply to correcting an improperly excluded employee to be used to correct a failure involving Roth contributions with one important distinction. The corrective QNEC for the missed Roth contribution does not enjoy the same benefits as a normal Roth contribution. It is excluded from income and the distributions are taxable.
New Rules Regarding Participant Loan Corrections
If a participant defaults on a loan from a qualified plan, the unpaid balance will at that time be treated as a distribution and taxed. Previously, the IRS said it could postpone income recognition until the year of the correction or waive it entirely if the correction was made through VCP. If a default was self-corrected, the defaulted principal had to be reported as taxable income in the year of the default and any later payments had to give the participant tax basis in the plan.
Rev. Proc. 2008-50 retains these rules, but extends the period in certain circumstances in which a defaulted loan, for which overdue payments have been made, could be re-amortized up to the 5-year maximum after the date of the original loan.
Correcting Code Section 415 Annual Addition Failures
Code section 415 limits the total amount of employer and employee contributions that may be added each year to each participant's accounts in any retirement plans sponsored by the same employer. Rev. Proc. 2008-50 revises the method for correcting failures to follow the rules issued under the final Code section 415 regulations published in 2007. These regulations eliminated provisions for correcting excess annual additions through their allocation to a suspense account or the refund of elective deferrals. The regulations now provide that Code section 415 violations are addressed through EPCRS.
For years before 2009, the correction is similar to the suspense account approach used under the old Code section 415 regulations. For failures beginning in 2009 or later, the correction is as follows:
- If the excess is solely attributable to nonelective employer contributions, then:
- If the plan contains a rule under which it can be reallocated to other participants' accounts, it must be reallocated.
- If there is no reallocation provision (e.g., if the plan specifies a flat percentage rate of contribution or if every participant is at the Code section 415(c) limit), it must be removed from the participant's account and applied to reduce future employer contributions. It may not be returned to the employer.
- If the excess is solely attributable to elective deferrals or employee after‑tax contributions, it must be returned to the participants, with earnings. If the plan provides for both types of contribution, after-tax contributions are returned first.
- If the plan provides for matching contributions, unmatched after-tax contributions and elective deferrals are returned first. If returning unmatched after-tax contributions and deferrals is insufficient to correct the violation, the remaining excess must be apportioned between the deferrals or after-tax contributions and the match (based on the match formula). The deferrals and after-tax contributions are returned, and the attributable match is forfeited and used to reduce future employer contributions.
Changes In Correction Principles Applicable To All Types Of Plan Failures
Adding Additional Failures To A VCP Application
Generally, a plan sponsor is able to add additional failures that are discovered after the initial submission and to request that such failures be added to its submission. However, the IRS retains the discretion to reject the inclusion of such failures if the request is not timely or the application of VCP would be inapplicable or impracticable.
Rev. Proc 2008-50 provides that if the IRS discovers a failure that is significant while processing a VCP submission, the IRS retains the discretion to determine that the failure is outside the scope of the voluntary request because the plan sponsor did not bring it forward. However, even more potentially disturbing is that if the failure is significant, the IRS retains the right to examine all aspects of the plan and to move the plan into Audit CAP. This makes it very important to fully examine the plan before submitting failures into VCP to ensure that all failures are covered by the original submission. Otherwise, you run the risk of the IRS discovering a significant failure during the VCP process and moving the plan into Audit CAP with its attendant higher sanctions.
New Rules For Earnings Calculations
In theory, earnings added to corrective contributions must reflect what each participant's accounts would actually have earned if the contributions had been made at the proper time. EPCRS permits the use of reasonable estimates when calculating corrections, including the use of a reasonable interest rate in circumstances when determining the actual investment return is not practicable.
Rev. Proc. 2008-50 allows employers to use the Department of Labor's Voluntary Fiduciary Correction Program Online Calculator as a proxy for a reasonable interest rate. Rev. Proc. 2008-50 does not provide that it will be used as a general rule but only where the plan sponsor cannot conveniently use the other methods of calculating earnings.
Changes In Procedures For Utilizing EPCRS
Determination Letter Applications In VCP And Audit CAP
There are certain cases where a plan amendment will be needed as the correction for a failure under EPCRS, and a determination letter request relating to the amendment will be necessary or recommended as part of a VCP application.
