How to Correct ADP/ACP Test Failures after the Statutory Correction Period

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1 How to Correct ADP/ACP Test Failures after the Statutory Correction Period This white paper is written for 401(a) defined contribution plans that offer the Internal Revenue Code ( IRC ) 401(k) and/or 401(m) feature. Overview Each plan year, plan sponsors must test their traditional 401(k) plans to ensure that the contributions made by and for the non-highly compensated employees ( NHCEs ) are proportional to the contributions made by owners and the highly compensated employees ( HCEs ). These 401(k) nondiscrimination tests are known as the Actual Deferral Percentage ( ADP ) and Actual Contribution Percentage ( ACP ) tests. A plan must take corrective action for any failed ADP/ACP test within the statutory correction period that is, the 12-month period following the close of the plan year for which the test failed and any required corrective distributions must be made within 2 ½ months in order to avoid excise tax.. If a plan does not take corrective action within this regulatory prescribed timeframe, the plan may lose its favorable tax-favored status. This white paper addresses the corrective options available once the 12-month statutory period for correction has ended. ADP/ACP Test refresher As a reminder, the ADP test counts elective deferrals (pre-tax, Roth (not catch-up contributions)) of the HCEs and the NHCEs. The ADP percentage is an average of all the individually calculated actual deferral ratios for the relevant group of employees. The actual deferral ratio is a participant s elective deferrals for the plan year divided by the participant s compensation for the plan year. The ACP percentage is an average of all the individually calculated actual contribution ratios. The actual contribution ratio is the sum of an employee s after-tax contributions and matching contributions (and amounts treated as matching FOR PLAN SPONSOR USE ONLY Massachusetts Mutual Life Insurance Company, Springfield, MA All rights reserved. MassMutual Financial Group is a marketing name for Massachusetts Mutual Life Insurance Company (MassMutual) [of which Retirement Services is a division] and its affiliated companies and sales representatives. RS C:

2 contributions) for a plan year divided by the employee s compensation for the plan year. The ADP and/or ACP test is satisfied (no further action!) if the percentage for eligible HCEs doesn t exceed the greater of: 125% of the applicable percentage (ADP, ACP) for the NHCES, or the lesser of: 200% of the applicable percentage (ADP, ACP) for the group of NHCEs, or the applicable percentage plus 2%. A plan may base the ADP and ACP percentages on either the current or prior year contributions. The election to use either the current or prior year contributions is found in the plan document. This election may be changed under limited circumstances. If a plan fails the ADP or ACP test, corrective action described in the plan must be taken during the statutory correction period (the 12-month period following the close of the plan year for which the test failed). Under the regulations, there are three types of available corrections for ADP and/or ACP failure: (1) QNECs (qualifying nonelective contributions to NHCEs) or QMACs (qualifying matching contributions to NHCEs; (2) excess contributions distributed and, (3) excess contributions recharacterized. Please note that if a plan is using the prior year testing method, the plan will probably miss the deadline for making QNECs or QMACs and would need to use the distribution or recharacterization methods. The deadline for allocating QNECs or QMACs is 12 months after the applicable year for the NHCEs. The applicable year is generally the year in which the ADP is determined for both NHCEs and HCEs. For plans using the prior year testing method, the ADP for the NHCEs is determined in the year prior to the year the ADP test is being run. Not only are QNECs and QMACs always fully vested, they are subject to certain distribution restrictions. If corrective action is taken after the first 2-1/2 months of the correction period, the employer is also liable for a 10% excise tax (in addition to the correction) that is paid using the Form 5330 (Return of Excise Taxes Related to Employee Benefit Plans). Correction methods beyond the 12-month period With its Employee Plans Compliance Resolution System ( EPCRS ), the Internal Revenue Service ( IRS ) offers two different methods by which ADP and ACP failures are corrected after the 12-month correction period. Both methods require the employer to make a QNEC to the plan for NHCEs. The IRS has clarified and revised its current EPCRS guidance (Revenue Procedure ) to state that the funding of a QNEC must satisfy the regulatory 2

