New IRS audit look back period?

[jmor99]

I've recently been told by someone who's supposed to know that when the IRS audits a 125 plan, they are looking back 7 years. It was my understanding that audits look back 3 years, and if a major problem is found, then they reserve the right to go back another 4 years for a total of 7. Anybody know the correct answer?

Thanks!

[Guest b2kates]

I am unaware of any IRS cafeteria audit initiative. Since 125 plans impact payroll and deduction issues, IRS may only audit open business years, 3 years open.

[E as in ERISA]

The statute of limitations on assessing additional taxes generally runs out 3 years after filing of the tax return. There are exceptions. Can't remember precisely. But I think they can go back another 3 for an understatement of income by more than 25%. And longer for fraud. So they can potentially look at older files, but they generally can't do anything about a problem if it's more than 3 years old unless one of the exceptions applied. Maybe they're finding a special opportunity with certain 125 plans. Because if the 125 plan isn't valid, then the taxability of the benefits could change. And that could result in a 25% understatement. So maybe they could threaten to assess additional taxes on an HCE who received benefits in a self-insured plan funded through a 125. And use that as leverage to get the employer to make changes they want.

[jmor99]

Thanks, b2kates. I understood that about the only time these plans get audited is if the auditor sees something amiss during a routine business audit, and then pulls the 125 plan in as well. So they cannot go back an additional 4 years, even if they find major problems for the last 3 years?

Just want to be sure! The answer may have a significant impact on sales strategies here.

[Guest mjb]

If the IRS is only conducting payroll audits of 125 plans what are income tax issues that can be audited other than the structural questions of whether there is a written plan and the salary reduction agreements have beens signed since there is no testing involved and contributions are exempt from income and FICA tax and the contributions are deductible without limit.

[jmor99]

mjb: Actually, there ARE tests involved. 125 plans must be tested at least annually for discrimimation. Further, a signed election form is not all there is to elections. If there is a qualifying event during the plan year and the employee wants to change their pre-tax election, then they have to sign a change-of-status form which documents the change and the reason for same. Failure to do these things amount to plan violations thereby running the risk of nullifying the plan.

[GBurns]

Aside from the annual tests, Plan Documents (Agreement, Adoption etc), salary reduction agreements, change of status/qualifying event issues, there are the actual benefits (I recently ran across a plan with pre-paid legal still in it and I have seen postings about STDs with untaxed benefits), FSA operation (including reimbursement issues) and coverage and effective date issues to mention some other things.

[Guest mjb]

I understand that there are rules under IRC 125 that must be complied with but many of the rules are only proposed and secondly agents doing payroll audits are there to make sure the correct amount of payroll taxes are collected and have no training in the operational aspects of 125 plans. It is unlikely that a payroll agent going to go through plan records to see if the plan is correctly paying reimbursments. As was suggested by E the payroll audit will focus on whether a 125 plan has been adopted and the employees have signed salary reduction agreements but not the 125 testing and benefit payment issues which would be subject to yet unissued audit guidelines and final regs. Has anyone had any experience with a payroll audit of a 125 plan?

Jmor: While a 125 plan must be tested annually for discrimination there is no definition of who is a HCE. The proposed regs state that HCEs will be determined on a facts and circumstances basis which is not suitable for an audit. Given the lack of specificity of who is an HCE there is very little discrimination that can be tested under a 125 plan.

[E as in ERISA]

Are you familiar with how the IRS has run 403(b) audits in the past? They do an audit at the employer level. But those are tax exempt entities and there is no trust, so even if the 403(b) plan is not run right there isn't tax risk at the entity level. But they find problems there and then threaten to perform individual audits of all the employees tax returns if the employer doesn't clean up the plan and run it the way they should.

I imagined the same could be true of 125's. I know that they've found that a lot of employers are just doing pre-tax deductions on medical insurance etc without any kind of documentation of a plan or irrevocable elections from employees that they want to have premiums taken out all year pre-tax. If they're not getting good reaction from employers, I assume that they'll use the technique they use with 403(b)'s. Gather years of information and threaten to audit individual employees if the employer doesn't clean up their act.

[GBurns]

If an auditor come across an issue that he/she is not conversant with, do you not think that they have enough sense and that the IRS has enough staff and reserves to bring in additional auditors who have training and expertise in the required area?

