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Correcting impermissible adoption of governmental 401(k) plan


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Has anyone dealt with correcting a situation in which a governmental employer impermissibly adopted a 401(k) plan, in spite of not being eligible for the grandfather?  It appears that this situation is not one contemplated by EPCRS, inasmuch as the plan as a whole is qualified, but the purported elective deferrals would not be a cash or deferred arrangement (and thus would be after-tax).

The client would like to follow the procedure for an employer that adopts a 403(b) plan, even though it is not eligible to do so—i.e., stop all contributions to the plan, pay the VCP fee, and make distributions only when otherwise permitted to do so.  Has anyone gone to the IRS to negotiate a VCP-like solution to such an issue—one that would protect the pretax status of the employees’ contributions?  What was the outcome?

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I am working from a very rusty recollection here and have not gone back to check details.

I obtained favorable VCP results for a nonprofit that had improperly adopted a SARSEP for its sole employee.  The improper part (maybe) was ineligibility of the organization to adopt the SARSEP.  EPCRS has correction procedures for bad IRAs.  Although the specific disqualification was not addressed, it was addressed with a specified fix that was very close in principle.  The IRS  allowed the fix that was essentially the same as a prescribed fix, thus rehabilitating the individual IRA without any taxation and proceeding properly with a 403(b) plan.  The problem arose from bad broker advice (have you heard that tune?) and I was not shy about laying that blame.

I think you can get any result that was allowable if properly executed, including that the actions stayed in bounds for what could have been done under legitimate options.  You do not quite fit that, based on the implication that the government was also not eligible for a 403(b) plan, either.  So the problem with the weird IRS approach to 457 plans under EPCRS.  I would be optimistic anyway because I view the problem as friendly and the IRS as not eager to beat up on governments.  However, the declining quality of the agents seems to parallel the willingness to be practical and flexible, so prediction is difficult.

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Yeah, my concern here is that we pay the fee, and get a boilerplate IRS letter back saying that the plan is now qualified.  Of course, we already know it is qualified.  What we need reassurance on is that the contributions are tax-deferred.

It's different from the SARSEP or 403(b) situation, because there is nothing that prohibits a governmental entity from adopting a purported 401(k) plan and having it qualified.  The only thing that happens is that contributions intended to be elective deferrals would be after-tax.

And it's that "declining quality of the agents" that bothers me.  We need to get the agent both to understand the problem, and to be willing to grant relief (allowing contributions to be tax-deferred, not just allowing the plan to be qualified) that is beyond the usual scope of VCP relief.

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Carol, a year ago I would have said that this would pretty easily go through VCP with the result you want, and it probably will. However, I had a somewhat similar (in some ways, and different in some ways) situation with a 457(b) recently, and the IRS effectively rejected our VCP submission, saying that the existing rules were adequate to provide the tax consequence (employees had income), and no VCP fix was available. (Actually, even though 2016-51 said that governmental 457(b)'s were now under EPCRS, the case didn't end up with the VCP group, but with the non-VCP corrections group in Southern Calif.). This was a surprise, because in the past I had had good experience with getting the result you are describing in "ineligible employer" situations for 403(b), SIMPLEs., etc. I don't think it's so much a quality issue as a resources issue, because in a way they were right. So in your situation, they could say that the regs (1.401(k)-1(a)(5)) do provide clearly for what happens in this case, and no VCP is required. They did tell us, however, that distribution of the amounts as taxable income in the current year, and treating just as current year income, was appropriate because we were doing that under EPCRS. That was OK with us since all the years were still open. If you have closed years then you have to work through all of that and the consistency doctrine, etc.

