Regulatory Brief: IRS updates plan correction program

Regulatory Brief: IRS updates plan correction program Vanguard Strategic Retirement Consulting July 2013 David Tooley Brian O Neill Executive summary The IRS allows and encourages plan sponsors to correct operational and compliance failures that may occur in their tax-qualified retirement plans. Since 1998, these corrections programs have been consolidated in the IRS Employee Plans Compliance Resolution System (EPCRS). Using EPCRS helps preserve the significant tax benefits both employers and employees can derive from tax-qualified plans. This year, the IRS has issued Revenue Procedure 2013-12, which is now the official guidance governing the EPCRS program. The effective date of the EPCRS update is April 1, 2013; however, plan sponsors are permitted to apply the provisions anytime on or after December 31, 2012. This Regulatory Brief describes some key changes made to EPCRS in the new IRS Revenue Procedure and outlines some fundamental principles that apply to plan corrections. For additional background, this brief also describes how to correct common errors under prior guidance that remains unchanged. Significant changes in the new EPCRS While most of the IRS Revenue Procedure remains unchanged from its last update in 2008, a few key changes are worth highlighting. Expanded 403(b) plan correction guidance. 403(b) plan sponsors are now explicitly permitted to correct plan failures in generally the same manner as sponsors of qualified plans. Additionally, 403(b) plan sponsors who failed to timely adopt a plan document can now correct this failure through a Voluntary Correction Program (VCP) submission. Those who submit a VCP filing to solely correct this failure by December 31, 2013, are eligible for a 50% reduction of their VCP fee. Client planning note: This is important news for 403(b) plan sponsors. Only a limited EPCRS program for 403(b) plans existed previously. Now there s a blueprint that guides sponsors to take remedial action if a 403(b) plan experiences operational failures. 1

Correction for missed matching contributions may be non-qnec employer contribution. The most significant operational change in the new EPCRS is the modified correction for improper exclusion of an employee from deferring in a 401(k) plan that has a match feature. Correcting this failure continues to require a qualified nonelective contribution (QNEC) 1 in the amount of 50% of the missed deferral (40% for a missed after-tax employee contribution). However, the corresponding match contribution is no longer required to be a QNEC (unless the plan is a safe harbor plan i ). The missed match contribution may now be made as a non-qnec corrective employer contribution, which avoids the conditions associated with a QNEC (i.e., immediate vesting, withdrawal restrictions, and inability to fund with forfeitures). Other highlights: The IRS will accept submissions related to funded governmental Code section 457(b) plans on a provisional basis outside of EPCRS through standards similar to EPCRS. New IRS Forms 8950 (Application for Voluntary Correction Program (VCP)) and 8951 (Compliance Fee for Application for Voluntary Correction Program) are required to be included with any VCP submission made on or after April 1, 2013. Defined benefit (DB) plans with benefit restriction failures 2 may be corrected by the plan sponsor making additional contributions to the plan. Payments from certain underfunded DB plans may be treated as overpayments and corrected in the same manner as other DB overpayment failures. Correction of certain impermissible distributions from a defined contribution plan does not require the plan sponsor to contribute to the plan (i.e., make the plan whole) when the participant who received the impermissible distribution fails to repay the distribution. The IRS Letter Forwarding Program has been removed as an available method for locating missing plan participants. In prior versions of EPCRS, depending on the specific correction utilized, it wasn t always clear whether an earnings determination would include losses. The term earnings is now explicitly defined to include gains and losses unless otherwise specified within EPCRS. Hot-button opportunities for future EPCRS updates In the 2008 EPCRS update, the IRS requested comments on how certain operational failures should be corrected. Unfortunately, despite this request, the new EPCRS procedure does not address correction of: Failures associated with the implementation of automatic enrollment programs. Failures to timely distribute safe harbor notices. Failures related to incorrectly making a pre-tax elective deferral instead of a designated Roth contribution. In the new revenue procedure, the IRS does, however, reiterate its request for comments on correcting these failures. 1 A QNEC contribution generally must be 100% vested when made to the plan and may not allow withdrawals before age 59½. i A safe harbor plan is generally exempt from nondiscrimination testing if (1) certain minimum contributions are made (2) accelerated vesting occurs and (3) in-service distributions are restricted. 2 These limits apply in the event that the plan falls short of funding targets established under the Pension Protection Act of 2006 (PPA). Limits start to apply if the plan s adjusted funding target attainment percentage (AFTAP), as certified by the plan s actuary, falls below 80%, and additional and stricter limits apply if the plan s AFTAP falls below 60%. 2

