401(k) plan fix-it guide: How plan sponsors can resolve errors with the IRS

It is not uncommon for employers with 401(k) plans to discover that a plan failure has occurred. For instance, the American Society of Pension Professionals and Actuaries (ASPAA) recently studied over 3,000 plans and found that nearly half of them failed the top-heavy test. Whether via audit or some other review process, it can be unnerving to learn that a failure has occurred and to determine how to correct it; however, employers should understand that plan failures do happen and that they are resolvable—and potentially without fees or penalties under the right circumstances.

Top 11 mistakes of 401(k) plan sponsors

Here are the top mistakes from the IRS’ “401(k) Plan Fix-it Guide”:

1. Lack of updates to the plan document to reflect recent changes in the law.
2. Failure to base plan operations on the plan document.
3. Improperly defining compensation for deferrals and allocations.
4. Employer matching contributions were not made to all appropriate employees.
5. Failure of 401(k) ADP and ACP nondiscrimination tests.
6. Failure to provide eligible employees the opportunity to make elective deferral.
7. Elective deferrals were not limited to the amounts under IRC Section 402(g) and excess deferrals were not distributed.
8. Failure to timely deposit employee elected deferrals.
9. Participant loans fail to conform to the requirements of the plan document and IRC Section 72(p).
10. Hardship distributions were not made properly.
11. Required contributions were not made to the plan.

The Internal Revenue Service (IRS) has adopted the Employee Plans Compliance Resolution System (EPCRS) to address such failures and the required corrective action(s). The EPCRS allows plan sponsors to correct plan defects and to protect the qualified status of such plans; however, some have found the EPCRS to be difficult to navigate. The information below is intended to assist employers determine how to correct plan failures using the EPCRS. 

Self-Correction Programs

Of the three ways to correct mistakes in the EPCRS, the Self-Correction Program (SCP) is the one that permits a plan sponsor to correct certain plan failures without contacting the IRS or paying a fee. In order to be eligible for the SCP, the plan sponsor must have established policies and procedures—whether formal or informal—designed to promote and enable compliance with applicable law. A plan document alone does not constitute evidence of established procedures.

The SCP is available to correct the following types of plan failures:

• Operational Failures. An operational failure is the failure to follow the terms of the plan. Rev. Proc. 2029-30, Section 8 sets forth the factors to be considered when determining whether an operational failure is significant or insignificant. The plan sponsor should follow the general correction principles in Revenue Procedure 2021-30, Section 6. Some operational failures can be corrected under the SCP via retroactive plan amendments to match the written plan to the plan’s operation if certain conditions are met. See Rev. Proc. 2021-30, section 4.05 and Appendix B section 2.07.
• Plan Document Failures. A plan document failure is a problem with the plan document under IRC 401(a) and IRC 403(b), such as the failure to keep the plan document current to reflect changes in the law. The SCP is available for plan sponsors if such plan document failure is discovered and corrected in a timely manner. See Rev. Proc. 2021-30, Sections 4.01, 4.05, 5.01, 5.02 and 9.02.
• Participant Loan Failures. Participant loan failures include instances where a defaulted loan is not paid back in a timely manner, where a participant received a loan amount that was more than what was permitted under the plan’s written terms/loan policy, or where spousal consent was not obtained as required by the plan’s written terms. See Rev. Proc. 2029-30, Sections 4.05, 6.07 and Appendix B 2.07.

A qualified plan sponsor may correct significant operational failures within two years of the end of the plan year in which the operational failures occurred; however, a qualified plan sponsor may correct insignificant operations failures at any time under the SCP. In order to determine whether a plan failure is significant or insignificant, a detailed legal analysis under the EPCRS rules and regulations is required.

If a plan sponsor and its legal counsel determine that the SCP is an acceptable correction method, the plan sponsor should be sure to maintain adequate documentation to demonstrate that correction under the SCP was warranted in the event the plan is audited. There is no fee under the SCP.

Voluntary Correction Programs

In the event a plan sponsor does not qualify for the SCP, the plan sponsor will likely need to file a correction under the voluntary correction program (VCP). This is a more detailed and formal process, but it can be very streamlined and efficient with professional assistance.

The VCP process includes a submission to the IRS by the plan sponsor via www.pay.gov that includes a completed digital Form 8950 and may include Form 14568, Model VCP Compliance Statement, and Forms 14568-A through 14568-I (Schedules), as applicable. Following its review of the VCP submission, the IRS will issue a Compliance Statement detailing mistakes identified by the plan sponsor and the correction method(s) approved by the IRS. The plan sponsor generally has 150 days from the issuance of the Compliance Statement to correct the identified mistakes. While the IRS is processing the submission, its Employee Plans division will not audit the plan, except in unusual circumstances.

Audit Closing Agreement Program

The Audit Closing Agreement Program (CAP) applies when the plan sponsor or plan is under audit. As part of the CAP, the plan sponsor:

• Enters into a Closing Agreement with the IRS;
• Makes the required plan correction prior to entering into the Closing Agreement; and
• Pays a sanction negotiated with the IRS. The sanction will not be excessive and will bear a reasonable relationship to the nature, extent, and severity of the failure(s).

Related: IRS to expand determination letter program to hybrid and merged plans

The sanction is determined based on facts and circumstances, including the following relevant factors:

• The presence of internal controls designed to ensure that the plan had no failures or that such failures were identified and corrected in a timely manner;
• The number of affected employees;
• The impact on non-highly compensated employees;
• Whether the plan failure is a demographic failure or an employer eligibility failure;
• The length of time the failure occurred; and
• The reason for the failure.

The Maximum Payment Amount is defined in Sections 5.01, 5.02 of Rev. Proc. 2021-30. In addition, the sanction paid under Audit CAP should be equal to or more than the fee paid under the VCP.

Regardless of the correction program used, employers should keep in mind the following general rules that govern all corrections.

1. Corrections should restore the plan and its participants to the position they would have been in absent the failure.
2. Corrections should be reasonable and appropriate for the error and should: (1) be consistent with existing laws and regulations; (2) provide benefits in favor of non-highly compensated employees; and (3) retain assets in the plan.
3. There should be a full correction for all plan years.
4. The correction should almost certainly include related earnings.

The rules governing 401(k) plans are complex. Despite an employer’s best intentions, mistakes will inevitably occur. The IRS can, and will, impose sanctions when failures are discovered during a plan audit, so it is always best for employers to self-audit proactively and correct plan failures under the applicable EPCRS correction program to avoid unnecessary costs and/or sanctions.

Emily R. Langdon is an Omaha, Nebraska-based partner in Husch Blackwell’s financial services and capital markets industry group.