Most retirement plans provided by employers have a tax-favored status to provide tax savings to both employers and beneficiaries. However, when a retirement plan does not continue to meet the necessary requirements, the plan can lose tax-favored status and end up costing plan providers.
Employers can use the IRS Voluntary Correction Program (VCP) to correct mistakes involving retirement plan benefits, in order to reduce assessed penalties and maintain tax-favored status. The IRS provides a list of the “Top Ten Failures Found in Voluntary Correction Program” to alert businesses to common benefit plan tax problems, including the following:
Review benefits plan for tax law changes.
Tax and benefit laws change every year. Setting up a benefits plan is not really a one-time event. Benefit plans need to be reviewed annually to ensure tax and benefit law changes do not require changes to the plan. In addition to implementing changes, benefit plan laws generally require notifying plan participants of any changes or updates to benefit plans or plan documents.
Review plan definition of compensation for determining contributions.
Compensation can have different definitions for individuals, employers, and the IRS. In determining benefit contributions, errors can be made that wrongly exclude certain types of compensation, or include compensation that is supposed to be excluded. This can include bonuses, overtime, or commissions. When changes are made to employee pay structure or if the employer changes payroll companies or software, compensation calculations should be reviewed to ensure contributions are properly determined.
After a merger, define eligible and ineligible employees.
In mergers, acquisitions, or changes in ownership, there is often a change in benefits plans as a group of employees come aboard. This may result in a number of formerly benefit plan included employees who should be excluded or vice versa. Making unintended contributions can cost employers a significant amount of money, especially when large numbers of employees are involved.
Collecting loan repayments under IRC 72(p).
Loans from benefit plans are another common source of correction issues with the IRS. The IRC 72(p) has specific requirements for how employers withhold loan payments. If the plan does not properly or timely collect loan repayments, the loan is in default and the participant is to be taxed on the loan in the year of the default.
Review in-service withdrawals and distributions.
Certain distributions can be made from benefit plans for hardships. However, these distributions or withdrawals need to meet certain requirements. If an improper hardship distribution was made, the plan participant should return the hardship distribution amount plus earnings. In the future, plans may be amended to provide for such hardship distributions.
Are the minimum age-based distributions being made?
Once participants reach a certain age, distributions are required. If distributions are not timely made, participants must pay an excise tax. However, in some cases, the IRS may waive the excise tax based on plan sponsor waiver requests.
Employer eligibility failure.
When adopting a benefits plan, some employers may be ineligible for the type of plan they end up choosing. Certain types of plans (like 401(k) or 403(b) plans) may not be available for certain businesses. This includes government plans or tax-exempt plans. Adopting an ineligible benefits plan can lead to significant tax liability.
Failure to pass the ADP/ACP nondiscrimination tests under IRC 401(k) and 401(m).
This common error involves classification of highly compensated and non-highly compensated employees. Using a safe harbor plan or automatic enrollment can help businesses avoid this mistake. As above, plan administrators should review employee classification to ensure classification is in line with plan documents and IRC requirements.
Failure to properly provide the minimum top-heavy benefit or contribution under IRC 416 to non-key employees.
Another area affected by employee classification involves non-key employees. When key employees' (often owners) benefits or balances constitute a substantial percentage of plan assets (generally 60%), non-key employees may require a minimum benefit or contribution.
Certain top-heavy plans may require minimum contributions made to the benefit plan. Lower paid employees are generally required to receive a minimum benefit if the plan is top-heavy. Plan providers should perform a top-heavy test to ensure contributions are properly allocated for all employees.
Failure to satisfy the limits of IRC 415.
In defined contribution plans, like 401(k)s or profit-sharing plans, participants are limited in the amount of contributions they can receive. Similarly, the IRC limits the amount of benefits a participant can accrue in a defined benefit plan. When a plan provider does not properly monitor contributions or benefits, these amounts can exceed the limits.
Plan administrators should prepare allocation schedules with reference to amounts contributed and amounts allocated to plan participants. These amounts should be monitored and compared with the IRC 415(c) limits.
Changes to the VCP Program in 2018 and 2019
In light of the changing benefits laws, it is important to keep up to date on changes to the VCP itself. Changes to the IRS Voluntary Correction Program that went into effect on January 2, 2018, resulted in changes to the user fees, intended to simplify the fee schedule based on the total amount of net plan assets. Beginning in April 2019, all VCP applications must be submitted electronically.
San Diego Benefit Law Attorneys
If you have any questions about tax implications for employee benefits plans or the voluntary correction process, the law firm of Butterfield Schechter LLP is here to help. We are San Diego County's largest law firm focusing its law practice on employee benefits law. Contact our office today with any questions on how we can help you and your business succeed.