Guest Article

(From the September 22, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Releases Long-Awaited Update to Employee Plans Compliance Resolution System

The Internal Revenue Service (IRS) on August 14 published Revenue Procedure 2008-50, updating its plan qualification correction program, the Employee Plans Compliance Resolution System (EPCRS). This is the first update in over two years. EPCRS allows plan sponsors to correct failures to satisfy plan qualification requirements, without suffering the severe consequences of plan disqualification. Rev. Proc. 2008-50 retains the basic structure and operation of EPCRS, but adds several new correction methods for common plan qualification failures and makes numerous, mostly liberalizing, technical and procedural changes.

This article contains a detailed analysis of the changes to EPCRS made by Rev Proc. 2008-50. As discussed below, these changes affect (a) guidance for correcting specific qualification failures (b) correction principles applicable to all types of failures, and (c) procedures for utilizing EPCRS.

Background

Tax-qualified retirement plans receive significant tax advantages. However, qualification comes with a price: The plan must, both in form and in operation, comply with the often complex requirements of IRC § 401(a) (or analogous rules that apply to other tax-favored retirement plans that are not "qualified" under IRC § 401(a)). Any failure, regardless of materiality, to meet these obligations can lead to plan disqualification, in the effects of which may include (a) income taxation of the plan's trust for all open tax years; (b) the employer's loss or postponement of deductions for contributions made to the plan during open tax years; and (c) for plan participants, immediate income taxation of vested contributions made on their behalf, as well as loss of their right to roll over distributions tax-free to individual retirement accounts or other plans. Because disqualification is so harsh a penalty, the IRS created EPCRS to allow these failures to be corrected without disqualification.

EPCRS consists of three "programs": self-correction without IRS involvement (SCP); voluntary correction with Service approval (VCP); and "correction on audit" (Audit CAP). For qualified plans, /1/ EPCRS identifies four categories of "qualifications failures": (1) plan document failures (document does not comply with applicable requirements); (2) operational failures (plan operation does not comply with plan document or applicable qualification requirements); (3) demographic failures (plan fails coverage, participation, or nondiscrimination testing); or (4) employer eligibility failures (the employer is not eligible to establish that type of retirement plan).

Revised and Expanded Correction Guidance

EPCRS is conditioned on full correction of the failure by the plan sponsor. It does not provide specific guidance for correcting every conceivable qualification failure. In many cases (particularly under VCP), the precise method of correction is subject to negotiations with the IRS. However, EPCRS does provide some general guidelines on correction principles and, for some issues, specific acceptable correction methods.

As discussed more fully below, Rev. Proc. 2008-50 expanded the list of failures for which correction guidance is provided and revised the previously provided guidance for certain other specific failures.

Guidance for Failure to Implement an Employee's Deferral Election

Prior versions of EPCRS provided guidance for correcting the failure to allow an otherwise-eligible employee to make elective deferrals under a 401(k) plan. Under versions of EPCRS prior to Rev. Proc. 2006-27, the plan sponsor was required to make a Qualified Nonelective Contribution on behalf of the affected participant equal to the amount he would have deferred if he had elected a deferral percentage equal to the Average Deferral Percentage (ADP) for his compensation group (highly compensated or nonhighly compensated). If the plan also provided for matching contributions, an additional contribution equal to the applicable ACP rate was required. This long-standing methodology was liberalized in Rev. Proc. 2006-27, which reduced the required contribution to 50 percent of the missed deferral, /2/ plus the matching contribution that would have been made on the missed deferral (rather than a contribution calculated at the ACP rate), plus earnings. Rev. Proc. 2006-27 also provided guidance for calculating this corrective contribution for a participant inappropriately excluded from a safe harbor plan that does not perform ADP testing.

Prior correction guidance did not distinguish between cases where the employee was not given the opportunity to make a deferral election and those where he made an election that was not honored. Practitioners generally understood that the appropriate correction was the same in both instances. /3/ The new Appendix A and Appendix B /4/ in Rev. Proc. 2008-50 distinguish between them by specifying that, where an employee's election has not been honored, the "missed deferral" is based on the deferral percentage that he attempted to elect, rather than on the average for his group.