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Thanks for letting me know about your experience.  It seems weird to say "that the regs (1.401(k)-1(a)(5)) do provide clearly for what happens in this case, and no VCP is required."  The regs clearly say what happens if your plan is disqualified, too, but people go into VCP precisely in order to avoid that result.  In this case, the situation was not abusive.  After all, if the employer had known the rules, they could have gotten the same result with a 457(b) plan.  The only tax effect is on the employees, who were not responsible for the error, not on the employer or on the plan trust.  And it seems comparable to an ineligible employer adopting a 403(b) plan, so one would think the correction could be the same.  But it sounds like they are not willing to bend at all.

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Carol, I agree, and I stated at outset in my post that you'd probably get it. But as you pointed out in your initial post, EPCRS (and I'm sure this can be supported by language in every EPCRS Rev Proc) was designed to permit correction of qualification errors, mostly where plan operations do not match plan wording. I don't recall actually that the ineligible employer issue for any type of plan (SIMPLE, 403(b), 401(k)) is specifically addressed in any of the Rev. Procs., e.g. with an "Appendix" correction method, though it might be.

Again, as your post pointed out, your plan may not be disqualified. Actually, probably isn't. It could be a perfectly good, qualified, 414(d) DC plan that just happened to permit after-tax employee contributions and the employer failed to properly report as such. That's a tax reporting failure, not qualification error.

Or maybe not. Maybe you show your document to IRS and say, "Look, it says here that sponsor is a government, and says here that will take 401(k) deferrals, so is disqualified as to form." Or the plan did not contain a provision for after-tax contributions, so arguably they cannot have been made?

Arguably there's a lot of ambiguity here even before you get to Service's lawful exercise of discretion.

Good luck.

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Over 10 years ago I had a governmental nursing home that had adopted a 401(k) plan improperly.  We filed under VCP requesting to convert the plan to a 457(b) plan and received a compliance letter approving the correction via restatement.  Funds remained in trust.  I have not looked at the later Rev. Proc's to see if they closed the door to that remedy but it made sense to us and the reviewer.

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26 minutes ago, MPLSLAW said:

Over 10 years ago I had a governmental nursing home that had adopted a 401(k) plan improperly.  We filed under VCP requesting to convert the plan to a 457(b) plan and received a compliance letter approving the correction via restatement.  Funds remained in trust.  I have not looked at the later Rev. Proc's to see if they closed the door to that remedy but it made sense to us and the reviewer.

Thanks for the insight, MPSLAW!

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MPSLAW and Carol V. Calhoun, I don't think it's ever been in any of the Rev Procs either way. My case dealt with matching contributions that COULD have been contributed to a companion 401(a), but were not, so exceeded 457(b) limit. We asked to be permitted to transfer the excess accumulations to the employer's newly established matching 401(a). The excesses were not properly reported on the employees' W-2's. Yes, you can say there is a distinction, in that you only asked to recharacterize one plan to a plan of a different type, whereas we were asking to have our new plan treated as if it had been created years earlier, but I think it's essentially same except for optics, although optics matter. Also, arguably, I guess, the 457(b) rules for including excess contributions currently in income are probably a little clearer in the 457(b) regs than the rules in 401(k) regs for including nonqualified cash or deferred amounts, but I think they're pretty clear in both places.

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In a 2012 IRS phone forum presentation, the IRS reps said the correction for this situation was exactly what you proposed - stop all contributions (both deferrals and after tax) to the plan not later than the VCP submission date, and keep existing assets in the plan until a 401(a) distributable event occurs (death, disability, or termination of employment). Under RP 2008-50 (which was in effect at that time), Appendix F, Schedule 6 was the form used for this - not sure what about what new form number (14568-?) is equivalent now. Admittedly not as nice as converting it to a 457b.

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On 10/26/2018 at 5:23 PM, bito'money said:

In a 2012 IRS phone forum presentation, the IRS reps said the correction for this situation was exactly what you proposed - stop all contributions (both deferrals and after tax) to the plan not later than the VCP submission date, and keep existing assets in the plan until a 401(a) distributable event occurs (death, disability, or termination of employment). Under RP 2008-50 (which was in effect at that time), Appendix F, Schedule 6 was the form used for this - not sure what about what new form number (14568-?) is equivalent now. Admittedly not as nice as converting it to a 457b.