A determination letter application is required for amendments made in connection with an EPCRS correction in the following situations:
- If a VCP submission is made during an on-cycle year which is the 12 month period immediately before the end of the plan's remedial amendment period under Rev. Proc. 2007-44. This means that the plan can be submitted in an on-cycle determination letter application.
- If an Audit CAP correction is made in the 12-month period immediately preceding the expiration of the plan's applicable cycle under Rev. Proc. 2007-44.
- If the plan did not timely adopt a required amendment, other than an interim good faith EGTRRA amendment, whether or not the plan is currently on-cycle.
A determination letter application is allowed, but not required, if the plan is newly adopted, is terminating or has an urgent business need for a determination. This includes situations where an off-cycle application is given priority such as in the case of a company and plan merger.
A determination letter application is required to correct a non-amender failure under VCP or Audit CAP whether or not the plan is submitted under VCP or corrected under Audit CAP during an on-cycle year.
In all other situations, a determination letter is not permitted if the plan is off‑cycle, including a situation in which the plan sponsor failed to timely adopt an interim good faith amendment for an optional change. An optional change would be a type of plan design feature that is not required, such as allowing for age 50 catch-up contributions to a 401(k) plan. For all of these non-amender or late amender failures, the plan sponsor can file in VCP without requesting a determination letter by using the streamlined application forms that have been greatly expanded with Rev. Proc. 2008-50.
If during an off-cycle year, a plan sponsor submits an operational or demographic failure in VCP to be corrected through plan amendment, then a determination letter application is not required and should not be submitted with the VCP submission. If the amendment is accepted as a proper correction, the compliance statement under VCP constitutes a determination on the effect of the plan amendment on the qualification of the plan. However the compliance statement is issued subject to the condition that the amendment be submitted as part of a separate determination letter application during the plan's next on-cycle year, or if earlier in connection with the plan's termination. The compliance statement should be included in the next determination letter application.
Retroactive Amendments In SCP
There are only a few failures that can be corrected in SCP by adopting a retroactive reformative amendment to conform the terms of the plan to its actual operation:
- To correct a violation of the Code section 401(a)(17) compensation limitation by amending the plan to provide an increased contribution to the employees who are not so limited;
- To allow hardship distributions or plan loans which the plan document did not allow; and
- To authorize the early inclusion of otherwise eligible employees who had not yet satisfied the age or service requirements.
In most other situations, corrective amendments must be submitted in VCP. However, Rev. Proc 2008-50 provides for situations where a plan amendment is needed in order to implement a correction through SCP where these amendments can be adopted retroactively without submitting the failures and the amendment in VCP. An example is where a 401(k) plan fails the ADP test, the 2‑year SCP period has not run, and the plan sponsor determines to correct the failure by making QNECs to nonhighly compensated employees, but the plan does not yet allow such QNECs. The failed ADP test can be corrected in SCP and the enabling amendment signed without submitting the plan in VCP.
Extension Of The SCP Period For Significant Operational Failures
Generally, in order to comply with the requirements of SCP, significant operational failures must be corrected by the end of the second plan year after the plan year in which the failure occurred. However, Rev. Proc. 2008-50 provides that the corrections can be completed a short time after the 2-year period as long as they are substantially completed at the end of the 2-year period. If the corrections are completed for 65% of the affected participants by the end of the 2‑year period, they are considered substantially completed. To maintain eligibility for SCP, the remaining corrections must be completed within 120 days after the last day of the 2-year correction period.
What To Do
If you discover errors (or, heaven forbid, the IRS discovers them first), remember that we have immersed ourselves in the EPCRS maze and are well-positioned to get your plan back into compliance. While Rev. Proc. 2008-50's additional guidance concerning application procedures and corrections are helpful, it is important to remember that the correction methods listed are not the only ways to correct plan failures. We often encounter situations where, after careful review of the plan problems, the client agrees that it makes sense to use a different correction method than the pre-approved methods. Furthermore, we encounter many situations that are not covered by Rev. Proc. 2008-50 for which we must negotiate an acceptable correction with the IRS.
If you find that you need help in preserving or restoring your plan's qualified status, just give us a call.