401(k) Plan that Never Permitted Deferrals

[Guest Corrections Questions]

I think I have an interesting problem on my hands in relation to a client coming from another firm talking about engaging my firm.

These are the facts as presented:

In March of 2011, an employer adopted a 401(k) plan (non-safe harbor, current year ADP testing), effective March 2011. The plan even submitted for a determination letter and received one. Unfortunately, the employer's internal process and procedure was to rely on their TPA who drafted their plan to tell them what to do to start deferrals and such. The TPA never assisted them with this and thus there were no 401(k) Contributions, matching contributions, or profit sharing contributions made to this plan in/for 2011. I'm assuming that no notices of the existence of the plan were sent to eligible plan participants.

Here are the issues I see presented:

1) Is this eligible for Self Correction? Does the reliance on the TPA for how to handle this plan count as an establish plan practice and procedure?

2) Is this a significant operational failure?

3) What would the appropriate correction be?

Here are my proposed answers.

1) I think this is eligible for self correction. The assertion is that the plan compliance procedure established would be to rely on the prior TPA to assist with these issues. While it's not exactly a good or effective procedure, it's a procedure that is most likely designed to reasonably assure overall compliance with applicable code requirements. I don't believe this is an egregious failure as NO contributions are being made for 2011. The descriptions of egregious failure under the regs suggest that egregious failures are mostly applicable to instances where highly compensated employees get impermissible benefits.

2) I think it's clearly a significant operational failure. When weighing the factors to be considered when determining "significance" listed in the regs, the fact that this error affected all participants in the plan (who also happen to be all the employees), as well as 100% of the assets (none), are enough of a thumb on the scale of significance to classify this as a significant failure.

3) This is where I think the idea of self correction gets even fuzzier. The generally accepted correction for a missed deferral opportunity is to provide the participants who missed their deferrals with half the deferral percentage of their group (either highly or non-highly compensated employees). In this case, the amounts associated with their group is 0. Thus, there would actually be no contribution needed for correction.

Do you think the plan sponsor could get away with calling this a self correction of a significant operational failure, and correct the failure by doing nothing but putting a note in their files explaining this is how they went about correcting the problem?

I'd imagine if they wanted to go through VCP, the most the IRS would probably require of them is to assume a 3% deferral rate for non-highly compensated participants as if they were using a first year current ADP test, but relying on a deemed 3% deferral. Thus, the sponsor would have to make a 1.5% contribution, adjusted for earnings. If the IRS would require this, do you think the client could get away with deeming that Highly Compensated employees would have made a 5% deferral, thus making a 2.5% corrective contribution for the highly compensated employees?

Any comments? Am I way off?

2)

[ETA Consulting LLC]

You're looking at a "false start" to a plan that was created, never communicated, and never used. Any notion of a larger correction to HCEs above NHCEs isn't going to happen. Given that, as fiduciary, the sponsor clearly failed to enforce every particpants' right to defer under the plan, I don't see anything insignificant about it. I'd go the VCP route.

I've seen worse.

Good Luck!

[Guest On Hiatus]

Before leaping into VCP or EPCRS, I would ask some questions.

First -- you note that there was a plan document. But was a trust ever really established? A plan does not exist under IRC 401(a) without a trust.

Second -- EPCRS is established, in part, as a way from an employer to escape tax sanctions. Under the circumstances described, no trust funds were deposited (so no, potentially, tax under IRC 1041). No deductions were taken under 404(a) by the employer. No deferrals where made under IRC 401(a). So, if this situation came up on audit, there would be no tax due. None.

Third, the one thing that makes me uneasy is the determination letter filing. Was a Form 5500 also filed?

Fourth, in light of all this, you may want to start a new plan (with the provisions of the old plan), and get a determination letter for that, and "terminate" the old plan. If the old plan gets into trouble on audit, you could always ask the IRS to figure what the maximum payment amount sanction would be. As I noted above, under the audit cap calcuilation guidelines, this should be 0.

Fifth. Find some technical wizard at your firm, a law firm, or your tax advisor's firm to give you real advice on this. Free advice is often the most expensive.

[ETA Consulting LLC]

Before leaping into VCP or EPCRS, I would ask some questions.

First -- you note that there was a plan document. But was a trust ever really established? A plan does not exist under IRC 401(a) without a trust.

Second -- EPCRS is established, in part, as a way from an employer to escape tax sanctions. Under the circumstances described, no trust funds were deposited (so no, potentially, tax under IRC 1041). No deductions were taken under 404(a) by the employer. No deferrals where made under IRC 401(a). So, if this situation came up on audit, there would be no tax due. None.

Third, the one thing that makes me uneasy is the determination letter filing. Was a Form 5500 also filed?

Fourth, in light of all this, you may want to start a new plan (with the provisions of the old plan), and get a determination letter for that, and "terminate" the old plan. If the old plan gets into trouble on audit, you could always ask the IRS to figure what the maximum payment amount sanction would be. As I noted above, under the audit cap calcuilation guidelines, this should be 0.

Fifth. Find some technical wizard at your firm, a law firm, or your tax advisor's firm to give you real advice on this. Free advice is often the most expensive.

I agree with most of what you stated, except that VCP isn't necessarily a leap. There's nothing to be fearful and it's an opportunity to come up with a solution and get IRS approval to remove all uncertainty. Tax issues aside, you have to also look at the potential "employee rights" issues. I don't necessarily believe that you can say employee rights under the plan is a moot point because there wasn't a plan (due to there being no trust). You may be right. It's just a bit much to swallow.

Good Luck!

[Guest On Hiatus]

Toolkit:

VCP will give you certainty that you cannot get through self-correction of any tax-qualification issues. I don't believe, however, that it would help with any ERISA issues.

More to the point, it has been my experience that clients are reluctant to make the leap to VCP, partly because of the VCP fee expense, and the expense of paying the advisors for the preparation of the VCP application. I think it is prudent, therefore, to think through whether there is a rationale for self-correction, and how that might be done.

[ETA Consulting LLC]

I don't necessarily disagree with you. I probably agree with you more than I disagree; except for the cost being a deterent from VCP. We often see posts here about IRS auditors challenging Self Correction methods. I think we could agree that VCP should be part of any analysis; and not necessarily write is off without considering the actual costs.

Good Luck!

[Guest Corrections Questions]

I appreciate the suggestions. I've suggested VCP to the potential clients, and they may eventually go that route. I didn't want to potentially misrepresent any parts of this argument about SCP when I present them with the requirements that must be met for a self correction to be properly utilized.

The best possible outcome (for them) would for their old TPA to pay for the VCP filing fee as well as having the old TPA do the work assembling the application without charge as well. If they were to choose to do a half of the imputed 3% corrective contribution amount, it would only be $5,000 to be adjusted for earnings. I would suggest asking for IRS permission to use the DOL Calculator since there are no investments in the plan to use as a benchmark.