Guest Article

(From the May 15, 2006 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

For the first time in almost three years the Internal Revenue Service (IRS) updated its plan qualification correction program, the Employee Plans Compliance Resolution System (EPCRS). EPCRS allows plan sponsors to correct failures to satisfy plan qualification requirements without suffering the severe consequences of plan disqualification. Rev. Proc. 2006-27 retains the basic structure and operation of EPCRS, but adds several new remedies for common plan qualification failures and makes numerous, mostly liberalizing, technical changes.

Background

Tax qualified retirement plans obtain significant tax advantages as a result of their qualified status. 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 section 401(a)). Any failure, regardless of materiality, to meet these obligations can result in plan disqualification, which can result in (a) income taxation of the plan's trust on all open tax years; (b) in the employer's loss or postponement of deductions for open tax years; and (c) income taxation of plan participants' vested benefits and loss of their right to roll over distributions tax-free to individual retirement accounts or other plans. Because disqualification is so harsh a result, the IRS created EPCRS to allow these failures to be corrected without disqualification.

EPCRS consists of three "programs": self-correction (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 requirements); (3) demographic failures (plan fails coverage, participation, or nondiscrimination testing); or (4) employer eligibility failures (not every employer can establish every type of retirement plan).

New Correction Methods

In General

EPCRS is conditioned on correction by the plan sponsor. EPCRS provides some general guidelines on correction principles and, for some issues, specific, acceptable correction methods. Rev. Proc. 2006-27 revised some of those principles, as discussed below:

Excluded Eligible Participants in 401(k) Plans

A very common qualification issue involves the exclusion of otherwise eligible employees from a 401(k) Plan. Historically, the IRS has insisted that plan sponsors correct this failure by making additional employer contributions on behalf of the affected employees. The required corrective contribution equaled the percentage of pay that the average participant in the same group (highly compensated or nonhighly compensated) had made to the plan, derived from the plan's ADP test for the year in question. The overlooked participant did not have to give up any take-home pay in return for this deferral "replacement", so this correction method was often criticized as a windfall. In response, Rev. Proc. 2006-27 reduces the windfall by creating a rule of thumb for estimating "the value of the lost opportunity to the employee to have a portion of his or her compensation contributed to the plan accumulated with earnings tax free in the future.

The new correction method takes the excluded employee's compensation for the pertinent period, and multiplies by a percentage based on plan deferral rates./2/ This "missed deferral" is then multiplied by 50 percent. IRS officials have stated that 50 percent was an approximation of the lost economic value of the deferral, according to their own internal studies. Replacement matching contributions are then based on the full amount that the participant would have received if the "missed deferral" had actually been made. Earnings are then added from the date contributions should have been made through the date of correction.

A slightly modified version of this new method applies to participants who are not permitted to make after-tax employee contributions. It is not, however, applicable to correct qualification failures resulting from the failure to permit eligible employees to make Roth 401(k) contributions or to any other failure (e. g., improper exclusion from salary reduction contributions under a 403(b) plan or ADP/ACP testing failures). In a departure from past practice, the Rev. Proc. requires the correction of any plan testing failures before addressing the operational failure (exclusion). The implications of that requirement are not clear./3/ Lastly, it is our understanding that improper exclusion of an eligible employee's compensation (i.e., not taking into account full compensation for deferral purposes) can be corrected under this "missed deferral" method, though Rev. Proc. 2006-27 does not include a specific statement to that effect./4/

Plan Loans

Plan loans to participants are, as a general rule, treated as distributions and taxed to participants, unless they comply with restrictions contained in IRC § 72(p) on the amount of the loan, the period over which it is repaid and level amortization of principal repayment. In addition, while a loan may initially satisfy section 72(p), if the participant later defaulted on the loan, the unpaid balance would, at that time, be treated as a distribution, and taxed. EPCRS had previously allowed plan qualification issues arising from improper loans to be resolved but did not deal with the participants' income tax problems. Rev. Proc. 2006-27 provides that where the plan loan failure is corrected through VCP (not SCP or Audit CAP), the participant is freed from any attendant income tax liability. The guidance allows a participant with loans in excess of the section 72(p) limit to repay the excess in a lump sum. The remaining principal can then be reamortized in level installments over the remainder of the original loan period. Where a loan's repayment term is too long, it may be shortened, again with reamortization of the principal. Lastly, a loan issued with uneven amortization, or on which the participant defaults may be corrected by either a lump sum repayment or an increase in periodic payments to the extent necessary to repay the principal and interest by the end of the loan's original term.

