Getting Straight A’s in Retirement Plan Audits

Nothing strikes fear into the heart of a qualified retirement plan sponsor like an audit notice from the Internal Revenue Service (IRS) or the U.S. Department of Labor (DOL). Although nothing can make an IRS or DOL audit entirely painless, employers can minimize the pain and cost by performing periodic “self-audits” of plan operations. This article discusses several aspects of plan operations that should be included in self-audits, because they are likely to be the focus of agency audits and are often undetected through regular plan processes and procedures. The article also discusses the methods for identifying and correcting these operational errors and the steps that employers may take to keep the errors from occurring in the future.

Prepare in advance to make an IRS or U.S. Department of Labor review easier

Nothing strikes fear into the heart of a qualified retirement plan sponsor like an audit notice from the Internal Revenue Service (IRS) or the U.S. Department of Labor (DOL). Although nothing can make an IRS or DOL audit entirely painless, employers can minimize the pain and cost by performing periodic “self-audits” of plan operations. This article discusses several aspects of plan operations that should be included in self-audits, because they are likely to be the focus of agency audits and are often undetected through regular plan processes and procedures. The article also discusses the methods for identifying and correcting these operational errors and the steps that employers may take to keep the errors from occurring in the future.

Understanding Self-Audits

A thorough self-audit should cover all key aspects of plan operations, including both an employer’s internal controls and processes and the services performed by the plan’s third-party administrator (TPA). A self-audit will provide multiple benefits, including:

  • Employers may self-correct errors under IRS and DOL correction programs without incurring the sanctions or additional costs that could apply if the error is discovered by the IRS or DOL.
  • The audit can lead to the early discovery of errors that would have significantly higher correction costs if discovered later.
  • The audit may also reveal issues that could result in litigation by participants.

Although any plan can benefit from a self-audit, one category of plan that is a prime candidate for a self-audit is a frozen or partially frozen defined benefit plan. There is a good chance that an employer will eventually terminate the plan or “derisk” the plan by purchasing annuities, and both of these processes will go much smoother if the operations and participant data have been cleaned up in advance. Defined benefit plans are also prime targets for DOL and IRS audits focused on timely benefit payments, as discussed below.

Lost Participants and Failure to Pay Benefits

In recent years, both the DOL and IRS have focused much of their audit efforts on what they see as a chronic problem with the nation’s private retirement system: the loss of retirement benefits due to the failure of plans to pay benefits when due. This failure is often attributable to lost participants and beneficiaries, or the absence of a beneficiary designation, but in some cases it results simply from a lack of sufficient administrative processes for paying benefits when they are supposed to be paid.

The DOL may consider the failure to pay benefits when due a breach of the plan administrator’s fiduciary duty. From the IRS perspective, this is a failure to follow the terms of the plan and Internal Revenue Code requirements, which could jeopardize the plan’s tax-qualified status. The failure to pay required distributions may also result in punitive excise taxes being imposed on plan participants and beneficiaries.

IRS rules generally require that benefits must begin by the April 1 after the later of (i) the year in which the participant reaches age 70ó or (ii) the year in which the participant retires from the employer. IRS rules also generally require either that payments to a deceased participant’s beneficiary begin by the end of the year following the year in which the participant dies, or that the benefit be paid in full within five years of the employee’s death.

The plan document may impose even earlier deadlines, since many plans do not allow a terminated participant to defer the commencement of benefits beyond the plan’s normal retirement age (typically 65), and plans often require beneficiaries to be paid as soon as administratively feasible after the participant’s death. In addition, most plans have a small benefit cashout rule, which requires that benefits under a specified dollar limit (typically either $1,000 or $5,000) be paid out when the participant terminates employment.

Finding Errors. An important first step is to read and understand the plan terms dictating when benefits must be paid even if not requested by the participant or beneficiary. A query of plan records can then identify participants and beneficiaries whose benefits are required to begin but who in fact have not commenced benefits. A death search can also identify deceased participants whose benefits have not been paid to a beneficiary.

Correcting Errors. The correction is simply to pay or commence the required benefit, but in many cases the first and most difficult step is to locate the lost participant or beneficiary. Unfortunately, guidance from the IRS and DOL on this topic somehow combines the inadequate with the impractical. At a minimum, the employer should review employment records and other employee benefit plan records, try to contact a designated beneficiary if there is one on file, perform “free” internet searches, and send a certified letter to the last known address. If these steps fail, it may be necessary to use a paid locator service. Most third-party administrators (TPAs) offer a basic locator service for a small additional charge, but may require direction from the employer to use the service. However, most TPAs would not perform additional steps to locate missing participants and beneficiaries or would charge extra fees for that type of service.