The updated EPCRS left unchanged the correction rules that apparently limit plan sponsors ability to use self-correction in connection with loan failures. Many plan sponsors and practitioners were hopeful that additional flexibility for correcting loan failures would be included in this version. However, the approach remains status quo that is, certain loan corrections generally require a VCP submission. Client planning note: The lack of new guidance for correcting automatic enrollment, safe harbor plan notice deficiencies, and loan failures is disappointing for plan sponsors. In many instances these situations will require adherence to the existing costly and administratively burdensome procedures. EPCRS fundamentals EPCRS includes key principles and rules that generally apply to all corrections. Restoration of benefits. The correction method should restore the plan and the participants to the position in which they would have been had the failure not occurred. Reasonable and appropriate correction. The correction should be reasonable and appropriate for the failure. Depending on the nature of the failure, there may be more than one correction. Consistency requirement. Generally, where more than one correction method is available, the correction method (including the earnings determination) should be applied consistently for all such failures within the same plan year. The structure of EPCRS includes three levels of correction programs. Whether a particular correction program may be used to correct a plan error generally depends upon the scope and size of the failure and the timing of the correction. Self-Correction Program (SCP). Under SCP, a plan sponsor may correct operational failures without having to notify the IRS and without paying any fee or sanction. SCP may be used to correct a failure regardless of when it occurred, provided the failure is deemed insignificant. A plan sponsor may also use SCP to correct significant operational failures as long as the correction is made by the last day of the second plan year following the plan year in which the failure occurred. The determination of whether an operational failure is insignificant or significant is subjective and based on several factors, including the percentage of plan assets and contributions involved, the number of years during which the failure occurred, and the percentage of participants affected. No single factor is determinative. Egregious errors may not be corrected using SCP. Voluntary Correction Program with Service Approval (VCP). A plan sponsor whose plan is not subject to an IRS audit may submit a correction application through VCP to the IRS at any time, pay a limited fee, and receive approval of the correction method. Significant or egregious errors that may not be selfcorrected through SCP may be submitted to the IRS for correction under VCP. 3

Audit Closing Agreement Program (Audit CAP). If a failure has been identified during an IRS audit, the plan sponsor may correct the failure through Audit CAP and pay a sanction based on the nature, extent, and severity of the failure. Client planning note: Whenever a failure is self-corrected under SCP, plan sponsors should document: 1) what happened, 2) what was done to fix the error, and 3) what measures have been established to prevent recurrence of that error. Correction of common mistakes In our work with thousands of plan sponsors, we have noticed certain common operational failures. Guidance for correction of these failures hasn t changed under the new EPCRS, but we highlight these six errors to raise plan sponsor vigilance and awareness of how they should be corrected. 1. Missed opportunity to participate. A failure occurs when an employee is not provided with timely notification of their eligibility to participate, an automatic enrollment plan inadvertently excludes a participant for a period of time, or a participant makes an election to participate that isn t processed or isn t processed in a timely manner. General correction: The employer makes a QNEC in an amount equal to the missed deferral opportunity, which is 50% of the missed deferral. The missed deferral is calculated using the participant s elected deferral percentage, the plan s automatic enrollment percentage, or the appropriate plan average deferral percentage (ADP), whichever is applicable. A contribution of any missed match must be made based on 100% of the missed deferral. Applicable earnings are contributed based on both the QNEC and missed match contribution. As stated previously, the prior version of EPCRS required a QNEC for the missed match. The IRS has liberalized this requirement. Now any corrective match contribution for a non-safe harbor plan does not need to be a QNEC and can be subject to a vesting schedule and have broader distribution events available, as permitted by the plan. Client planning note: The applicable QNEC is calculated based on the actual participant election, if available. The ADP is generally used when a participant was not provided the opportunity to enroll and an election is not available. If a plan with an automatic enrollment feature fails to default a participant, the QNEC would be based on the plan s applicable default percentage. 2. Excess amounts. A failure occurs when the amount deferred or contributed to the plan on behalf of a participant exceeds the maximum annual amount allowed by the Internal Revenue Code (currently $17,500 for deferrals, not including catch-up contributions) or exceeds a plan-imposed annual limit, or when the plan has not satisfied the ADP and/or the average contribution percentage (ACP) nondiscrimination tests in a given plan year. 4

