Get back on track: an IRS program helps correct retirement plan defects so tax benefits are not lost.

EXECUTIVE SUMMARY

* QUALIFIED RETIREMENT PLANS THAT HAVE NOT BEEN properly updated or have not been operating according to plan provisions may be disqualified and, as a result, lose important tax benefits.

* THE IRS's EMPLOYEE PLANS COMPLIANCE RESOLUTION System (EPCRS) can help plan sponsors correct qualification failures.

* THE EPCRS CONSISTS OF THREE DISTINCT PROGRAMS: the self-correction program (SCP), the voluntary correction program with service approval (VCP) and the correction on audit (Audit CAP).

* PLAN SPONSORS MAY CORRECT INSIGNIFICANT operational failures at any time, even if a plan or sponsor is under IRS examination.

* THE VCP ENABLES RETIREMENT PLAN SPONSORS, at any time prior to an IRS audit, to voluntarily disclose qualification failures they've discovered, pay a fee and receive approval for correction.

* THE AUDIT CAP IS AVAILABLE IF THE IRS identifies a failure during an examination. The plan sponsor can correct the failure, pay a sanction, satisfy any additional requirements and enter into a closing agreement with the IRS.

When CPAs review financial papers and prepare tax returns, they often discover that their clients or employers have not updated their retirement plans to meet new legal requirements or have not been operating the plans correctly. Retirement plans that don't meet the government-mandated form and operational requirements may be disqualified and, as a result, lose important tax benefits. The consequences can include

* The employer may not be allowed a tax deduction for contributions made to the plan.

* The plan earnings may become taxable.

* The employer contributions may become includable in participants' gross income.

* The vested accrued benefit of highly compensated employees may become includable in their gross income.

* Tax-free rollovers may not be allowed.

The IRS provides a comprehensive program to correct disqualifying defects and ensure that plans remain tax-qualified. The Employee Plans Compliance Resolution System (EPCRS) contained in Revenue Procedure 2003-44 may be used to correct failures in qualified retirement plans, simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLE IRAs) and tax-sheltered annuities (403(b) plans).

This article discusses the most common errors and the programs CPAs can use to help their clients and employers correct plan violations.

QUALIFICATION FAILURES

The IRS's EPCRS can be used to rectify

* Plan document failures that occur when a plan provision (or the absence of a plan provision), on its face, violates Internal Revenue Code requirements, such as when a plan is not amended to reflect a new qualification requirement. A plan document failure generally can be corrected by amending the plan.

* Operational failures that occur when plan provisions are not followed, as when a company fails to allow an eligible employee to participate in the plan. An operational failure generally can be corrected by restoring the plan to the position it would have been in had the failure not occurred, including restoring the benefits and rights participants would have had.

* Demographic failures that occur when a plan fails to satisfy the nondiscrimination requirements of IRC section 401(a) (4), the minimum participation requirement of IRC section 401(a)(26) or the minimum coverage requirement of IRC section 410(b). For example, rapid employee turnover and a change in the composition of a company's employees can cause a plan to no longer pass the section 410(b) requirement that it provide benefits to at least 70% of non-highly-compensated employees. A demographic failure generally can be corrected by adding new benefits, increasing the existing ones or expanding the coverage.

* Employer eligibility failures that occur when a 401(k) plan is adopted by an employer that is not permitted to maintain such a plan under the Internal Revenue Code, as when a state or local government sponsors a 401(k) plan. An employer eligibility failure generally can be corrected by the cessation of all contributions.

THREE PROGRAMS WITHIN A PROGRAM

The EPCRS is made up of three distinct correction programs: the Self-Correction Program (SCP), the Voluntary Correction Program with Service Approval (VCP) and the Correction on Audit Program (Audit CAP).

Self-Correction Program. Under the SCP, the sponsor of a qualified plan may correct an insignificant operational failure at any time, even if the plan or plan sponsor is under IRS examination. To determine whether an operational failure is insignificant, the IRS considers whether other failures occurred during the period being examined, the percentage of plan assets and contributions involved, the number of years over which the failure occurred, the number of participants affected, the reason for the failure and whether correction was made within a reasonable time. In addition, the sponsor of a qualified plan that has received a favorable de termination letter may correct a significant operational failure by the last day of the second plan year following the plan year in which the failure occurred.

For example, Corporation 1 established a profit-sharing plan in 1984. In 2000, the allocations for 50 of the 250 participants were subject to certain legal limitations. During its examination of the plan for the 2000 plan year, the IRS discovered the contributions allocated to the accounts of three participants exceeded the maximum limitation. Corporation 1 had contributed $3.5 million to the plan, and the excess allocations totaled $4,550. Because of the small number of participants affected relative to the total and the small monetary amount relative to the total employer contribution, the failure was deemed insignificant and eligible for correction.

