401(k) contribution preceded services

[tpacpa]

Employer started a new 401(k) safe harbor plan in August 2013. Problem: The employer has only been making quarterly contributions of the participant deferrals, as well as the safe harbor 3% contribution. His first quarterly contribution was made mid September 2013, and every 3 months thereafter. Therefore, this first quarterly contribution included about 1 1/2 to 2 months of salary deferral contributions that hadn't been withheld from participants comp yet. There are only 3 participants total. The owner is self employed, so his "early" contributions really aren't an issue. It is basically the other two participants that are an issue. And to complicate matters further, all 3 participants have self directed brokerage accounts. The employer does not want to make a PSP contribution for the 2013 year.

Among the many issues that are presented, what are the issues with the early deposit of the participant contributions? Can he just "go forth and sin no more" (start making contributions with each paycheck going forward)? If he does this, is the concern that the IRS would audit the plan and require him to reclassify the "early" participant deferrals as a PSP contribution instead? Which of course would mean that all the allocations from the beginning of the plan would be incorrect? Any other problems this would present if he doesn't reclassify it as a PSP contribution?

[Lou S.]

He needs to change his procedure to deposit the employee contributions when they are withheld.

The first issue I see is you probably have late deposits on a fair amount of the withheld contributions. Assuming the are doing the current quarter deposits retrospective and prospective in the middle of each quarter. That is the deposit on 8/15 is for the period 7/1 - 9/30.

The second issue is you are depositing 401(k) contributions that have not yet been withheld (if I read your post correctly). In this second case, what do you do if you make the deposit then the employee, stops contribution, takes a hardship or terminates employment before the deposited contributions are ever withheld or if the estimates of the future deferrals run out to be wrong?

But my guess is what is likely happening is he is making quarterly deposits of deferral and safe harbor AFTER the period not in the middle and then you have a lot of late deferrals.

[tpacpa]

As soon as it was determined that he was just making quarterly deposits, that was immediately stopped and he began making deposits with each payroll. The problem is what to do about the year's worth of quarterly deposits he has already made. (There were no hardship distributions, no other issues during this time.)

The deposit he made on 9/11/13 was for the 8/15 - 9/30 payrolls...so possibly 1 or 2 late deferrals with that one. Another deposit in November, for 10/15 - 12/31...so possibly 1 or 2 late deferrals with that one, etc.

I know what to do with the late deferrals (contribute lost earnings, etc.). The guidance on that is very clear. It's the EARLY deposit of the salary deferrals that I'm concerned about. Can he still treat those "early deferrals" that he's made over the last year as participant salary deferrals and just immediately stop making quarterly deposits and start making them with each payroll? If not, what to do?

[BG5150]

I don't understand. Did the ER not withhold anything and still sent money in September? How did he know how much to send?

Is this a Safe Harbor Match?

[Kevin C]

The regs are clear that amounts deposited before the services are performed are not salary deferrals [1.401(k)-1(a)(3)(iii)©. If you treated prefunded amounts as deferrals and the IRS catches it, I would expect them to treat the prefunded amounts as employer contributions and ask for the rest of the deferrals to be deposited with lost income. That would be under Audit CAP, which has a negotiated sanction. I would also expect them to want the Forms 5330 filed along with the excise taxes, late filing and late payment penalties and interest. I'm not sure how the DOL would view it, although it would be an interesting conversation trying to explain how some of the deferrals were deposited that far in advance. Oh, and the DOL does refer cases to the IRS when they feel it is warranted.

I'm not aware of any prefunding restrictions on deposits of the 3% safe harbor. Maybe you'll get lucky and when the dust settles on determining what really was deferral deposits and what was employer contributions, you just have more late deferral deposits than you originally thought.

[tpacpa]

I don't understand. Did the ER not withhold anything and still sent money in September? How did he know how much to send?

Is this a Safe Harbor Match?

It's a weird situation. One I've never run across ever...an employer that wanted to put the salary deferrals in the plan early for the participants. He just determined what the salary deferrals were going to be for the upcoming payrolls based on the participants' elections at the time and deposited them early into the plan. (He was assuming the participants would not change their elections during that time, quit, etc. Both participants were on salary, so he knew the amount of each payroll...assuming of course they wouldn't quit during that time.) As the payrolls were paid in the upcoming weeks/months, they were withheld from the participants' paychecks as they elected. I'm sure he thought he was doing a good thing depositing it into the plan "early".

And no, it's not a safe harbor match. He is doing the 3% nonelective. He's just also depositing that quarterly in addition to the participant "deferrals".

[Lou S.]

I'm tempted to say - no harm, no foul. But I don't know if the IRS would go for that.

If you are correcting under VCP (because of late deferrals) ask the IRS to rule on this and explain it was simple misunderstand on the deposit rules and document that the client changed procedures as soon as it was discovered.

