On May 5, 2006, the U.S. Internal Revenue Service (IRS) updated its voluntary program for correcting errors in administration or design of tax-qualified retirement plans. Revenue Procedure 2006-27 reflects the terms of this long-promised update to the Employee Plans Compliance Resolution System (EPCRS) and allows plans that have failed to meet qualification requirements to be corrected under one of three programs: the Self-Correction Program (SCP) for self-correction not requiring IRS approval and without a fee or sanction; the Voluntary Correction Program (VCP) requiring IRS approval and a limited fee; and the Correction on Audit Program (Audit CAP) requiring a monetary sanction based on the nature, extent and severity of the failure. The structure of EPCRS remains relatively unchanged, but numerous important revisions and clarifications have been made.
Plan sponsors should pay particular attention to the new plan document correction procedure. If a plan was not timely and properly amended for any of the changes required by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the plan sponsor may simply pay a $375 VCP fee, prepare a VCP filing and correct the defect. By doing so, the plan sponsor will avoid the potentially very steep penalties the IRS will impose if it finds that even one seemingly minor EGTRRA-related plan change was not timely made and the error is found first by the IRS on audit or through a regular determination letter request.
In Revenue Procedure 2006-27, the IRS expanded the type of plan loan errors that can be corrected through EPCRS. As explained below, the IRS will now allow correction of three common categories of plan loan errors. Significantly, the correction methods for the first two categories are only available (and automatically approved by the IRS) for plan loan failures that are corrected through VCP. They are not available if the maximum period for repayment of the loan (generally five years) has expired.
Dollar Limit on Loan Amounts Pursuant to IRC § 72(p)(2)(A)
A failure to comply with plan provisions requiring that loans not exceed the amount specified in Internal Revenue Code (IRC) § 72(p)(2)(A) (generally, loans cannot exceed the lesser of $50,000 or 50 percent of the participant’s account balance) may now be corrected. Plan sponsors may repay the excess amount to the plan and amortize the loan over the remaining period of the original loan (not to exceed the maximum permitted duration for plan loans).
Plan Loan Term Requirements of IRC § 72(p)(2)(B) or (C)
If loan terms fail to provide for repayment within the maximum time period (generally five years) or under a substantially level repayment amortization, sponsors may reamortize the loan balance. This correction is not available when the statutory term of the loan has expired.
Defaulted, Unreported Loans with Unexpired Repayment Periods
A plan sponsor may correct a participant’s failure to repay a loan in accordance with the loan terms in several ways. Under option one, the participant makes a lump sum payment (plus interest) to bring the loan current and then continues payments under the old payment schedule. Under option two, the loan is reamortized over the remaining life of the original loan term. Under option three, any combination of option one or option two may be used. Defaulted loans that are corrected using a VCP submission and one of the above correction methods do not have to be reported on Form 1099-R.
If the employer is partially at fault for the failure to make plan loan repayments, the employer may be required to pay a portion of the correction payment on behalf of the participant equal to the additional interest owed by the participant for failure to timely repay the loan.
Failure to Include Eligible Employee in 401(k) Plan
The current correction for excluding an otherwise eligible employee under a 401(k) plan is that the employer has to contribute both:
- a Qualified Non-Elective Contribution (QNEC) equal to the average deferral percentage (ADP) for the class of the excluded employee—either Highly Compensated Employees (HCEs) or Non-Highly Compensated Employees (NHCEs)—times the employee’s compensation, and
- an additional QNEC equal to the average contribution percentage (ACP) for the class of the excluded employee (NHCE or HCE) times the employee’s compensation.
The ADP portion of this correction method creates something of a “windfall” for affected employees because the employee receives both the corrective contribution and the cash compensation upon which the QNEC is made.
401(k) Non-Safe Harbor Plan Correction
The new correction for a failure to include an eligible employee in a 401(k) non-safe harbor plan is based on the “lost opportunity cost” to make deferrals. For salary deferrals, the required make-up payment is 50 percent of the pre-tax deferrals the employee would have made had the employee been timely included in the plan. This is based on the employee’s compensation times the ADP of the employee’s class (NHCE or HCE).
The matching contribution for the excluded employee equals the matching contribution that would have been received had the employee made pre-tax deferrals. However, the corrective matching contribution is based on the full amount of deferrals (ADP) and not the 50 percent lost opportunity cost applicable to employee deferrals.
Under the new EPRCS, if an NHCE has compensation of $30,000 and is incorrectly excluded from a plan that provides a match equal to 100 percent of the first 3 percent of compensation and the plan has an NHCE ADP equal to 4 percent, then the QNEC for lost opportunity cost to make deferrals is $600 ($30,000 times 4 percent times 50 percent). The QNEC for the matching contribution is $900 ($30,000 times 3 percent).
401(k) Safe Harbor Plan Correction
Similar correction rules apply to safe harbor 401(k) plans. However, in calculating the correction amount the plan must apply its safe harbor formula rather than the ADP amounts for the applicable class of employees.
