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Guest Article
(Reprinted from The 401(k) Handbook, published by Thompson Publishing Group, Inc.)

Voluntary Correction Cheaper Than Audit Roulette


by Martha Priddy Patterson

"Always do the right thing. This will gratify some people and astonish the rest," advised Mark Twain. A recent report by the General Accounting Office (GAO) confirms Twain's advice. Fortunately for 401(k) plan sponsors, as well as sponsors of other types of plans, the IRS is one of the people gratified when plan sponsors "do the right thing" by using one of the IRS's voluntary correction programs to correct errors in the design and operation of 401(k) and other pension plans.

According to the GAO's recent report, pension plan sponsors who use one of the IRS self-correction programs, such as the Voluntary Compliance Resolution (VCR) program, can expect to pay about one-tenth of the sanction paid by plan sponsors who lose at "audit roulette" and are caught by the IRS. And these average savings do not include the savings by plan sponsors that quickly and voluntarily correct plan problems under the Administrative Policy Regarding Self-Correction (APRSC), which does not require notifying or paying fees to the IRS.

These are some of the key findings of the GAO study, "Pension Plans: IRS Programs for Resolving Deviations from Tax-Exemption Requirements" released this fall. The GAO looked at the voluntary correction programs the IRS began developing in 1992, which emphasize self-correction over sanction for plan qualification defects. These programs, known as EPCRS, include the APRSC, the Closing Agreement Program (CAP) and the Walk-in CAP, and the VCR program. (For more detailed information on EPCRS, see The 401(k) Handbook.

The GAO study found that plans eligible to use the VCR program could have avoided sanctions that were approximately 13 times higher than the applicable VCR fee. Likewise, plans eligible to use the walk-in program could have avoided sanctions that were approximately 30 percent higher than the applicable walk-in fees.

The IRS itself recently released a report on its examination of 472 plans from 1995 to 1997. The report found that 56 percent of those plans had no violations. The best compliance record was among plans with 16 or fewer participants, where 59 percent had no violations. Among plans with 17 to 53 participants, 53 percent had no violations. Of the plans with 54 or more participants, 56 percent had no violations.

Good News for Plan Sponsors

The findings of the GAO study, supported by the IRS report, confirm what practitioners and plan sponsors probably already know - in general, voluntary reporting and correction of plan qualification defects is less painful to the plan sponsor than correcting those defects as part of an IRS audit. But the data and the numbers the GAO developed from its review of actual IRS audits and actions in 1999 also help provide plan sponsors with hard evidence of the economic benefit of self-correction. The data help practitioners and plan sponsors more accurately calculate the likely costs and benefits associated with voluntary reporting and correction versus those associated with possible discovery of the defect during an IRS audit.

Summary of the GAO Study

The objectives of the GAO study, requested by Rep. Amo Houghton (R-N.Y.), chairman of the U.S. Congress' House Committee on Ways and Means' Subcommittee on Oversight, were to:

  • identify the frequency and types of pension plan qualification failures detected and corrected through IRS audits and those identified by plan sponsors and reported to IRS for approval of the correction;
  • compare the sanctions established under the IRS' audit program with the compliance fees that could have been imposed if the same qualification failures had been self-reported by the pension plans to IRS; and
  • determine whether any cost-effective means, other than pension plan audits, have been identified to detect unreported qualification failures.

Based on a review of all IRS fiscal year 1999 qualification failure case closings, the GAO study found that:

  • 42 percent experienced "plan document failures" (that is, the plan documents did not follow applicable tax law requirements);
  • 66 percent experienced at least one "operational failure" (that is, the plan did not operate according to provisions in the plan documents);
  • less than 2 percent experienced demographic failures (that is, the plans had failed certain nondiscrimination tests);
  • 9 percent had both operational and document failures; and
  • in general, all types and sizes of plans were represented among those with qualification failures.

In fiscal year 1999, the IRS audited about 14,000 returns filed by the nearly 965,000 pension plans submitting annual reports to the IRS and the Department of Labor. The IRS approved 1,802 plan submissions for voluntary correction (about 0.2 percent of all pension plans) during that same time. According to the GAO report, approximately 80 percent of these plans self-identified the failures and used the IRS' reporting programs to obtain approval for the corrections. The remainder entered into agreements to correct their failures as a result of an IRS audit.