Corporation 2 established a profit-sharing plan with a 401(k) feature and received a favorable determination letter. During 2000, its CPA discovered that, despite established practices and procedures, several employees who were eligible to participate for 1999 were accidentally excluded. Corporation 2 can make corrective contributions on behalf of the excluded employees during the 2001 plan year, crediting each corrective contribution with earnings at a rate appropriate for the plan from the date the corrective contribution should have been made to the date of correction.

Voluntary Correction Program with Service Approval. The VCP enables the sponsor of a qualified plan, at any time prior to an IRS audit, to voluntarily disclose qualification failures it has discovered to the IRS, pay a limited fee and receive approval for correction. In return the IRS issues a compliance statement that outlines the failures identified, the terms of correction and the time period within which the proposed corrections must be implemented. The IRS agrees not to disqualify the plan due to the failures if the conditions are satisfied.

The compliance fees for all VCP submissions are on a sliding scale based on the number of participants in the plan. They range from $750 for plans with 20 or fewer participants to $25,000 for plans with more than 10,000.

The IRS provides a list of acceptable correction methods to be used with the correction programs but also may accept other reasonable and appropriate methods. Since VCP applications are made to the IRS for approval, in practice, the correction method can be tailored to the specific facts of the case and the needs of the client (for example, choosing the least costly correction method).

Corporation 3, for example, maintained an 8-percent-of-compensation money purchase pension plan. The annual compensation limit for 1999 was $160,000. That year an employee received compensation of $220,000 and a pension contribution of $17,600 (8% x $220,000) rather than a contribution of $12,800 (8% x the $160,000 limit), resulting in an over-allocation of $4,800. Corporation 3 corrected the failure under the VCP by amending the plan to increase the 1999 contribution percentage for all participants by three percentage points ($4,800 / $160,000), from 8% to 11%. Another acceptable and less costly correction method would have been to reduce the employee's account balance by $4,800 (adjusted for earnings) and credit that amount to an unallocated account to be used to reduce future employer contributions.

Correction on Audit Program. If the IRS identifies a qualification failure on examination of a qualified plan, the Audit CAP is available if the plan sponsor corrects the failure, pays a sanction, satisfies any additional requirements and signs a closing agreement with the ILLS. The sanction is a negotiated percentage of the maximum payment amount (MPA). According to IRS rules, sanctions will not be excessive and will bear a reasonable relationship to the nature, extent and severity of the failures.

The MPA is a monetary amount approximately equal to the tax the IRS could collect by disqualifying the plan. Generally, it's the sum of the tax on the trust, additional income tax resulting from the loss of employer deduction for plan contributions, any interest or penalties applicable to the plan sponsor's tax return and additional income tax resulting from income inclusion for participants in the plan for the open taxable years.

Corporation 4 established a profit-sharing plan in 1988 that was timely amended and received a favorable determination letter in 1996. A newly hired pension consultant discovered the compensation of four participants in 1996 and 1997 was incorrectly calculated and contributions exceeded the legal limitation. While preparing a request to the IRS under the EPCRS, the company received notice of an audit for the 1996 plan year. The operational failures were corrected by placing the excess contributions in a suspense account. The closing agreement's sanction equaled $12,960 (20% of the plan's $64,800 MPA).

BENEFITS OF THE EPCRS

CPAs who discover a qualification failure during the review of a retirement plan should recommend one of the above-described IRS procedures to correct the failure, keep the plan qualified and protect the plan's tax benefits.

At press time, the IRS advised the author that new guidance updating and revising the EPCRS would be issued shortly. The new revenue procedure will not substantially change the current guidance.

RESOURCES

AICPA Resources

Publications

* Adviser's Guide to Tax Planning Strategies for Retirement (# 091017JA).

* The CPA's Guide to Retirement Plans for Small Businesses (# 017237JA).

CPE 

Qualified Benefit Plans: Taxation and Administration for Small to Mid-Sized Companies (# 731901JA).

For more information about the above products or to order, go to www.cpa2biz.com or call the Institute at 888-777-7077.

Other Resources

Conferences

IRS Employee Plans (EP) co-sponsors a series of employee plans benefit conferences across the country throughout the year. For a complete schedule, see www.irs.gov/ep.

Publications

* IRS Publication 4224, Retirement Plan Correction Programs.

* The Pension Answer Book by Stephen J. Krass, Aspen Publishers, 2005.

* Retirement News for Employers is a periodic newsletter from the IRS. Each issue discusses a common mistake and presents a correction. To subscribe go to www.irs.gov/ep and click on the link for Newsletters.

PRACTICAL TIPS

* If you discover a failure, no matter how large or small, make voluntary and timely corrections to minimize fees and sanctions.

* Tailor plans you submit to the IRS under the Voluntary Correction Program to the facts of the case.

* Use a correction method that restores the plan to the position it would have been in had the failure not occurred.

A Helping Hand

More than 2,000 plan sponsors/taxpayers took advantage of the IRS Voluntary Correction Program in fiscal 2004

Source: IRS, www.irs.gov.

STEVEN SCHMUTTER, Esq., is a member in the law firm of Krass, Snow & Schmutter, PC. His e-mail address is sschmutter @ksslaw.net.