The IRS has issued the long-expected update of the Employee Plans Compliance Resolution System (“EPCRS”). The new procedure, Rev. Proc. 2006-27, replaces Rev. Proc. 2003-44, and generally is effective September 1, 2006. However, practitioners may apply the procedure on or after May 30, 2006. The revised procedure expands the type of failures correctible under EPCRS, and adds allowable correction methods for some previously-addressed failures. The correction methods are consistent with methods IRS officials have discussed publicly since last fall.
Correcting a failure to include an eligible employee in a 401(k) plan (other than a safe harbor plan). In addition to the available correction methods for failure to include an eligible employee, the new procedure adds a new correction method based on the “lost opportunity cost” to make elective deferrals. Under this method, the employer determines the amount of missed deferrals, as under the prior procedure, by multiplying the employee’s compensation during the period of exclusion by the ADP of the employee’s group (HCE or NHCE). However, instead of making a QNEC equal to that amount, the employer contributes a QNEC equal to 50% of that amount (taking into account the fact that the employee actually received his/her compensation outside the plan, and that therefore the employee’s loss is less than 100% of the missed deferrals). If the plan also provides a match, the new correction method is to give the employee a QNEC equal to the match the employee would have received if he/she would have made the missed deferrals (rather than equal to the employee’s excluded compensation times the ACP of the employee’s group, as the prior procedure provides).
The cost of the new correction of missed deferrals always will be cheaper for the employer than under the prior procedure, since the employer’s cost is only 50% of the “deemed” missed deferrals. The cost of the new correction of a missed match may be more or less expensive than under the prior procedure, depending on whether deferring the average ADP of the employee’s group would result in a match that is more or less than the plan’s average ACP for the employee’s group.
Note: The “lost opportunity” correction method is available only for a failure to include an eligible employee, and not, for example, to correct a failure to satisfy the ADP or ACP test. Also note, the correction method involves making a QNEC, and not an after-tax contribution. Even if the plan permits Roth (after-tax) deferrals, the plan must permit pre-tax deferrals. There is no mechanism in the procedure for the employer to make a corrective Roth (after-tax) deferral on an employee’s behalf. As under the prior procedure, the correction amount must include earnings, the missed deferral calculation is limited by the 402(g) limit and by any plan limit on deferrals, and the corrective match is limited by the maximum match available under the plan.
Comment:The procedure provides that the correction methods discussed above do not apply until after the correction of other qualification failures, e.g., the ADP and ACP tests. Although not specifically stated, this apparently means the plan does not have to rerun the ADP or ACP tests after correcting the improper exclusion, even though the corrective ADP contribution is 50% of the deemed deferrals, and the corrective matching contribution is based on the participant’s deemed deferrals, and not on the average ACP of the participant’s employee group.
Correcting a failure to include an eligible employee in a safe harbor 401(k) plan. If the plan that improperly excluded the employee is a safe harbor 401(k) plan, the correction amount depends upon whether the plan uses a 3% nonelective contribution or a matching contribution to satisfy the ADP safe harbor. If the plan uses the 3% nonelective contribution, the missed deferral is deemed to be 3% of compensation. The employer therefore must make a QNEC equal to 50% of the deemed missed deferral (the lost opportunity cost of the deferral), plus the 3% nonelective contribution the plan otherwise would require. If the plan uses a safe harbor match, the deemed missed deferral is the greater of 3% or the maximum deferral percentage for which the plan provides at least a 100% match (e.g., 3% if the plan uses a “basic” safe harbor match, or 4% if the plan uses an “enhanced” match of 100% of deferrals not exceeding 4% of compensation). The employer then must make a QNEC equal to 50% of the deemed missed deferral, plus a QNEC equal to the match the employee would have received based on the deemed missed deferral.
Correcting an improper exclusion of ability to make after-tax contributions. If the plan improperly excludes an employee from a plan that permits after-tax employee contributions (not Roth elective deferrals), the correction process is similar to the correction of the failure to permit elective deferrals, except that the correction amount (the missed opportunity cost) for the after-tax employee contributions is 40%, rather than 50%, of the deemed missed after-tax contribution. If the plan’s ACP consists of both matching and after-tax employee contributions, the employer, for purposes of correction, may determine separately the portions of the ACP attributable to matching contributions and to after-tax employee contributions.
Correcting participant loan failures. The new procedure offers alternatives to declaring a deemed distribution on a participant loan that fails to satisfy a statutory participant loan requirement. The employer must use VCP to implement these correction alternatives, and may not use the self-correction procedure (“SCP”) with these methods. The IRS may limit these correction methods to “appropriate” situations, such as where employer action caused the loan failure. If a participant loan exceeds the statutory maximum loan amount, the participant may correct the failure by repaying the loan amount in excess of the statutory limit, and reamortizing the loan over a period that does not exceed the statutory maximum period (generally 5 years). If a participant loan fails to satisfy the quarterly amortization requirement or the maximum period requirement, the plan may reamortize the loan to comply with these requirements, based on the original loan date. If a loan is in default because of a loan repayment failure, the plan may reamortize the loan over the remaining payment schedule of the original loan term, may make up the missed repayments in a lump sum, or may use a combination of both methods. In any of the loan failures mentioned in this paragraph, the employee generally is responsible for paying the corrective payment. However, in case of a loan repayment failure, the employer must pay a portion of the correction payment equal to the interest that accumulates as a result of the failure. The correction methods in this paragraph may not extend the loan beyond the maximum repayment period, and are not available after the statutory period has expired. Apparently, the IRS (under VCP) will determine the extent to which the employer is at fault for a plan loan failure. If a participant faces a heavy tax burden as the result of a deemed distribution, VCP can be an attractive option, particularly if the employer is at fault.