The special waiver of the application of section 72(p) requires a VCP application, and is not available once the loan has been outstanding for longer than the maximum period allowed (five years, except for certain residential loans). Rev. Proc. 2006-27 also gives the IRS some discretion to deny a request to waive the application of section 72(p). Where the loans in question do not qualify for this special waiver, VCP will allow the plan sponsor to treat the loan as taxable in the year of correction, rather than when the violation of section 72(p) first occurred. This is only available under VCP.

Spousal Consent

Benefits under defined benefit and money purchase pension plans must be distributed in the form of a qualified joint and survivor annuity (QJSA), unless the participant's spouse consents to a different form. If a non-QJSA distribution is made without spousal consent, EPCRS allows consent to be given retroactively. The spouse, however, has no incentive to cooperate because, in the absence of consent, the plan must pay the survivor portion of a QJSA benefit after the participant's death, even if the full value of the benefit was paid to the participant during his lifetime (e. g., as a lump sum distribution). As alternatives, EPCRS allowed the plan to automatically commence payment of a QJSA (with the participant's portion of the QJSA offset by payments already made), or if the spouse did not consent, to pay the spousal portion of the QJSA to the spouse, upon a claim by the spouse, but only if the spouse becomes entitled to the benefit. Rev. Proc. 2006-27 offers an alternative to waiting to see whether and when the participant predeceases the spouse; the plan may pay her a lump sum equal to the actuarial value of the survivor benefit. There is no economic saving from doing so, but at least the problem will not linger for years or decades.

Excise Tax Relief

In the past, EPCRS had been limited to correcting a plan's qualification defects. It did not relieve employers or participants from income or excise taxes that those defects might entail. As noted above, Rev. Proc. 2006-27 provides relief from income taxes that would otherwise result from improper plan loans. It also authorizes the waiver of excise taxes in three situations. In each case, the waiver is available only through VCP, not SCP or Audit CAP.

New Submission Procedures

Synchronizing the Determination Letter Cycle and EPRCS Corrections through Plan Amendments

Revenue Procedure 2005-66 revamped the IRS's determination letter program, which provides plan sponsors assurance that their plans' terms conform to the IRS's interpretation of applicable qualification requirements. Among other changes, sponsors of individually designed plans generally may apply for determination letters only during a one-year window out of every five year period. A six year period applies for sponsors who adopt IRS, pre-approved plans. The letter obtained at that time covers all plan amendments and legal changes since the end of the last cycle. Rev. Proc. 2006-27 coordinates EPCRS's requirement that plans obtain determination letters for amendments adopted as part of the correction process with the new determination letter procedure. In some cases, the new rules will lengthen the delay between the adoption of an amendment and the issuance of a determination letter confirming that it does not adversely affect the plan's qualification.

Under the previous revenue procedure, plan sponsors were generally required to include determination letter requests with VCP submissions, and the VCP submission and related determination letter were processed together. A determination letter was not always required, and where none was requested, the compliance statement would not constitute a determination that the language in the proposed amendment satisfied the requirements of section 401(a) (even though the IRS approved the amendment as correction). Rev. Proc. 2006-27 states that a compliance statement will provide the plan sponsor with reliance on the amendment. IRS officials also have informally stated that in cases where a determination letter accompanies a VCP application (where the plan is "on-cycle"), the VCP program will consider all amendments made to the plan since the last cycle, and will issue the determination letter in lieu of requiring the plan sponsor to apply separately for its determination letter.

"Orphan Plans"

Rev. Proc. 2006-27 contains special rules with respect to "Orphan Plans" -- those whose sponsor has gone out of business, cannot be located or is unable to maintain the plan. For Orphan Plans, an "eligible party" may correct plan defects either through VCP or Audit CAP. Eligible parties include court-appointed representatives, a "qualified termination administrator" appointed in accordance with the DOL regulations, or the surviving spouse of a sole participant in a plan that covers only the owner of a business (and possibly the spouse, too). In a departure from general correction principles under EPCRS, the IRS may permit such plans to make less than full corrections and may waive the VCP fee. Preserving the qualified status of the plan will allow participants to roll over distributions that they receive on plan termination. Self-correction under SCP is possible only if full correction can be achieved. A plan is not considered an "Orphan Plan" under Rev. Proc. 2006-27 if it has already terminated under the Department of Labor's regulations governing terminating abandoned individual account plans.

Group Submissions

Rev. Proc. 2006-27 clarifies that, where the vendor of a master, prototype or volume submitter plan makes a group VCP submission on behalf of all adopting employers' plans, the plans will be protected against examination only with respect to the failures that were identified in the submission. Other plans submitted to VCP continue to be protected against examination in almost all cases while the application is pending.

