Who's eyeing your 401(k)?

You thought your company's 401 (k) plan was a model of Erisa compliance. But now the IRS is coming to audit you. What did you overlook?

Take heed of a recent blow - a double hit, actually - to Microsoft. When the Internal Revenue Service imposed heavy payroll tax obligations on the company as a result of what they claimed was a misclassification of independent contractors, workers followed through with a request for employee benefits based on their new-found employee status. The Ninth Circuit Court of Appeals in Vizcanino vs. Microsoft Corporation ruled for the workers, though the case is scheduled for rehearing. With tighter plan language and better documentation, Microsoft might have avoided the audit and the workers' claim altogether.

The goal of the IRS is compliance, not enforcement. Likewise, the goal of the CFO in a 401(k) audit should be prevention, not defense. The tone management sets sends a clear message to col. leagues directly involved with day-to-day plan operations that compliance is important - and critical to the bottom line.

To improve its examination program, the IRS is adding a fourth year of Form 5500 data to its Employee Plans Return Inventory Classification System. This tool allows the IRS to compare information from one year to the next, making it easy to identify patterns, inconsistencies and issues of concern. In addition, the IRS can use it to determine the compliance level of plans with common attributes and select specific returns for examination.

The IRS expects EPRICS will reduce the overall likelihood of an audit because examination efforts will be more focused. Plus, the IRS now educates its auditors about specific retirement plan issues, making them more savvy reviewers. If you do hear from IRS auditors, expect them to raise very specific concerns.

In two recent audits, the IRS told both plan sponsors precisely why it had targeted them. One had revealed a high turnover on Form 5500, the reporting form for 401 (k)s. The IRS auditor randomly selected the names of 50 terminees and asked to see benefit calculations for each. The IRS selected the second employer because it sponsored a 403 (b) program. These programs are audit triggers, having been identified as problematic during past audits that reviewed the tax-exempt purpose of sponsoring organizations.

All this doesn't necessarily mean the IRS is out to "getcha." On the contrary, the IRS would rather have plan sponsors discover their own errors and correct them than go to an audit and find mistakes. To help plan sponsors do that, the IRS has created several programs for taking corrective action. Plan sponsors who use these programs and act responsibly usually can avoid significant extra tax sanctions. Plan sponsors who ignore these opportunities may find their IRS auditor inclined to levy maximum penalties.

Of course, no plan sponsor ever wants to be faced with an audit. Good administrative controls and proper documentation can't prevent an audit of your 401 (k) plan, but they can increase your preparedness in the event an audit does occur. Here's a checklist of the key areas to watch.

AN OUNCE OF PREVENTION

* Make sure the basic plan documents are in order. Your 401(k) plan documents should be clear in spelling out plan benefits, operational procedures and financing. Also, make sure your plan incorporates the most current tax and labor legislation. If changes are in order and you've missed the adoption deadlines, consider the merits of an advance closing agreement with the IRS to ensure ongoing favorable tax status.

* Get a determination letter from the IRS. This letter states the IRS has reviewed your plan and concluded that it satisfies the qualification requirements that gain favorable tax status for both the employer and employees. The letter simply addresses the form of the plan at the time the IRS reviews it; it doesn't guarantee your plan won't be disqualified if subsequent laws and regulations change the playing field.

If the IRS audits your plan, the determination letter is the first item it will request. Make sure you have a letter for each of your plans. You can request a copy from your attorney, consultant, accountant or the IRS. If the letter isn't current, consider requesting a new one now. You should expect to amend the plan again shortly to conform to the retirement plan changes included in the Small Business Jobs Protection Act of 1996, such as revised nondiscrimination standards and individual tax rules. It may make sense to wait and submit all outstanding amendments together.

* Check the results of compliance tests. As you know, the level of benefits provided for highly compensated employees must be nondiscriminatory relative to the benefits provided for employees who aren't highly compensated. The "ADP and ACP" tests used for 401(k) plans are examples of such compliance tests. Confirm that appropriate tests have been done for each plan and that you have documentation showing summary results, including details to back up the summary.

* Identify the structure of any con. trolled group to which your company belongs and assess coverage of plans within that group. Identifying the structure of your controlled group is essential to properly assess coverage and conduct nondiscrimination tests. A worksheet or diagram illustrating the group's structure is a helpful tool for your service providers as well as IRS reviewers.

* Confirm that the actual operation of the plan matches the rules detailed in the plan's documents. This will be a critical point for an IRS reviewer. Plan eligibility is one key area to watch. Don't make the mistake of leaving out "part-time" or "temporary" employees who have met a plan's "1,000 hours of service" requirement. Be on the lookout for potentially misclassified workers disguised as leased employees or independent contractors.