If you are fixing under SCP document the same but know there is a potential the IRS may disagree with your correction.

[austin3515]

Maybe I am a cowboy but for a two person plan I would not be too concerned. Those rules on "its really profit sharing" were for those companies that would make a $200,000 deposit on December 1st as an advance for next years 401k (and take the deduction in the year funded).

Yes, technically it is profit sharing. As others will tell you, advise the client of the right thing to do (in writing) but as TPA we are not their parents.

[tpacpa]

As often happens when employers inadvertently "mess up", they never intended it to be discriminatory, weren't trying to "beat the system", and feel they are being punished for just ultimately trying to do a good thing for their employees. Sigh.

Thanks for the discussion. It consists of everything that's been running through my mind, but it's good to see others thinking it too.

[tpacpa]

The regs are clear that amounts deposited before the services are performed are not salary deferrals [1.401(k)-1(a)(3)(iii)©. If you treated prefunded amounts as deferrals and the IRS catches it, I would expect them to treat the prefunded amounts as employer contributions and ask for the rest of the deferrals to be deposited with lost income. That would be under Audit CAP, which has a negotiated sanction. I would also expect them to want the Forms 5330 filed along with the excise taxes, late filing and late payment penalties and interest. I'm not sure how the DOL would view it, although it would be an interesting conversation trying to explain how some of the deferrals were deposited that far in advance. Oh, and the DOL does refer cases to the IRS when they feel it is warranted.

I'm not aware of any prefunding restrictions on deposits of the 3% safe harbor. Maybe you'll get lucky and when the dust settles on determining what really was deferral deposits and what was employer contributions, you just have more late deferral deposits than you originally thought.

This just keeps getting worse. It just occurred to me if there were in fact late deposits, and the employer files under the DOL VFCP, the employer will have to submit documentation to prove that the deposits were made. In submitting this documentation, it's going to indicate one large deposit (each quarter) that will obviously be more than just the late deferrals that were deposited. That "one large deposit" will also include the 3% safe harbor elective contribution, as well as the "early deposit" of the deferrals above discussed.

And keep in mind, this plan has self directed participant brokerage accounts for the three participants. So any documentation provided will include documents from each participant's brokerage account.

I've never had to file under VFCP for a late deferral. I assume the employer will have to show a canceled check and/or a monthly statement showing the deposit of the late deferral. The monthly statement will obviously show that regular deposits of the deferrals were not made. The canceled check will be for an amount that is much larger than just the one or two late deferrals that the employer would be reporting. Does the client have to submit the monthly statements? Will the employer have to explain the total amount of the check, or will it be sufficient to say the late deferral was included in that canceled check? What documentation will the employer need to provide the DOL, and will this be a dead giveaway to the DOL about the early deferral deposits? As you indicated above, the DOL shares with the IRS, so can I assume the DOL will notify the IRS about this situation?

If that is the case, does this start a train wreck, where if the employer reports late deferrals on the Form 5500, files the Form 5330s, files under the DOL's VFCP, then they will also have to file under the IRS's VCP and report ALL of these problems, and ask the IRS to rule on the "early deferral deposit" situation?

Or, what if the employer reports the late deferrals on the Form 5500 and files the appropriate Form 5330s, but doesn't file under the DOL's VFCP? I assume the DOL will send one of those letters "suggesting" that they file under the VFCP? Then what? Can the employer get by with NOT filing under the VFCP in this situation? How would they get out of it? Write a letter back to the DOL and explain how they corrected it? In this case, would they have to send documentation to the DOL proving they corrected it, or would just a letter of explanation suffice indicating how they corrected it and that they filed the Form 5330s?

At this point I'm sure the employer would gladly file the Form 5330s if this could possibly make it go away...but I'm concerned about that "followup VFCP suggestion letter" from the DOL for the Form 5500 reporting the late deferral. Will this cause the entire situation to implode?

[BG5150]

You don't HAVE to file under VFCP for the late deferrals.

Safest thing to do might be to get an ERISA attorney involved.

[Kevin C]

As mentioned, VFCP is voluntary. The main reason to file under VFCP is to get the exemption on the PT excise tax. Filing the 5330s is another option. If you report late deferrals on the 5500, you get a form letter from the DOL inviting you to use VFCP. The letters our clients have received do not require a response. They don't automatically come to visit if you don't use the program.

Most of our clients that have late deferrals are only a few days to a couple of weeks late with the deposits. The "amount involved" ends up being small and the excise tax is usually under $10. For those, we have the client deposit the lost income plus what the excise tax would have been into the plan and we go on.

It's not unusual for deposits to include deferrals, loan payments and employer contributions in the same check, ACH or wire. If the IRS/DOL is verifying deposits they will ask for cancelled checks or other documentation of the deposits and a list of the amounts withheld by paydate. If deposits are combined, they will need a breakdown of each deposit so they can tie the deposits to the list of amounts withheld each paydate.