In public statements discussing this new guidance, IRS officials have indicated it was intended to apply only to the complete failure to implement an employee's deferral election. However, as written, it could arguably be used to address a more common situation, namely, the failure to implement the deferral election for all items of compensation subject to the election, e. g., not withholding deferrals from bonuses where they are not excluded by the terms of the plan. There is no obvious reason why a partial failure should not be dealt with in the same manner as a complete one; in fact, in most cases, IRS agents have historically accepted this method of correction when this failure was presented in VCP applications.

Guidance for Correcting Catch-Up Contribution Exclusions

Another new method of correction provided within Appendix A involves a failure to provide catch-up contributions. To the extent an employee is improperly excluded from making a catch-up contribution, the correction method provided requires a QNEC in an amount equal to 50 percent of the "missed deferral" but, for this purpose, the "missed deferral" is defined as one half of the catch-up contribution limit in effect for the year of failure. To illustrate: If an employee is excluded from the ability to make catch up contributions during 2006 (when the catch up contribution limit was $5,000), the "missed deferral" is equal to $2,500, and the "missed deferral opportunity (and therefore, the required amount of the QNEC) is equal to $1,250. The QNEC must be adjusted for earnings to the date of correction. An additional QNEC is required if the plan provides employer matching contributions on employee catchup contributions. The additional QNEC representing the missed matching contribution is based on the missed deferral. The QNEC associated with the matching contribution, likewise, must be adjusted for earnings.

Other Modified Correction Rules for Improper Exclusions from 401(k) Plans

Rev. Proc. 2006-27 specifically stated that the method for correcting the failure to include an otherwise eligible employee in a 401(k) plan did not apply to a plan that allowed participants to make designated Roth Contributions. Rev. Proc. 2008-50 now addresses this, and states explicitly that the same correction method used generally for correcting an excluded employee may be used where a participant is inappropriately excluded from a plan that allows the participant to make designated Roth Contributions. However, the corrective QNEC does not enjoy the benefits of a Roth contribution. Instead, it is excluded from income, and distributions are taxable.

Rev. Proc. 2006-27 required that any ADP test failure be corrected before the correction of improper exclusions. Rev. Proc. 2008-50 retains this principle but clarifies that the ADP test is performed without considering the improperly omitted participants. The ADP test results (reflecting any required corrections) are then used to calculate the excluded individuals' missed deferrals. After that, the test is not run again. This rule for how the ADP test is run also applies where the employee's deferral election was not honored.

New Guidance on Participant Loan Corrections

Plan loans made to participants are included in taxable income unless they comply with restrictions in IRC § 72(p) regarding the amount of the loan, the period over which it is repaid, and level amortization of principal repayment. In addition, if the participant defaults on a loan, the unpaid balance will, at that time, be treated as a distribution and taxed. Under Rev. Proc. 2006-27, the IRS may postpone income recognition until the year of the correction or to waive it altogether if, and only if, the correction is made through VCP. If a default is self-corrected, the defaulted principal must be reported as taxable income in the year of the default; any subsequent repayments give the participant basis in the plan.

Rev. Proc. 2008-50 retains these rules and liberalizes the correction requirements for defaulted loans in one major and two minor respects. Rev. Proc. 2006-27 allowed a default to be corrected by a one-time payment of the overdue principal and interest, after which regularly scheduled payments would resume, by reamortization of the remaining principal in level installments over the remainder of the original loan period, or in some circumstances, by a combination of the two methods. Regardless of the method chosen, the loan had to be repaid over a period not longer than its original term. Thus, for example, if the original term of the loan was 3 years, and the participant defaulted after one year, the unpaid portion of the loan could not be reamortized over a period of longer than two years.

Rev. Proc. 2008-50 allows a defaulted loan that originally had a shorter term than the maximum permitted by IRC § 72(p) (five years except in the case of a loan whose proceeds are used to acquire a principal place of residence) to be reamortized over the longest period for which it could have been taken out. Hence, in the case of the typical participant loan where the maximum term was 5 years, the loan may be reamortized over any that ends no later than 5 years from the date of original issuance.

One of the minor changes is the elimination of the previous condition that correction was possible only if the plan provisions explicitly mandated compliance with IRC § 72(p). Under the new procedure, loans made by a plan without IRC § 72(p) language (or even without any provision for loans at all) may be brought into compliance with the tax rules, although, as the procedure observes, they may result in fiduciary violations or prohibited transactions that will have to be dealt with separately under the rules established by the Department of Labor.

