So let’s assume you made a retirement plan mistake with your cash balance plan, defined benefit plan, 401(k) or other qualified plan. There was nothing done intentionally. Maybe one of the following happened:
- failure to follow the plan terms and requirements
- you accidentally excluded certain plan participants
- failure to make contributions that are promised under the plan
- not making proper distributions
- loan failures, like non-payment
Is there a way to correct the mistake yourself or do you need approval from the IRS?
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The Self-Correction Program (SCP)
Well you have options, so you should not be too concerned. The IRS has a program called the Self-Correction Program (“SCP”). This program is authorized under Revenue Procedure 2016-51. It allows companies to self-correct many retirement plan errors without needing to contact the IRS to seek correction or having to pay the required fee.
If eligible for self-correction, there is no application for the error and it is not reported to the IRS. That’s good news. However, the company must maintain adequate records of the event and the corrective actions that were taken.
The majority of the corrections under SCP are basically made to correct certain “operational errors.” This occurs when the written terms and procedures of the plan are not followed or compliant.
The first step in determining whether an operational failure is eligible for SCP, the company must determine if the error is “significant” or “insignificant.” This can be a little difficult, but stay with me.
How to Determine Whether a Failure is Significant or Insignificant
Significance is subjective, but is based on the facts and circumstances of the situation. Factors that should be considered would include:
- other failures that may have occured in the same time period applicable to the plan
- the percentage of retirement plan assets that were involved
- the number of participants impacted compared to the total number in the plan
- the size of contributions involved
- the number of participants affected relative to how many could have been affected
- how many years the error occurred and went undetected (the timeframe)
- whether the correction was made timely or soon after the discovery of the error
- the reason for the failure and whether there was any intent by any party or fiduciary
This list above does not include any and all possible factors. There is no single factor or weighting that can be used to determine how significant an error is.
Failures are not exactly considered significant just because they occur in more than one year of plan operation. They could have occurred over multiple years.
In addition, the IRS does not apply these factors in such a way that it will prevent small companies from being eligible for the SCP just because of their small size or limited number of participants. You have to weight all the factors and make your own determination (with the help of qualified professionals).
What is the Timing for Error Correction under SCP
When an operational error happens that parties have determined to be “insignificant” it should be self-corrected immediately. However, an operational error that is deemed “significant” will normally only be eligible for self-correction if corrective action is taken and completed (or substantially completed in some situations) before the close of the second plan year subsequent to the date the operational failure was deemed to have occurred.
What if an IRS audit has occured? If self-correction has been completed or at least substantially completed at the time the IRS has selected a plan for audit, the IRS can often allow the company to complete the self-correction process.
“Substantially completed” is somewhat vague but typically means that the correction has been finalized for at least 65% of the participants impacted by the error. However, the correction for the remaining participants must be completed in a diligent manner.
Other Eligibility Requirements for Self-Correction
- Once the company has uncovered the error, procedures must be establised to operate the plan in compliance with all applicable rules and laws. Just the plan document itself is not evidence that adequate procedures are in place.
- The failure occurred as a result of:
- a mistake or oversight occurred in applying the rules of plan, or
- the policies and procedures that were in effect, while reasonable, were not adequate or sufficient to prevent the occurrence of the failure in the first place.
- In general, you cannot correct an error by merely amending the plan. However, the IRS does allow a corrective amendment under SCP in the following four failure types:
- the failure to limit compensation under Code Section 401(a)(17);
- making employee hardship distributions under a plan that did not allow them;
- allowing plan loans to employees when not allowed under the plan; and
- including an eligible employee in the plan before the employee has met age and service requirements before the employee’s applicable participation entry date.
Overview of Steps to Self-Correct
- Make sure that the retirement plan is eligible for self-correction. Make sure it is not a document error and the plan in place had appropriate practices and procedures that were followed if not for the error.
- Make sure the plan participants are made full. The participants should be in the position they would have been in should the error had not occurred. EPCRS includes general correction principles, as well as examples of reasonable and appropriate self-correction methods that may be used to make the corrections.
- The company adjusted the administrative procedures to ensure the error does not happen again.
- Document the steps that were taken to correct the mistake. A best practice is to prepare a “self-correction memorandum” which documents how the plan sponsor determined the error was eligible for self-correction, as well as the steps taken to complete the correction. This self-correction memorandum, including any exhibits demonstrating corrective calculations made, should be provided to the IRS in the event of a plan audit.
What about document failures?
Unfortunately, document failures are not covered under SCP. This type of failure occurs when the plan document is not up-to-date or the plan document doesn’t fully comply with the tax law.
What if your plan mistakes can’t be corrected under the “do-it-yourself” program?
You still have another option. It is called the Voluntary Correction Program (VCP). This program is in place for plan sponsors who have errors that are not eligible for SCP. The VCP is for any error in which you want IRS assurance about the methods you used to fix the error.
For VCP, you have to make a written IRS submission and pay the required compliance fee. The errors are then corrected and the plan’s preferred tax status is preserved with IRS assistance.
Assuming you meet the conditions for SCP, you plan is likely to maintain its favorable qualified plan status. Certainly, you can apply to the IRS and ask for assurance on your correction. This would be through the Voluntary Correction Program. It is costly and time consuming, but it can be done.