General correction: Excess contributions made by the participant, including applicable earnings, are distributed to the participant. Any associated matching amounts contributed by the employer are transferred from the participant s account into the plan s forfeiture account, including any applicable earnings on such employer amounts. Forfeited amounts would be used and/or allocated in accordance with the plan s general rules for its forfeiture accounts (e.g., to reduce employer contributions and/or pay plan expenses). Client planning note: If any excess employer contribution has already been distributed to a participant who has terminated, an effort should be made to reclaim the excess amount from the participant. The participant would also need to be notified that the excess amount is not eligible for rollover. 3. Failure to suspend contributions following a hardship withdrawal. A failure occurs when a participant s elective deferrals and after-tax contributions are not stopped as required after a hardship distribution. General correction: Although not specifically addressed in EPCRS, the IRS has indicated that the same correction method as described above for plan limit violations may be used here. The plan should distribute the elective contributions made during the suspension period to the participant and any associated match should be forfeited, along with any applicable earnings for both. 4. Failure to report a loan as taxable. Loans corrected within a plan s cure period aren t required to be reported as taxable income. A failure occurs following the expiration of the plan s cure period when a defaulted loan hasn t been corrected and isn t reported as taxable income. If participant loan repayments aren t made in accordance with the terms of the loan, a deemed distribution to the participant should result. That would subject the participant to income taxation for the year of the default. General correction: The plan sponsor may choose to report the defaulted loan as taxable to the participant in the year in which the failure occurred. Alternatively, this failure may be corrected by reporting the defaulted loan as taxable to the participant in the year of correction (current year). Client planning note: EPCRS states that the ability to report a defaulted loan as taxable in the current year, which should have been reported as taxable in a prior year, is available only if a VCP filing is made and approval is granted by the IRS. Alternative correction: If the plan sponsor determines that the loan default was the result of an operational failure and should not be reported as taxable, the failure can be corrected by (i) the participant making a lump-sum repayment equal to the additional repayments that would have been made to the plan if there had been no failure to repay the loan, plus interest accrued on the missed repayments; (ii) reamortizing the outstanding balance of the loan, including accrued interest, over the remaining payment schedule of the original term of the loan or over the maximum period that complies with 72(p)(2)(B) (generally five years), measured from the original date of the loan; or (iii) any combination of (i) or (ii). Loans that have exceeded the maximum period provided by IRS rules (for most loans that period is five years) cannot be reamortized. 5

Client planning note: EPCRS states that the ability to correct loan repayment failures and avoid a deemed distribution and taxation by allowing the participant to make a lumpsum repayment or to reamortize a defaulted loan is available only if a VCP filing is made and approval is granted by the IRS. 5. Required minimum distributions (RMDs). A failure occurs when participant RMDs are not distributed in years in which they are required. Generally, the participant or beneficiary is subject to a 50% excise tax on the late RMD amount. General correction: The plan should distribute the RMD(s) as soon as possible, including earnings. While the SCP can be used to correct missed RMDs, only an approved VCP filing provides an explicit waiver of the 50% excise tax. Note that the VCP filing fee for RMD failures is limited to $500 if certain conditions are met. 6. Spousal consent for a distribution was not obtained. A failure occurs when a participant receives a distribution without obtaining written spousal consent in a plan where the normal form of payment required is a qualified joint and survivor annuity (QJSA). Next steps Given the complexity of rules applicable to the operation of tax-qualified retirement plans, it s understandable that errors may occur even for the most vigilant plan sponsors. The very existence of EPCRS recognizes that mistakes will happen and plan corrections will be required. The key is to remain focused on your plan s operation so as to promptly identify and correct operational errors. If you have any questions regarding this Regulatory Brief or if you need assistance addressing any plan issues, please contact your Vanguard representative. Vanguard Strategic Retirement Consulting (SRC) is a valuable technical resource that can help both defined contribution and defined benefit plan sponsors optimize their plan design, develop fiduciary best practices, and achieve regulatory compliance. The strategies developed by SRC consultants are grounded in expert analysis of broad-based data and are informed by Vanguard s highly respected research teams, including the Vanguard Center for Retirement Research. General correction: The participant can obtain his or her spouse s consent for the distribution already made. If not obtained, the participant must repay the distribution and receive a QJSA. EPCRS also offers alternatives in which the spouse would be entitled to either a survivor annuity benefit or a one-time lumpsum payment in an amount equal to the actuarial equivalent present value of the survivor annuity benefit payable under the QJSA. 6

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