The new procedure also allows corrections when a loan is made by a plan that has no provision for loans.

The other minor change relates only to Audit CAP. Rev. Proc. 2008-50 states that the "maximum payment amount" (the basis for negotiating sanctions under Audit CAP) will now include the amount of income tax that would be due under IRC § 72(p) if a loan failure is discovered upon examination and corrected through the Audit CAP process. While not stated explicitly, because Audit CAP sanctions are paid exclusively by the employer, this presumably means that the participant will be excused from the income tax consequences normally associated with loan failures.

Guidance for Correcting IRC § 415 failures

Rev. Proc. 2008-50 revised the guidance for correcting IRC § 415(c) failures in defined contribution plans. The revised guidance reflects the new final regulations under IRC § 415. The new final regulations eliminated provisions for correcting excess annual additions through their allocation to a suspense account or the refund of elective deferrals (prior Treas. Reg., § 1.415-6(b)(6)). Instead, the regulations stated that IRC § 415 violations would be addressed through EPCRS Previous EPCRS correction guidance for 415 failures specifically referenced the suspense account rules.

For years prior to 2009, the guidance is the same as under Rev. Proc. 2006-27, which simply followed the prior regulations. For failures in years beginning in 2009 or later, the guidance is as follows:

Discussion of Changes of General Applicability to Correction Methods

New Definitions for Overpayment, Excess Allocation, and Excess Amount

The IRS has revised its definitions of the key terms "excess amount" and "overpayment," and coined a new term, "excess allocation." The new definitions are as follows:

Relief from Additional Excise Taxes

Historically, the ability to address excise and income tax issues related to qualification failures under EPCRS has been limited. Plan sponsors have always been able to obtain waivers through VCP of the IRC § 4974 excise tax for failure to satisfy the required minimum distribution requirements. In Rev. Proc. 2006-27, the IRS extended this relief to excise taxes imposed under IRC § 4972 (for nondeductible contributions) and IRC § 4979 (for failures related to ADP and ACP test violations), with some limitations:

Rev. Proc. 2008-50 expands the income and excise tax relief as follows for corrections made through VCP:

New Rules for Earnings Calculation Periods

Previous guidance indicated that the general period for calculating earnings on corrective contributions or distributions begins on the date of the failure. Rev. Proc. 2008-50 states that the "date of the failure" is determined without regard to whether the IRC permits a corrective contribution or distribution at a later date.

It is not entirely clear when or how this principle would be applied. Here is the kind of situation for which it seems to have been devised:

More problematic is the following:

New De Minimis Threshold

The general EPCRS principle requiring full correction of violations is relaxed when the amount involved is very small. Rev. Proc. 2008-50 liberalized these de minimis thresholds. Under the new guidance, corrective distributions need not be made to participants who are entitled to no more than $75 (increased from $50). Overpayments and Excess Amounts of $100 or less may be left uncorrected. That threshold remains the same as before but is now available for self-correction as well as VCP and Audit CAP.

VFCP Calculator

In theory, earnings added to corrective contributions must reflect what participants' accounts would actually have earned if the contributions had been made at the proper time. EPCRS permits the use of reasonable estimates when calculating corrections, including the use of a reasonable interest rate in circumstances when determining the actual investment return is not practicable. Rev. Proc. 2008-50 allows employers to use the Department of Labor's online VFCP Calculator as a proxy for a reasonable interest rate. Rev. Proc. 2008-50 does not contemplate that it will be used as a general rule, but only where the plan sponsor cannot conveniently avail itself of the other methods for calculating earnings.

Procedural Changes

Determination Letter Applications in VCP and Audit CAP

In some cases, a plan amendment will be necessary as the correction for a failure under EPCRS, and a determination letter request relating to the amendment will be necessary or advisable as part of a VCP application or Audit CAP settlement. Rev. Proc. 2008-50 provides the following guidance on determination letter requests associated with EPCRS corrections:

A determination letter submission is required for amendments made in connection with an EPCRS correction in the following situations:

A determination letter application is allowed, but not required, if the plan is newly adopted, is terminating or has an urgent business need for a determination (the situations in which off-cycle applications are given on-cycle priority).