Avoiding Future Errors. Here are some of the steps that plans can take to minimize the number of lost participants and beneficiaries:

  • Follow up immediately on returned mail, such as annual notices.
  • Establish a regular process for starting benefits when the plan requires.
  • Conduct periodic death searches to avoid delays in making payments to beneficiaries.
  • Use plan communications to remind participants of the need to keep addresses and beneficiary designations up to date.
  • Identify search steps that the plan’s TPA is not performing and allocate internal resources or engage the TPA or another vendor to complete them.

Failure to Follow the Plan’s “Compensation” Definition

A common error identified by IRS auditors is the failure to follow the plan’s “compensation” definition in calculating contributions and benefits. This typically results from mistakes in identifying pay types or payroll codes that are included – or excluded – from the plan’s “compensation” definition.

Finding Errors. Employers should compare the plan’s “compensation” definition with the actual pay types being used to determine contributions to defined contribution plans and accrued benefits under defined benefit plans.

Correcting Errors. The appropriate correction will depend on the nature of the error, but in many cases additional contributions or benefits will be required. If the mistake was favorable to participants – such as if ineligible compensation was included in calculations – the employer may consider requesting IRS approval to retroactively amend the plan to conform with operations. Employers should also consider making a prospective amendment if the plan’s “compensation” definition is impracticable to administer, such as a 401(k) plan definition that does not exclude equity compensation or other amounts that are not paid through payroll.

Avoiding Future Errors. Errors in determining plan compensation often arise when payroll codes are added or revised, or when there are changes in the payroll software or vendor. These changes should not be made by the employer’s payroll department without input and review from the benefits department.

Failure to Use or Allocate Forfeitures

Sponsors of 401(k) and other defined contribution plans often allow forfeitures to accumulate in the plan over several years, rather than (i) using those forfeitures to offset employer contributions or pay plan expenses, or (ii) allocating the forfeitures to participants. The permitted use of forfeitures, and the time frame for using them, depend on the plan terms, but the deadline may be as soon as the end of the year in which the forfeiture arises.

The failure to follow plan terms in using forfeitures is a qualification defect, and the IRS has been known to take the position that the failure to use forfeitures within a reasonable period is a defect even if it does not violate plan terms. In addition, the IRS may deny a tax deduction for contributions made at a time when the plan had unused forfeitures and may assess an excise tax.

Finding Errors. A defined contribution plan’s account records normally will include a separate account designated as a forfeiture account. A large forfeiture balance at year-end is a sign that forfeitures may not have been properly applied.

Correcting Errors. The method for using forfeitures will depend on the plan terms, so employers are advised to consult legal counsel to assess the options for dealing with any excess forfeitures. Counsel can also address the potential legal issues resulting from the prior failure to use forfeitures.

Avoiding Future Errors. Employers should verify the plan’s requirements and establish a regular process for using forfeitures shortly after they arise.

Improper Exclusion of Part-Time, Temporary and Seasonal Employee

Although some employers routinely treat employees classified as parttime, temporary or seasonal (or similar service-based classifications such as “on-call” or “project-based” employees) as “ineligible for all benefits,” IRS rules prohibit employers from categorically excluding these employees from participating in qualified retirement plans. A plan may properly require that employees in these classifications complete 1,000 hours of service during their first year of employment or a subsequent year before becoming eligible, but the plan cannot impose a greater hours requirement.

Employers should keep in mind that part-time employees can satisfy a 1,000-hour requirement while working only 20 hours per week, compared to the 30-hour standard that many employers require for general benefits eligibility. Errors may also occur when (i) an employee changes from full-time to part-time status, and (ii) prior service as a full-time employee is not properly taken into account in determining whether any service requirement is satisfied.

Finding Errors. Eligibility errors are usually identified in an audit of the employer’s processes for enrolling new participants. The existence of this issue is often highlighted by statements in employee handbooks or in the plan’s summary plan description that describe plan eligibility as limited to full-time employees. An employer may also examine whether part-time or similar classifications are being included on data files being sent to the TPA and how those classifications are being handled during the eligibility process.

Correcting Errors. The employer may need to make corrective contributions to defined contribution plans or provide retroactive benefit accruals under defined benefit plans. This may be a costly outcome, especially if the failure occurred over many years.

Avoiding Future Errors. Employers should bolster their processes for accurately and timely determining when an employee has met the plan’s eligibility requirements. Prospective plan amendments may be needed if the plan document does not contain the proper language for a legally allowed and desired design. Employers may also consider simplifying the plan eligibility rules.

Other Common Errors

Other issues that often arise in IRS and DOL plan audits and that should be audited periodically by the plan sponsor include:

  • Failure to timely adopt plan amendments;
  • Failure to deliver 401(k) safe harbor notices and other participant notices;
  • Errors in plan loan administration;
  • Failure to timely deposit participant contributions;
  • Failure to timely and correctly implement participant deferral elections and changes; and
  • Failures in administering service-counting and break-in-service rules.