If the plan does not correct a participant loan as provided in the previous paragraph, the alternative is to declare the loan as a deemed distribution and to report the deemed distribution on Form 1099-R. As in the prior procedure, as part of a VCP application, the plan may report the deemed distribution for the year of correction rather than the year of the failure.
Amendment to permit participant loans. The new procedure expands the limited provisions for correction by a plan amendment to conform to the plan’s prior operation (applicable for SCP and VCP correction under Appendix B of the procedure), to include a retroactive amendment of a plan that does not permit participant loans to provide for loans that actually were made available. The amendment must satisfy the qualification requirements and the Code §72(p) requirements. While (as under the prior procedure) an employer making an SCP correction by a permitted plan amendment must submit the plan for a determination letter, the new procedure provides that the employer simply must submit the determination letter application before the end of the plan’s remedial amendment period. Therefore, the employer need not file a special application to take advantage of the SCP plan amendment option. However, as part of the determination letter submission, the employer must identify the amendment as an SCP amendment in the cover letter of the determination letter application.
Failure to obtain spousal consent. If a plan subject to the joint and survivor annuity (J&S) rules failed to obtain spousal consent for a distribution, under the old procedure the plan may attempt to obtain spousal consent or the participant may repay the distribution and receive a qualified joint and survivor annuity. Under the new procedure, if the plan is unable to obtain the spouse’s consent, the plan may offer the spouse a choice between a survivor annuity benefit or a single-sum payment equal to the actuarial present value of the survivor annuity.
Orphan plans. The new procedure expands VCP and audit CAP to include Orphan Plans. Under the procedure, “Orphan Plan” means a plan for which an “Eligible Party” has determined the sponsor no longer exists, cannot be located, is unable to maintain the plan or has abandoned the plan pursuant to DOL regulations. An “Eligible Party” is a court-appointed representative with authority to terminate the plan, a person the DOL determines has accepted responsibility for terminating the plan in case of an Orphan Plan under DOL investigation, or the surviving spouse of a sole business owner and sole participant in a qualified plan to which Title I of ERISA never has applied. An Orphan Plan does not include a plan terminated pursuant to the DOL abandoned plan regulations. The new procedure therefore permits an Eligible Party to take action to assure the plan is qualified when it makes distributions. The IRS may waive the requirement of total correction for a terminating Orphan Plan, and may waive the VCP compliance fee upon request.
Abusive tax avoidance transactions. If an employer has been a party to an abusive tax avoidance transaction (see the IRS web site under “EP Abusive Tax Transactions” for a discussion of these transactions), the new procedure limits the employer’s use of EPCRS.
Clarifications and simplifications. The new procedure provides some clarifications, updates some definitions and streamlines certain submission requirements. For example, the procedure provides that in “appropriate cases,” as part of VCP, the IRS will not pursue an excise tax for a nondeductible contribution where correction requires the employer to make a contribution that is not deductible, or the excise tax for “late” distribution of excess contribution or excess aggregate contributions. The employer, as part of its application, must provide explanations of the failures causing the potential excise tax. The procedure includes a suggested order of submission documentation filed with the IRS. The procedure provides the IRS will acknowledge VCP submissions, and includes a sample acknowledgment form the employer may include with its submission.
User fees. The basic compliance fee schedule for VCP submissions, which is based on the number of plan participants, has not changed. However, compliance fee changes include the following: (1) the basic compliance fee for a SEP or SIMPLE submission is $250 (reduced from $500), subject to the IRS’s right to apply the general fee schedule in “appropriate circumstances;” (2) under a new provision, the compliance fee for a VCP submission only for failure to adopt timely a good faith EGTRRA amendment, a Code §401(a)(9) final regulations amendment or an interim amendment as provided in Rev. Proc. 2005-66 is $375; (3) the compliance fee where the sole failure is failure to satisfy the required minimum distribution rules for 50 or fewer participants (regardless of the plan’s size) is $500; and (4) the procedure adds a new fee schedule for nonamenders discovered during the determination letter application process rather than in a VCP submission, if the only failure is the nonamender failure. Depending on number of participants and the date of the last plan update, the nonamender fee is a minimum of $2,500 and can be as high as $80,000. Thus, it behooves sponsors to check their plans carefully for required amendments prior to a determination letter application, and make a much less expensive VCP application if needed.
Request for comments regarding future enhancements. The IRS, in the new procedure, requests comments regarding methods to correct: (1) failure to provide an eligible employee an opportunity to make catch-up contributions permitted under the plan; (2) failure to provide the opportunity to make Roth deferrals for a plan that permits Roth deferrals; and (3) excess annual additions, which the current proposed 415 regulations state will appear in EPCRS rather than in the 415 regulations. (The new procedure does not expand the 415 correction alternatives previously included in EPCRS.) The IRS also requests comments regarding whether additional correction methods are necessary for a plan subject to the J&S rules to take advantage of the orphan plans fiduciary safe harbor in light of the ability to satisfy the J&S requirements by purchase of a commercial annuity contract.
Comment: The new procedure does not include any correction methods for failure to provide a timely annual notice for a safe harbor 401(k) plan. This omission leaves practitioners in the dark as to how to correct such a failure. If the notice failure relates to a plan using the 3% nonelective ADP safe harbor contribution, the employer should be able to self-correct the failure by providing a late notice, since the failure arguably did not affect any participant’s deferral election. If the notice failure relates to a plan using an ADP safe harbor match, the employer must determine a reasonable and appropriate correction method without any IRS guidance. The safest method to correct a failure to provide the notice in a plan with an ADP safe harbor match is to apply for correction under VCP, since different participants may have elected to defer more or less than the amount necessary to receive the full safe harbor match, and crafting a reasonable “fix” for all participants may be difficult. In addition, the new procedure does not provide a correction method for failure to implement a participant’s deferral election.