Introduction:

To encourage employers to provide a tax qualified retirement plan, and to encourage employees to participate in such retirement plans, the Internal Revenue Code (“IRC”) provides tax incentives to both employers and employees. To receive these tax advantages, the retirement plan must satisfy certain requirements.  Generally, any failure to meet these requirements may result in the “disqualification” of the retirement plan, which would result in the retroactive loss of tax deductions for the employer, retroactive income for an employee, taxation of plan earnings and loss of the employee’s ability to rollover a distribution from the plan to avoid current taxation.

If an employer unintentionally fails to comply with the qualification requirements of the IRC with respect to its plan, the employer may be able to avoid disqualification of the retirement plan if the failure is corrected using the Employee Plans Compliance Resolution System (“EPCRS”).

For reference, the current EPCRS guidance is contained in IRS Revenue Procedure 2013-12.

EPCRS Q&A # 1

Question:  Can an employer “self-correct” a compliance failure in a tax qualified retirement plan without a formal submission to the IRS?

Answer: An employer may self-correct certain “operational failures” made during the administration of a tax qualified retirement plan and maintain the tax qualified status of such plan without submitting any information to the IRS.

Generally, to be eligible for self-correction, a plan must have received a Favorable Determination Letter from the IRS and have operational procedures in place that are intended to prevent the failure from occurring.

An “operational failure” is a failure that occurs during the administration of the plan, but the terms of the plan with regard to such failure comply with the applicable IRC requirements. For example, an operational failure would occur if a 401(k) plan document prohibited a participant from contributing an amount in excess of the IRC 402(g) limit (which is $17,500 for 2014) but, due to a payroll error, the participant exceeded such deferral limit.

There are two types of operational failures that may be self-corrected, significant and insignificant. If an operational failure is determined to be insignificant, the correction can be made at any time (as long as it is made within a reasonable time after it is discovered). If an operational failure is determined to be significant, the correction must be substantially completed by the last day of the second plan year following the plan year in which the significant operational failure occurred (with certain limitations).  Note that this correction period is based on the occurrence of the failure, not on the date it is discovered.

In determining whether an operational failure is insignificant, an employer must consider (but is not limited to) the following seven factors:

  1. whether other failures occurred during the period being reviewed;
  2. the percentage of plan assets and contributions involved in the failure;
  3. the number of years the failure occurred;
  4. the number of plan participants affected relative to the total number of plan participants;
  5. the number of plan participants affected as a result of the failure relative to the number of plan participants who could have been affected;
  6. whether the correction was made within a reasonable time after discovery of the failure; and
  7. the reason for the failure (for example, a data entry or arithmetic error).

For example:  Employer X sponsors a profit-sharing plan. During an audit, the employer discovers that, due to a payroll error, three of the 250 plan participants received contributions in excess of the limits allowed by the plan and the IRC during a plan year.  Employer X contributed $3,500,000 to the plan for the plan year and the amount of the excess contributions totaled $4,550. There were no other operational failures made during the plan year.  After considering all of the required factors, the employer determined that the operational failure was insignificant because the number of participants affected relative to the total number of participants who could have been affected was only 1.2% and the monetary amount of the failure relative to the total employer contribution was only .13%. The employer corrected the error within a reasonable time after discovery of the failure.

To correct an operational failure, the employer must generally fully correct the failure, which means the plan and the affected participants must be put in the same place they would have been had the failure not occurred. This could require

the employer to make additional contributions to the plan. However the failure is corrected, we strongly suggest employers draft a detailed memorandum on the determination of whether the failure was insignificant or significant, how the correction was made and how the correction method was determined.

In certain instances, a “full” correction of the operational failure may not be required.  For example, if a corrective distribution due a participant is $75 or less and the cost of processing and delivering the distribution is greater than $75, the plan sponsor is not required to make the corrective distribution.