[Guest mjb]

E: If you had read my initial post you would have noticed that I acknowledged that payroll audits will check for plan adoption and salary reduction agreements because there are cases that hold that a 125 plan must be adopted before the contributions can be exempted from income. I am interested in what audit, if any is conducted regarding the operational aspects of a 125 plan, e.g, nondiscrimination, change status, correct reimbursements (now that non 213 items can be paid), etc is conducted in a payroll audit. 403b audits can conducted because there are final regs under 403b which do not exist for 125 plans, e.g., who is a HCE and what is a non discriminatory benefit (see Q-19 of prop reg 1.125-1). A 403b audit is not based on a facts and circumstances determination of who is a HCE and whether the benefits are discriminatory as noted in Q19.

GB: The IRS cant bring in auditors to reivew plan compliance where there are no standards for auditing under the appplicable law. the IRS has not conducted compliance audits of 125 plan operations because there are no regulations to determine what constitutes compliance as there are for qualified plans. No audit of a plan based upon facts and circumstances under a proposed reg would hold up in an IRS review. Under the 1998 IRS reform act a taxpayer has to be informed of the particular provisions that have been violated and "facts and cirmumstances" is not a definitive term.

[E as in ERISA]

I'm not aware of any operational tests that they are reviewing. Last time I heard that question asked and answered there was no activity. But that was a while ago.

But your original question is "what tax issue can they audit." And I'm saying that they are not necessarily looking for a tax issue in the 125 plan other than no document or forms. The answer I'm proposing is that they are building a case for saying there are tax issues on the participant's side. If there was no plan document and no forms, then there was no 125 plan. So the premiums or benefits should have been included in the employee's income.

[GBurns]

mjb

Why can an audit not take place that covers 1.125-4 related issues?

Are you saying that an issue that is in the IRC, but for which no final Treas Regs have been issued, cannot be audited?

[jmor99]

mjb: I hope you're right--I'll be ecstatic. But this sounds too good to be true. In the first place, I heard the words right out of Harry Becker's mouth (at an ECFC conference) that field agents WERE being trained to check for change of status and discrimination test violations (this was in the late '90s). Secondly, if you look at the very long list of items an agent can ask for in an audit, it becomes obvious that catching these kinds of violations is not only doable, but is being addressed. (Of course, that doesn't necessarily mean the agent will actually go thru with it). It is extremely easy to catch change of status violations if you know what to ask for. I know, I've done it. (And I've never found a plan yet that didn't have violations and most were major).

Further, it seems to me that there is a very accurate description of what and who an HCE is, according to 125(e), and provides further requirements for finding them all by referring to sec. 414 [sec. 125(g)(4)].

If you are right, then I see no reason to caution key employees and HCEs in regard to their participation and contributions. The sky is the limit. After all, there are no penalties. Wouldn't this be an accurate, logical conclusion?

Again, I hope you're right, but it sounds too good to be true.

[Guest mjb]

IRS cant do audits if the definition of HCE/discrimination is facts and circumstances. There are no final 125 regs because the IRS cant figure out how to create an objective definition of an HCE without further legislation.What do the controlled group provisions of IRC 414 have to do with determining who is an HCE/discrimination under 125?. What is the accurate description of an HCE in 125 other than a 5% owner? Is non owner who makes 95k an HCE?

There are practical ways to avoid discrimination in a 125 plan by having the employer pay the HCEs entire health ins premium outside the plan. If an agent claims the plan is discriminatory then ask for a letter showing what provisions of 125 have been violated. The letter has to be reviewed by an IRS attorney before it can be sent to the employer.

I dont take IRS statements on 125 plan enforcement too seriously because IRS priorities change every year and agents are reassigned to areas which raise the most revenue.

[Guest Wislndixie]

We just finished an IRS audit with one of our clients. They were getting a payroll audit. We were asked to provide a copy of the SPD and a copy of discrimination tests. I'm told by the client that the agent wasn't looking specifically at the 125 but realized they had a 125 plan during his payroll audit and only asked for those two items.

Wisln

[Guest mjb]

How was discrimination tested and how were HCEs determined since proposed reg 1.125-1 Q13 defines the classificiaton of HCES other than 5% owners as based on facts and circumstances? Q19 tests 125 discrimination on the basis of the facts and circumstances of each case.