Failure to Include Eligible Employee in Plan with After-Tax Contributions
This correction is based on a different “lost opportunity cost”—namely, 40 percent of the after-tax contributions the employee would have made had the employee been timely included in the plan. The amount is based on the employee’s compensation times the ACP of the employee’s class (NHCE or HCE). The applicable ACP in this calculation is only that portion of the ACP that is attributable to after-tax employee contributions (excluding matching contributions). The new revenue procedure does not include provisions regarding the failure to offer an eligible employee the right to make Roth or age 50 catch-up contributions. However, the IRS is seeking comments on these issues.
Orphan Plans (i.e., plans for which a plan sponsor: (i) no longer exists; (ii) cannot be located; (iii) is unable to maintain the plan because of major impediments; or (iv) has filed for Chapter 7 bankruptcy) may now be submitted for correction through the VCP and Audit CAP programs. However, the IRS’ definition of Orphan Plans does not include a plan terminated pursuant to Department of Labor (DOL) regulations governing the termination of abandoned individual account plans. The IRS retains the right under VCP or Audit CAP not to require full correction for Orphan Plans. Moreover, the IRS may waive VCP fees in the case of a terminating Orphan Plan where the submission includes a request for a waiver.
Failure to Obtain Spousal Consent
If spousal consent is not obtained in a distribution situation where it is otherwise required, a spouse is entitled to a benefit equal to the portion of a Qualified Joint and Survivor Annuity (QJSA) that would have been payable to the spouse under the plan at the annuity starting date of the prior distribution or its lump sum equivalent.
- The basic compliance fee for VCP filings (based on the number of participants in a plan) has not changed.
- The compliance fee for a plan where the sole failure is the failure to timely adopt certain plan amendments (including failure to adopt good faith EGTRRA amendments, 401(a)(9) regulations amendments and temporary/interim amendments pursuant to Revenue Procedure 2005-66) is $375. While the new guidance indicates that the fee is $375 “per year of the failure,” the IRS has indicated this reference is incorrect; a correction will be issued indicating the fee is a flat $375 for this type of submission.
- A new significantly higher fee schedule will apply to “non-amender” issues discovered during the determination letter process. The fee will be based upon the number of participants in the plan and the law change for which the plan is not amended. It could be as high as $80,000 in an extreme case. It is essential for all plans to ensure that all legally required amendments have been adopted prior to submitting a determination letter application. Plan sponsors should examine all plans for compliance with recent pension legislation and the IRS’ annual “Cumulative List of Changes” to qualified plans. In particular, the IRS takes a very limited view of what constitutes a “good faith” EGTRRA amendment. To avoid penalties, plan sponsors should ensure that plan amendments include all EGTRRA-related changes. In light of the minimal $375 VCP fee that applies to EGTRRA non-amenders, plan sponsors should consider filing VCP applications in any situations in which it is not crystal clear that all required changes have been adopted. If the non-amender failure is discovered during an Employee Plans audit, it is possible that the fee will be even greater than that in the new schedule.
- For VCP submissions involving the failure to make required minimum distributions, a reduced fee of $500 will apply for any size plan where the number of affected participants is 50 or less.
- The VCP compliance fee for Simplified Employee Pension (SEP) plans and SIMPLE IRAs has been reduced to $250, although the IRS reserves the right to impose a different fee in appropriate circumstances.
- The VCP fee for an Orphan Plan may be waived in the discretion of the IRS.
Other Significant Changes
- If the plan or the plan sponsor has been a party to an abusive tax avoidance transaction (ATAT, referred to in other contexts as “listed transactions”), SCP is not available to correct any “Operational Failure” that is directly or indirectly related to the ATAT. Also, VCP is not available for correcting an error related to an ATAT, and the IRS could refer the plan for Employee Plans Division examination. If an error is unrelated to an ATAT, the plan error is generally eligible for correction through VCP; however, the IRS reserves the right to refer the plan to audit.
- VCP is not available for any issue that is “Under Examination.” The term was clarified to provide that when a determination letter request is under IRS review and the IRS requests additional information that indicates a qualification failure not previously identified by the plan sponsor, the plan is considered to be Under Examination even if the determination letter request is subsequently withdrawn.
- The term “Operational Failure” now includes the failure to comply with good faith/interim amendments.
- The new procedures expand the situations under which the IRS will not pursue an excise tax that is otherwise owed to include excise taxes for certain non-deductible contributions or distributions of excess contributions or excess aggregate contributions.
For most corrections, Revenue Procedure 2006-27 is effective September 1, 2006. However, for certain provisions (most notably the fee schedule for non-amenders discovered during the determination letter process), the effective date is May 30, 2006. Except as otherwise specified, from May 30, 2006 until September 1, 2006, a plan sponsor may choose to rely on the provisions of either the old EPCRS in Revenue Procedure 2003-44 or the new EPCRS in Revenue Procedure 2006-27.