Note: In limited situations, an operational failure can be self-corrected by a retroactive amendment. If a plan self-corrects an operational failure through a retroactive amendment conforming the terms of the plan to its operation (as permitted in some cases), it must identify the amendment specifically in its next on-cycle determination letter application. Though not explicitly stated, presumably, the failure to comply with this requirement would negate the correction.

In all other situations, a determination letter is neither required nor permitted. This includes, for example, the failure to adopt interim amendments or optional law change amendments in a timely fashion, where the plan is not yet "on-cycle." A current example of such a situation would be a failure to adopt an automatic rollover amendment by a plan that is a "Cycle E" filer.

If a determination letter request is made, Rev. Proc. 2008-50 clarifies that the plan will be reviewed based on the current cumulative list, and therefore must be updated to reflect the requirements on the list.

Rev. Proc. 2008-50 also provides that a failure to adopt an interim amendment must be corrected before the submission of a VCP application (that is, the VCP application must contain an executed interim amendment). This is an exception to the normal rule that allows corrections to be implemented after receiving IRS approval.

Clarification of Retroactive Amendments in SCP

A limited number of failures may be self-corrected by adopting a retroactive plan amendment conforming the plan terms to its actual operation: to implement the correction of a violation of the IRC § 401(a)(17) compensation limitations, to allow hardship distributions or plan loans that are not provided for by the plan, or to authorize the inclusion in the plan of employees who do not satisfy its age or service conditions. Otherwise, corrective amendments must be submitted through VCP. Sometimes, however, a plan amendment is needed not as the method of correction, but in order to allow a correction to be implemented. A common example is an amendment to authorize QNECs, which can then be made to correct an ADP failure. Rev. Proc. 2008-50 clarifies that a plan sponsor otherwise eligible for self correction will not be precluded from using SCP merely because it must adopt such an amendment to its plan in order to authorize the correction.

Extension of the Period for Self- Correction of Significant Operational Failures

Self correction is available for "significant" operational failures, provided that correction is made within a specified time (generally the end of the second plan year following the plan year of the failure). Rev. Proc. 2008-50 does not require that correction be complete at the end of the specified period; sponsors are permitted to complete self corrections shortly after the conclusion of the self correction period, so long as the correction is "substantially complete" at that time.

Rev. Proc. 2008-50 liberalized the requirements for completion of self correction:

New Appendix F Applications

Rev. Proc. 2008-50 significantly expanded Streamlined VCP, under which the IRS processes the application and issues a compliance statement without requiring the employer's signature. By eliminating back-and-forth mailings and potential negotiation, this procedure expedites the completion of the VCP process. It is available for nine specified qualification defects. A plan sponsor may utilize it by submitting the appropriate schedule from Appendix F of the Rev. Proc. and agreeing to implement the correction that the schedule prescribes. The schedules and the defects to which they correspond are as follows:

Revised Appendix C Checklist.

VCP applications are required to include a completed checklist, set forth in Appendix C. That checklist has been revised.

Miscellaneous

Requested Comments

As it has done with each EPCRS revision, the IRS requested comments on several issues:

403(b) Arrangements

Rev. Proc. 2008-50 does not make significant changes to the rules for correcting failures in 403(b) arrangements. Final regulations under 403(b) were issued last July, to be effective January 1, 2009. Subsequent revisions of EPCRS are likely to reflect the new final 403(b) regulations, including the new written plan requirement.

VCP Compliance Fees

Rev. Proc. 2006-27 retains the same compliance fees and fee structure as its predecessor.

Effective Date

The changes found in Rev. Proc. 2008-50 are not effective until January 1, 2009; however, applicants may, on a voluntary basis, begin using Rev. Proc. 2008-50 on or after September 2, 2008.

/1/ EPCRS is also available for other types of tax-favored retirement plans, such as 403(b) arrangements, SIMPLE IRAs, and SEPs. The categories of failures for those plans differ slightly.

/2/ Rev. Proc. 2006-27 denoted the amount equal to the ADP multiplied by the participant's compensation as the "missed deferral" and the required contribution, equal to 50% of that amount, was referred to as the "missed deferral opportunity."

/3/ While Rev. Proc. 2006-27 did not include a specific statement to that effect, this information was conveyed by IRS representatives in public discussions.

/4/ Appendix A and Appendix B of Rev. Proc. 2008-50 contain guidance on methods of correction that are deemed to be acceptable under EPCRS, for certain failures specified.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.