Thanks--good to know!

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For those following along at home, I was able to talk to a senior IRS official about this.  He says that although EPCRS is not explicit about VCP fixing the participant taxation issue (as opposed to the qualification issue), the IRS will not challenge the tax-deferred status of elective deferrals to an ineligible 401(k) plan if VCP procedures are followed.  Thus, we can do what we hoped:  shut down the 401(k) plan to future deferrals (and eventually terminate it), and allow participants to make new deferrals and roll over the old money to a new 457(b) plan.  Of course, this means that participants won't have to roll over, but can choose to just take the money, but the client does not consider this a problem.

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  • 1 year later...
On 10/30/2018 at 12:11 PM, Carol V. Calhoun said:

For those following along at home, I was able to talk to a senior IRS official about this.  He says that although EPCRS is not explicit about VCP fixing the participant taxation issue (as opposed to the qualification issue), the IRS will not challenge the tax-deferred status of elective deferrals to an ineligible 401(k) plan if VCP procedures are followed.  Thus, we can do what we hoped:  shut down the 401(k) plan to future deferrals (and eventually terminate it), and allow participants to make new deferrals and roll over the old money to a new 457(b) plan.  Of course, this means that participants won't have to roll over, but can choose to just take the money, but the client does not consider this a problem.

Carol, I know this is an older thread, but I have a client with this exact situation and I was wondering if you could confirm that you were able to go through VCP and obtain the desired result?

Also, to your last point, I'm curious what the basis would be for allowing the participants to elect a rollover to the new 457(b).  Wouldn't they need a distributable event? 

Thanks in advance!

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  • 1 month later...
On 8/14/2020 at 12:39 PM, BTG said:

Carol, I know this is an older thread, but I have a client with this exact situation and I was wondering if you could confirm that you were able to go through VCP and obtain the desired result?

Also, to your last point, I'm curious what the basis would be for allowing the participants to elect a rollover to the new 457(b).  Wouldn't they need a distributable event? 

Thanks in advance!

Yes, the VCP submission was successful.

The basis for allowing a rollover to the new 457(b) would be a complete termination of the 401(k) plan.  A 457(b) plan is not considered a successor plan for purposes of the successor plan rules.  However, in the end, the client decided not to go this route, because it wanted to maintain a 401(a) plan for employer contributions.  It therefore just left the existing money in the 401(k) plan, but barred future contributions.

Practical note:  The client had hoped simply to bar future deferrals under the 401(k) plan, but use it as the 401(a) plan for future employer contributions, in order to avoid the need to maintain three different plans.  This proved impossible to do, not for legal reasons but because of vendor issues.  The vendor had a pre-approved 401(k) plan, but it was not intended for governmental entities.  It had a pre-approved 401(a) plan for governmental entities, but that did not contain the restrictions on distributions required for 401(k) deferrals.  And it had a  457(b) plan.  So rather than adopt an individually designed plan, the client ultimately went with having three different plans.

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Thank you!  That all makes complete sense.  

I was overlooking the obvious, i.e., that the plan could be terminated post-correction to create a distributable event (unless the sponsor is faced with the successor plan issues you identify above).  I wonder if the IRS would approve a VCP application that requests to merge the frozen 401(k) into a new governmental 457(b) (effectively converting the frozen 401(k) to a 457(b)).  I believe one of the earlier posters on this thread indicated he or she was successful in such an effort.  There are obviously some differences between these plan types, but once the 401(k) is frozen, it seems to me that we're really only talking about the distribution provisions (which are substantially similar).  From a policy standpoint, I think you can make a compelling argument that the distribution differences are minor, and that keeping these assets in any plan would be a preferable outcome to terminating the plan and distributing assets (which participants may or may not rollover).

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