Abusive Tax Avoidance Transactions (ATATs)

In recent years, Congress and the IRS have taken a hard line against transactions they view as abusive, requiring additional disclosures and registration for reportable transactions, and maintaining a growing list of tax avoidance transactions, most recently updated in Notice 2004-67. (IRS's Employee Plans division maintains its own list of abusive tax transactions, which is available online [click here]). With Rev. Proc. 2006-27, EPCRS is folded into the larger IRS effort against tax avoidance. Plan sponsors may not make use of any EPCRS program (SCP, VCP or Audit CAP) to correct plan defects that are directly or indirectly related to an "abusive tax avoidance transaction" (ATAT). For purposes of EPCRS, ATATs consist of both employee plan and more general "listed transactions."

If the IRS determines that a VCP applicant or its plan has participated in an ATAT, the submission will be referred to the Employee Plans Tax Shelter Coordinator. Where a plan failure at issue is found to be related to an ATAT, no compliance statement will be issued and the plan will be referred for examination. As part of this revision, the IRS will now require a new ATAT disclosure statement to be filed as a basic part of each VCP submission. If the IRS determines that an ATAT is not related to the failures, it will continue to process the compliance statement request.

The new ATAT disclosure increases the risk of filing a VCP submission for plan sponsors that have taken part in an ATAT; clients will likely have to settle their tax shelter issues before being able to obtain any plan compliance assurances. The Coordinator's determination that no tax shelter activity was involved will not, however, bind the IRS in other examinations or proceedings.

If an ATAT is discovered during the course of an examination, the IRS reserves the right to deny resolution under Audit CAP. Withholding Audit CAP may result in the plan being disqualified.

Modification of Fees and Penalties

VCP Compliance Fees

Rev. Proc. 2006-27 retains the same basic fees and fee structure of its predecessor. However, the basic compliance fee has been reduced in several specific situations.

New Maximum Payment Amount under Audit CAP

The sanction for correcting qualification failures under Audit CAP is a negotiated percentage of the "Maximum Payment Amount" (MPA). Rev. Proc. 2006-27 expands the definition of this term. The MPA had previously included the tax that the plan's trust would have paid during open years. The term now includes any interest or penalties applicable to the hypothetical trust return. The MPA had previously included the additional income tax resulting to employees for all open years. The Rev. Proc. clarifies income tax on amounts that were distributed or rolled over during open years, and any applicable interest or penalties also are included, as are FICA, FUTA and any other applicable taxes.

In some instances, a disqualified plan ceases to be liable for excise taxes that apply to various violations by qualified plans. The MPA definition does not give the plan "credit" for the excise taxes that disqualification would avoid. For example, if a plan is subject to Audit CAP as a result of failed ADP or ACP nondiscrimination testing, the MPA will include the IRC § 4979 tax on excess contributions, despite the fact that such penalty does not apply to a nonqualified plan.

If a plan finds itself in Audit CAP solely as a result of nonamendment failures discovered by the IRS in the course of its review of a determination letter application, a special Audit CAP fee schedule will apply. The fees will vary depending on the number of participants in the plan and the statutes that were not properly reflected by plan amendments (the older the law, the higher the fee).

Miscellaneous Technical and Procedural Changes

The Revenue Procedure includes a number of additional technical and procedural changes that practitioners and plan sponsors should be aware of:

Requested Comments

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

Effective Date

The IRS has been discussing the contents and changes found in Rev. Proc. 2006-27 for several months and has been letting practitioners know that they could use some of the new correction methods in their VCP submissions. However, the guidance itself states that it will become generally effective on September 1, 2006, with certain requirements taking effect May 30. As of May 30, applicants must (1) begin including a return receipt letter in order to obtain confirmation that the IRS has received the filing; (2) begin following the revised assembly instructions for VCP filings (including the new ATAT disclosure statement); and (3) pay the new Audit CAP fees if the plan's amendment failure is discovered through the determination letter process. Applicants may begin using Rev. Proc. 2006-27 provisions voluntarily on May 30.

/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 Appendix A.05 clarifies that for a typical 401(k) plan, the "missed deferral" is the participant's compensation multiplied by the average deferral percentage (ADP) of the comparable discrimination testing group (highly compensated or nonhighly compensated) for the year at issue. For a "safe harbor" plan that uses fixed contributions, the rate is a fixed 3%, and for a safe harbor plan that uses matching contributions, the percentage used is the highest percentage entitled to a 100% match (usually 3%).

/3/ A broad principle of EPCRS is that the plan and the participants should be restored to the position they would have been in had the failure not occurred. Many believe that this principle, as applied, would require correction of the excluded employee before the test is re-run.

/4/ This information has been conveyed by IRS representatives in several previous public discussions of the EPCRS update.

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 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, Laura Edwards 202.879.4981, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2006, Deloitte.