In your situation, I would start with the worst case. Start by looking at each deposit and applying it first to deferrals where the services have already been performed. Then, apply the rest to the 3% SH for the year. After you do this for all of the deposits, identify late deferral deposits, see if all of the deferrals have been deposited and see if the employer contribution exceeds the amount needed for the 3% SH. This is what I would expect the gvt to make you do if they were to audit. Ultimately, it's up to the client to decide what they want to do.

[Peter Gulia]

Aside from adjusting the past, could this employer considering changing its wage-payment periods to quarterly?

[BG5150]

Aside from adjusting the past, could this employer considering changing its wage-payment periods to quarterly?

I should hope not. Would you want to be paid every three months?

[tpacpa]

If the law requires it, the employer doesn't have a problem, going forward, paying it to the plan semi-monthly as the employees are paid. The problem is what has already, inadvertently, happened.

[Peter Gulia]

My employer pays me only once a year, on New Year's eve.

Anecdote aside, it's not entirely unusual for a micro business (the originating post mentioned three participants) to use less frequent pay intervals, especially if the workers are owners and executives.

[tpacpa]

As mentioned, VFCP is voluntary. The main reason to file under VFCP is to get the exemption on the PT excise tax. Filing the 5330s is another option. If you report late deferrals on the 5500, you get a form letter from the DOL inviting you to use VFCP. The letters our clients have received do not require a response. They don't automatically come to visit if you don't use the program.

Most of our clients that have late deferrals are only a few days to a couple of weeks late with the deposits. The "amount involved" ends up being small and the excise tax is usually under $10. For those, we have the client deposit the lost income plus what the excise tax would have been into the plan and we go on.

It's not unusual for deposits to include deferrals, loan payments and employer contributions in the same check, ACH or wire. If the IRS/DOL is verifying deposits they will ask for cancelled checks or other documentation of the deposits and a list of the amounts withheld by paydate. If deposits are combined, they will need a breakdown of each deposit so they can tie the deposits to the list of amounts withheld each paydate.

In your situation, I would start with the worst case. Start by looking at each deposit and applying it first to deferrals where the services have already been performed. Then, apply the rest to the 3% SH for the year. After you do this for all of the deposits, identify late deferral deposits, see if all of the deferrals have been deposited and see if the employer contribution exceeds the amount needed for the 3% SH. This is what I would expect the gvt to make you do if they were to audit. Ultimately, it's up to the client to decide what they want to do.

So, your clients have received the DOL letter and just not responded to it, and nothing more happened?

Or they responded to it explaining to the DOL how it was corrected? If the employer in this situation files the Form 5330s and doesn't file under VFCP, and IF an explanation to the DOL's letter is needed, they would just explain to the DOL they filed the Form 5330s, made the late deferral deposits, and paid the lost earnings?

I think even under VFCP, the employer would still be required to file the Form 5330s and would not be eligible for the class exemption because these transactions occurred more than once--4 quarters to be exact.

Your third paragraph explains my concerns under VFCP, "If deposits are combined, they will need a breakdown of each deposit so they can tie the deposits to the list of amounts withheld each paydate." If the employer files under the VFCP, they will have to indicate not only the late deferrals, which the employer is filing to report, but also the "early deferral" deposits. I don't know that the DOL will be concerned about the early deposits, but if the DOL notifies the IRS, they may be.

As to your final paragraph, unfortunately we've already done what you suggested, and there are "early deferral" deposit issues, regardless of how you classify it, for 2013 and 2014. The problem is that the employer also (generously) put in the 3% nonelective safe harbor contribution each time he made a salary deferral deposit, so the "early deferral" deposits could not be considered safe harbor contributions, because those were already put in.

It will obviously be the employer's decision to make, I just want to make sure he understands all the various ramifications...especially when complete and full filings (VCP, VFCP, Form 5330s) for all of this may cost him $8,000 to $10,000. Paying the lost earnings is truly nothing compared to the cost of the filings. Since this is a brand new plan and the total plan assets aren't even very large yet, I'm not sure the maximum sanction amount under Audit CAP would even be that high.

[Kevin C]

If the DOL or IRS wants a response, they will tell you that in the letter. The letters I'm referring to were form letters with information about VFCP and inviting you to take advantage of the program. We have not responded and so far, no issues. it's been a couple of years since I looked at the details of VFCP. We rarely have a client with enough late deposits to make it worth the trouble of using the program.

If you go by the Regs those early deposits are employer contributions. If the 3% SH has already been funded, profit sharing is probably the only other reasonable option. Of course, that also means they would have to deposit the amount of the early deferrals again along with lost income for the now late deferral deposit. If they choose to not follow the regs, they run the risk that if the IRS/DOL comes looking, the agent may notice the issue and make them correct. That will probably be two years farther down the road when the cost of correction will be more.