Check your maximum contribution and benefit limits, too. Where employees are covered by a single defined-benefit or defined-contribution plan, compliance is generally straightforward. Complexities arise when compensation is adjusted by elective deferrals and flex-plan contributions, or when coverage is provided under multiple plans. Relief is in sight, thanks to changes in the Small Business Jobs Protection Act passed last year. For now, though, use the "combined plan test" that applies to participants covered by both a defined-benefit plan and a defined-contribution plan.

On the compensation side, confirm that the actual pay records used to determine plan allocations and perform ADP and ACP tests match the choices made in the plan document. Pay particular attention to executives whose compensation is limited by the $160,000 limit on plan pay.

* Keep complete records of benefit payments. This includes benefit calculation forms, rollover notifications, spousal consent forms and Form 1099-R filings. Make sure that every spousal consent form has been witnessed by a plan representative or notary public. (Do this for all beneficiary designation forms on file, too.) Also, be sure to keep copies of all 1099-Rs issued to participants who received distributions. In an audit, the IRS will check whether amounts reported on Form 1099-R reconcile with the distribution amount shown on Form 5500. Be prepared to explain any differences.

* Check contributions and deductions. If your plan is audited, anticipate that the IRS reviewer will compare actual plan contributions, based on the plan and trust records, with the amount deducted on the corporate return. A system for tracking and summarizing contributions, particularly if multiple plans are involved, will help you communicate the correct information to your corporate tax professionals and establish credibility with the IRS reviewer.

* Make sure you comply with all reporting requirements. Retirement programs must report basic plan and trust information to the federal triumvirate (IRS, DOL and PBGC) each year on Form 5500. In addition, there may be other filing requirements. Obtain a list of the requirements that apply to your plans from your consultant or auditor and set up a control list to record compliance dates. One item that's often overlooked until the IRS reviewer asks for it is the statement of plan benefits that must be given to terminated, vested participants who are entitled to deferred benefits from the plan. These statements are due by the time the participant is reported on Schedule SSA of Form 5500. The statement should include the name of the plan; the name and address of the plan administrator; the participant's name and taxpayer identification number; the nature, amount and form of benefit; and a notice of any benefits forfeitable if the participant dies. Penalties for failing to file generally increase with each passing day. Adequate controls will limit your exposure here.

* Scrutinize "other assets" listed on Form 5500. Showing an entry on the "other assets" line is an audit trigger. Before purchasing assets that must be reported here, consider whether the asset is worth the trouble of an audit. If your company does show an amount under "other assets" on Form 5500, make sure specific details on these assets are available. "Other assets" include options, index futures, repurchase agreements, state and municipal securities and collectibles. If these assets include collectibles such as coins, paintings, metals or gems, the IRS will want to know who has them, where they're stored and how they're valued. IRS Announcement 94-101 describes the audit guidelines for the valuation of assets. These guidelines call for special scrutiny of partnerships, real estate, employer stock (if not readily traded on an established securities market) and springing cash values.

* Record plan decisions. Plan administrators and other plan fiduciaries are charged with the responsibility for many important plan decisions. In general, federal agencies and courts will not second-guess those decisions, but they are likely to review the process that was followed. For future reference, make sure you keep records of the criteria set and the choices that were considered.

Audit Targets

The IRS selected the following audit targets for fiscal 1997:

* Pension underfunding

* Simplified employee plans

* Non-amenders, particularly TRA '86

* Terminated plans that have not requested a determination letter

* Plans that have not valued their assets properly

* Prohibited transactions

IRS Audit Guidelines

These are the areas in which the IRS is educating its agents. You can use these guidelines for self audits.

* Section 401(k) and (m) requirements

* Qualified joint and survivor notices

* Defined-benefit lump-sum calculations

* Prohibited transactions

* Plan asset valuations

* Plan terminations

* ESOPs

* Section 403(b) annuities

* Top-heavy plans

* Defined-contribution (and defined-benefit) single-plan 415 limits

* Distribution rules under 401(a)(9) and 401(a)(14)

* Multi-employer plans

IN SHORT

* IRS scrutiny of 401(k)s is more focused, so audits are less likely overall. But if you're audited, expect to answer very specific questions.

* Showing an entry on the "other assets" line of Form 5500 is an audit trigger.

* Keep copies of all 1099-Rs issued to participants receiving distributions. Auditors check whether the reported amounts reconcile with the distributions shown on Form 5500.

Ms. Martin and Ms. Simcox are based in the Roseland, N.J., office of Sedgwick Noble Lowndes. Ms. Martin is a senior research consultant and actuary in the Technical Resources Center, and Ms. Sirncox is national practice leader for defined contribution plans. You can reach them at [phone].