The Numbers on APRSC

The APRSC self-correction method, which enables plans to correct relatively minor errors if done within a brief time period after the end of the plan year in which they occurred, requires no filing or notice to the IRS. Consequently, the GAO report numbers do not reflect the APRSC corrections, and there is no creditable method of tracking such data. Nevertheless, practitioners are aware that a significant number of plan sponsors use APRSC. Of course, because errors must be found and correction must occur within a specified time frame, good planning and timing and periodic reviews are necessary to use APRSC. Consequently, some plan sponsors are beginning to make an APRSC review a regular practice, recognizing that once the APRSC compliance checklists and procedures have been designed and developed, the process can be conducted relatively quickly.

Given the fact that APRSC corrections cannot be quantified, the GAO report probably significantly understates the use by plan sponsors and the value to plan participants of the voluntary correction programs.

Common Problem Areas

The GAO report offers interesting guidance on the type of common plan errors, especially in comparing the errors found on audit and those reported in the voluntary correction procedures. Among the top five operational errors in gross numbers found on audit and voluntarily reported were (1) misallocation or miscalculation of contributions, (2) violation of employee/employer contribution limits under Code Section 415, (3) excluding employees, (4) other contributions or benefit issues and (5) 401(k) plan actual deferral percentage testing. By contrast, the top five errors found in IRS audits were in (1) 401(k) ADP testing, (2) misallocation or miscalculation of contributions, (3) violation of employee/employer contribution limits under Section 415, (4) violation of the cap on includible compensation used to calculate contributions or benefits (the $170,000 limit) and (5) violating general nondiscrimination rules under Code Section 401(a)(4). A 401(k) plan is deemed to satisfy most Section 401(a)(4) rules generally if the plan satisfies the Section 401(k) and Section 401(m) nondiscrimination tests or safe harbor standards. However, 401(a)(4) failures can occur in 401(k) plans when the plan is not offered to all employee groups or where plan amendments appear to favor certain classes of employees.

The IRS Report

The IRS' findings in its study of 401(k) plan violations offer insight into common problem areas. The single largest number of 401(k) plan violations involved plan distribution rollovers. Most rollover violations included not providing a rollover option and not giving timely notice of the right to roll over. There were also errors in withholding and reporting. These findings may be skewed by the fact that examinations occurred relatively soon after the rollover provisions were enacted. Plan sponsors may not have had time to fully inform appropriate human resources representatives or to set up procedures that would meet the short time frames required for rollover notices. The next most common type of violations in the IRS study involved 401(k) nondiscrimination testing, an area also noted in the GAO report. Part of these errors were based on failure to include employees when running the tests, but many of the failures were purely numeric-- - highly compensated employees contributed too much money to the plan. Problems with loans were the third most common cause of failure in the report, including such things as failure to collect on defaulted loans. Making 401(k) benefits contingent on other benefits or actions (other than in the case of employer matching contributions) was the fourth largest problem area. The treatment of hardship distributions was a runner-up in creating plan violations.

Most 401(k) plan sponsors or plan practitioners would not be surprised by most of these findings. Each of these error classifications cited in the GAO report involve extremely complex determinations subject to several interdependent regulations. In addition, much of the data involved pertain to the records for almost every employee in the employer's organization, and those records must be gathered from several sources, including the payroll department, human resources department and recordkeepers. The most diligent and careful plan sponsor can easily be tripped up by minor errors in any of these areas.

The IRS report specifically acknowledges that it is designed to help plan sponsors understand where problems are likely to occur with the hope that sponsors will pay special attention to these areas. And the report suggests implicitly that plan sponsors would be well advised to give special attention to those areas, because clearly the IRS will be focusing its efforts there.

Martha Priddy Patterson is director of employee benefits policy analysis with Deloitte & Touche LLP's Human Capital Advisory Services in Washington, D.C. Patterson is the contributing editor of The 401(k) Handbook.
Reprinted with permission from the November 2000 supplement to The 401(k) Handbook, ©Thompson Publishing Group, Inc., 2000. All rights reserved.

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