If you read the sidebar (below) on the dangers of relying solely on your TPA and Form 5500 auditor for compliance, you will understand why self-audits are so important. A qualified professional can assist the employer in identifying gaps in plan administration and heading off trouble before it arrives.


Assuming Others Are Monitoring Your Plan’s Compliance

(Or, the Best Way to Run Into Trouble in an IRS or DOL Audit)

When an IRS or DOL auditor finds errors in plan operations, the employer’s first reaction is usually surprise. The employer often asks how those issues were not detected by the plan’s annual Form 5500 auditor or by the plan’s TPA. The answer is that the auditor and TPA perform specific functions that do not include overall monitoring of plan compliance.

The accounting firm performing the Form 5500 audit is only auditing the plan’s financials. While that process may reveal certain errors from time to time, it does not involve an in-depth review of the plan’s operations or compliance. Similarly, the TPA is only providing a menu of services based on its system and procedures, and does not take responsibility for many aspects of plan operations. The TPA also does not monitor the employer’s internal operations, such as payroll, where many errors occur. Ultimately, it is the employer’s responsibility to ensure compliance, and in most cases it will be the employer that will bear the cost when errors happen.

An important step is to understand the limits of the services the TPA is performing. Does the TPA take responsibility for locating missing participants, ensuring that forfeitures are allocated timely, or ensuring that proper compensation types are used? The answer is almost certainly “no,” and there are many other functions where the TPA will not take action without specific, proactive direction from the employer.

The next time you receive a communication from the TPA about plan administration, whether it be a draft participant communication, plan amendment or change in procedures, take the time to read the disclaimers provided by the TPA. Almost invariably, the disclaimers will state that the TPA is not providing legal advice and that employers are advised to consult counsel. Other disclaimers are also common, such as stating that provided documents are just forms and that the employer is ultimately responsible for ensuring that they are correct and legally compliant. Many employers tend to ignore these warnings. See the main article on self-audits for more detail about common errors that are unlikely to be raised by the Form 5500 auditor or TPA.

Uh-Oh! We Found An Error…Or Tons of Errors. Now What?

From time to time, you may discover an error in a retirement plan document or its operation. This is just a fact of life when navigating a complex set of rules and administrative systems. Luckily, almost every error can be corrected and, in many cases, without significant penalties. The IRS has established a correction program for operational and plan document errors that could otherwise result in the loss of a plan’s tax-qualified status. Some statutory penalties and taxes that attach to specific errors can also be waived. There are three basic elements to the program:

1. Self-Correction Program (SCP)

Operational errors can be self-corrected by the employer if either:

The error is corrected by the end of the second plan year after the year in which the error occurred; or

The errors continue for a longer period but all of the plan’s combined errors are considered “insignificant” based on factors such as the number of all errors involved, the percentage and amount of assets and participants involved in the errors, how long the errors went on, and the reasons behind the errors. In addition, the employer must establish and follow practices and procedures that are reasonably designed to promote future compliance.

2. Voluntary Correction with IRS Approval Program (VCP)

Errors in the plan document and operational errors that do not qualify for SCP can be corrected through VCP, as follows:

The employer (i) prepares an application, using IRS forms, describing the errors and proposed corrections, (ii) pays a fixed fee (currently $1,500 to $3,500, based on plan asset size), and (iii) submits the application to the IRS. The IRS may accept the proposed correction or may suggest modifications, in which case the parties negotiate the final terms of an acceptable correction.

Once the VCP is finalized, the employer will receive a letter confirming relief from IRS penalties related to the errors.

3. Audit Closing Agreement Program (Audit CAP)

Audit CAP is the method of correcting errors that are discovered by the IRS, such as in a plan audit, rather than being discovered by the employer and voluntarily corrected. In Audit CAP, the employer corrects the error, which allows the plan to remain tax-qualified, but must pay a negotiated penalty based on factors such as the plan’s assets, the scope, and type of the error, steps the employer took to avoid and detect errors, and the reasons for the error. A recent Audit CAP sanction imposed on a large plan that failed to utilize its forfeiture account for several years was more than $100,000.

Any correction must follow certain basic principles, which include: (i) full correction generally must be made for all affected participants; (ii) the correction should restore the plan and participants to the position they would have been in if the error had not occurred; and (iii) the correction should be consistent, reasonable and appropriate.

The IRS has specific methods for particular types of corrections, so it is important to consult the IRS procedures before implementing a correction. If the IRS determines that an SCP correction was not done properly, the plan would still be out of compliance and the IRS could impose an Audit CAP penalty. The IRS correction program makes it straightforward to correct plan errors through SCP and VCP. Regular self-audits not only can identify errors and allow them to be corrected, but also can support lower penalties if the employer ends up negotiating penalties in Audit CAP.

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