3 definition for a QNEC; this means a QNEC must come from nonelective contributions that satisfy both the 100% vesting requirement and the 401(k) distribution requirements under 401(k)(2)(b). Since forfeitures are derived from contributions that were not fully vested when made, they can t be used to fund a QNEC. To satisfy IRC 401(k)(2)(B), these contributions may not be distributable from a profit-sharing plan earlier than the employee s separation from service, death or disability; the employee s attainment of age 59 ½, the employee s hardship or events that include plan termination. First Method Determine the amount necessary to raise the ADP or ACP of the NHCEs to the percentage needed to pass the tests. Then, make QNECS for the NHCEs generally for all eligible NHCEs. These contributions must be the same percentage for each participant. Second Method A one-to-one correction method which consists of: a) returning the excess contributions (adjusted for earnings) to the HCEs or forfeiting it from the HCEs accounts; and (b) contributing that same dollar amount as a QNEC to the plan and allocate, based on compensation, to all eligible NHCEs. Matching contributions (and earnings) related to the excess contributions distributed to the HCEs are forfeited. For plans using the Current Year testing method, the contribution is allocated to the account balances of: a) eligible NHCEs for the year of the failure or b) eligible NHCEs for the year of the failure who are also NHCEs for the year of correction. For plans using the Prior Year testing method, the account balances to be increased are those balances that made up the NHCE ADP for the prior year. The contribution of the excess contribution is allocated to the account balances of those individuals who were either: a) eligible employees for the year prior to the year of failure who were NHCEs for that year, or b) eligible employees for the year prior to the year of the failure who were NHCEs for that year and who are also NHCEs for the year of correction. Alternatively, the contribution may be allocated to accounts of those eligible employees employed on a date during the year of correction that is no later than the date of correction. For any option chosen under either Current Year or Prior Year testing method, each NHCE must receive a uniform allocation (as a percentage of compensation) of the contribution. Under either Method, the employer must include those non-participating NHCEs when correcting the ADP or ACP failure. As plan sponsor, you would need to provide this information to your recordkeeper, as eligible NHCEs (even if they are not participating) will be receiving an allocation. 3

4 EPCRS Correction Programs SCP, VCP and Audit Closing Agreement Program Within two years from end of 12-month statutory correction period: The IRS s Self Correction Program ( SCP ) may be used to correct both significant and insignificant failures. There are certain requirements that must be met in order for a plan to be able to self-correct (e.g., established practices and procedures to keep the plan compliant). In addition, a plan sponsor may file an application with filing fee (based upon number of plan participants) under the Voluntary Correction Program ( VCP ). With the VCP, the sponsor receives a compliance statement after the IRS examiner has reviewed and approved the application. More than two years from end of statutory correction period: The SCP may still be used to correct as long as a determination is made that the operational mistake can be classified as insignificant. Whether an operational failure is significant or insignificant is a facts and circumstances determination. The IRS has explained that factors to consider include: other failures in the same period (not how many people were affected); percentage of plan assets and contributions involved; number of years the failure occurred; participants affected relative to the total number in the plan; participants affected related to how many could have been affected; whether correction was made soon after discovery; and, the reason for the failure. No single factor is determinative. A plan sponsor has the option of using the VCP to correct both significant as well as insignificant mistakes. Audit Closing Agreement Program ( CAP ), if the failure to correct the ADP and/or ACP test failures is identified while the plan is under audit by the IRS, a plan sponsor is generally allowed to correct the mistake and pay a negotiated sanction amount. This amount is in relationship to the nature and severity of the failures discovered under audit. How to avoid this testing failure Consider establishing a safe harbor 401(k) plan or changing an existing 401(k) plan to a safe harbor 401(k) plan. Under a safe harbor 401(k) plan, the employer isn t required to perform the ADP and ACP tests, if the plan meets certain requirements. Even if the tests are done and corrections made within the correction period, data problems may be discovered after this timeframe (missing data, incorrect compensation, not all eligible employees were counted) which then require further correction. Thus, it is important that you are familiar with the plan s definition(s) of compensation, have verified its accuracy; and that all eligible employees are counted. 4

5 Contact your MassMutual representative We always recommend you review this type of issue with your ERISA Counsel. In addition, you can work with your MassMutual representative to determine next steps. Our services (fees may apply) include determining QNEC calculation amounts and drafting the VCP application, if that option is chosen. MassMutual Regulatory Services If you have questions about the information in this white paper or wondering what your next steps might be with respect to How to Correct ADP/ACP Test Failures after Statutory Correction Period, please contact your MassMutual representative and/or MassMutual Regulatory Services. This document is for informational purposes only and should not be construed as legal and/or tax advice. Please consult with your own legal counsel and other experienced advisors regarding the application of the matters 5