IRS Announces Top Ten Reasons For Plan Failures

7/6/2009 - Beaufort, SC

IRS ANNOUNCES THE TOP TEN REASONS FOR PLAN FAILURES

The IRS recently published the ten most common retirement plan mistakes reported to it under the Voluntary Correction Program ("VCP"). The list gives us a roadmap of where to look for problems.

Background Qualified retirement plans are complicated and require maintenance. Errors in plan documents or in plan operations can easily cause plan disqualification. In the distant past, the "big stick" used by the IRS to enforce compliance was the dreaded "plan audit." About ten years ago the IRS got smart and started a self-correction program to encourage employers to fix plan problems themselves. The program was successful and evolved into the Employee Plans Compliance Resolution System ("EPCRS"). EPCRS is a "carrot and stick" program. If a plan sponsor finds and fixes problems, the "carrot" is that no penalty is imposed for simple problems and a small penalty for larger ones. The "stick" is that if the IRS finds those problems on audit, very large penalties will be imposed. With the EPCRS program, the IRS is issuing "Get Out of Jail Free" cards to employers who take the initiative to self-correct plan mistakes.

The Top Ten Minor plan problems can be self-corrected without even notifying the IRS or paying a penalty. Larger problems require a filing under the EPCRS "Voluntary Correction Program," or "VCP." The ten most common errors reported under the VCP are:

•1. Failure to Amend for Updates Plan documents must be updated to reflect tax law changes. If the updates are not timely, the plan is disqualified. We are now in a cycle of updating plans for recent tax law changes, yet many employers do not know that or are putting it off.

•2. Failure to Follow the Plan's Definition of Compensation Plans define what kinds of participant compensation serve as the base for the employer contribution. "Compensation" can exclude certain kinds of pay. Plans are simply disregarding their own definitions and terms in making contributions.

•3. Failure to Include or Exclude Employees Plans may permissibly exclude some categories of employees. With this kind of failure, a plan excludes those who should have been covered or includes those who should not have been covered. Again, this is a case of the employer not following the terms of its own plan.

•4. Failure to Comply with Plan Loan Procedures Many plans allow participants to borrow from their plan accounts. If the participant defaults, the loan must be reported as income to the participant. The failure occurs when the income is not reported. I discourage employers from allowing participant loans in plans.

•5. Impermissible In-Service Withdrawals Benefits to participants are paid when certain events occur, such as retirement, death, disability, or termination of employment. This error occurs when a participant receives benefits while still employed. Once more, this is a case of the employer ignoring the terms of its own plan.

•6. Failure to Satisfy Minimum Distribution Rules Generally, participants are required to take mandatory minimum distributions at age 70-1/2. Failure to make the required minimum distribution will disqualify the plan and expose the participant to a 50% penalty on the underpayment.

•7. Employer Eligibility Failure Some employers are prohibited from using particular types of retirement plans. For example, a government entity cannot use a 401(k) plan. Some categories of tax exempt employers cannot adopt 403(b) plans.

Second, several of these failures arise from employers simply not knowing or following what their own plan says. Who's watching the store?

•8. Failure to Meet 401(k) Non-Discrimination Tests Employee deferrals and employer matches in 401(k) plans are subject to special annual non-discrimination tests. These failures occur when those tests are not satisfied.

•9. Failure to Meet Top-Heavy Rules A plan is "top heavy" if more than 60% of assets are in the accounts of key employees. If so, non-key employees must receive a minimum benefit contribution annually.

•10. Failure to Meet Section 415 Requirements Section 415 of the Code limits how much a participant can receive as an employer contribution each year. If the limit is exceeded in any year, the plan is disqualified.

This list is instructive. Note four common aspects of these errors.

First, each of these ten problems is obvious, or should be obvious, to any competent plan administrator. These plan failures are not violations of arcane or obscure rules. There are no traps on this list.

Second, several of these failures arise from employers simply not knowing or following what their own plan says. Who's watching the store?

Third, several of these failures are purely arithmetic. They could be quickly identified by a knowledgeable administrator with a pocket calculator.

Fourth, most of these failures are insidious, as they are likely to be repeated from year to year. For example, if the plan did not make top-heavy contributions last year, it is likely it did not make them in prior years

Which employers are more likely to have these problems in their plans? In my experience, small employers run the greatest risk. It is that group that tends to have minimal assistance or have no administrator at all.

Small employers often use plan documents provided by financial institutions, such as brokerage firms and mutual fund companies. That's fine. The problems arise when employers mistakenly assume that the financial institution is the plan administrator and is "taking care of everything."

Conclusion The IRS's top ten list of plan mistakes illustrates the importance of using competent plan administrators. Every one of these top ten errors is easily avoided. The IRS's EPCRS program allows all plans to self-police and self-correct at minimal cost or for free.

Eugene Parrs