Correcting Plan Failures Following a Business Transaction

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Title:
Correcting Plan Failures Following a Business Transaction
Date:
April 1, 2011
Publication:
The April 2011 Riker Danzig Employee Benefits and Executive Compensation UPDATE
Author(s):
James N. Karas, Jr.
Area(s) of Practice:
Employee Benefits and Executive Compensation

The IRS generally will approve plan amendments as a method of correcting a failure to follow the terms of a tax-qualified retirement plan when the failure is discovered after an employer merger, acquisition or other structural transaction.

Recently, Avaneesh Bhagat, a coordinator for employee plans voluntary compliance at the Internal Revenue Service, explained this principle by providing the following example. If a smaller company sponsors an IRS-preapproved prototype plan that defines the term "employer" as "the employer and all affiliated employers" and the smaller employer is acquired by a larger company with its own retirement plan, Bhagat affirmed that "the correction would be to fix the [smaller] plan by plan amendment." In this case, the small-plan sponsor would request the approval of the IRS using the Voluntary Correction Program ("VCP") of the Employee Plans Compliance Resolutions System ("EPCRS") to correct the failure to follow the terms of the plan. Bhagat emphasized that the failure would be treated by the IRS as a failure to follow the terms of the plan and not as a "scrivener's error," a concept which the IRS currently does not recognize as part of EPCRS. Bhagat also cautioned that each case would be considered on the basis of all relevant facts and circumstances.

In the example described, Bhagat indicated that the IRS would expect the sponsor of the smaller plan to show that the employees of the larger plan had no expectation to benefit from the smaller plan and that the sponsor of the smaller plan clearly intended only to offer benefits to its employees. The sponsor of the smaller plan would have to provide the IRS enough documentation to show what the intent of the employer was and what the employees understood the benefits to be.

In general, the four types of tax-qualified plan failures that can be corrected using EPCRS include:

 

  • Operational failures, or any failure that results solely from a failure to follow the terms of a plan; Plan document failures, or any inclusion of language or absence of language required to qualify for tax-favored status;
  • Demographic failures, or any failure to satisfy IRS numerical markers for coverage, minimum participation, and nondiscrimination; and
  • Employer eligibility failures, or adoption of cash or deferred arrangements by employers that do not meet the employer eligibility requirements to establish a 401(k) plan.

All four types of failures may be corrected using the VCP, which requires application and disclosure of the failure to the IRS, payment of a compliance fee and IRS approval of the method used to correct the failure.

Alternatively, a plan sponsor may self-correct certain plan failures under certain circumstances. Operational failures can be corrected using the Self Correction Program ("SCP") under EPCRS, which does not require the payment of a compliance fee or IRS involvement, if (a) the operational failure is insignificant, or (b) the operational failure (even if significant) is corrected and the correction is either completed or substantially completed by the last day of the second plan year following the plan year in which the failure occurred. The factors used to determine whether or not an operational failure is "insignificant" and, therefore, eligible for correction under SCP include: (i) whether other failures occurred during the period being examined; (ii) the percentage of plan assets and contributions involved in the failure; (iii) the number of years the failure occurred; (iv) the number of participants affected relative to the number of total participants; (v) the number of participants affected as a result of the failure relative to the number of participants who could have been affected by the failure; (vi) whether correction was made within a reasonable time after discovery of the failure; and (vii) the reason for the failure.

Multiple failures in a single year or failures that occur in more than one year may be corrected under SCP only if all of the failures are insignificant in the aggregate. Even significant failures that previously were corrected under SCP or VCP are not taken into account for purposes of determining whether the failures are insignificant in the aggregate. To use SCP, a plan sponsor must also have practices and procedures designed for compliance in place and, if the failure(s) at issue are significant, the plan involved must have received a favorable determination letter.