IRS Administrative Policy Regarding Self-Correction

(Note: This IRS "field directive" was published by the National Office for its district offices on January 7, 1997.)

I. Introduction

This document sets forth an administrative policy of the Internal Revenue Service (Service) under which, at the discretion of the district offices, certain operational violations of the qualification requirements for pension, profit-sharing and stock bonus plans, and of the special requirements of tax sheltered annuity plans will not result in either plan disqualification or loss of the exclusion allowance nor the related adverse tax consequences. This policy is called the Administrative Policy Regarding Self-Correction (APRSC). It replaces the Administrative Policy Regarding Sanctions (APRS). To promote the Service's voluntary compliance initiatives, this document broadens the scope of the guidelines as originally established in three significant ways: (1) it expands the original criteria for eligibility under APRS, (2) it establishes a self-correction procedure whereby plan sponsors may correct their plans for operational violations within a specified time period, and (3) it extends APRSC to tax sheltered annuity plans as described under § 403(b) of the Internal Revenue Code ("403(b) plans"). The general requirements for eligibility under APRSC are set forth in section III. The self-correction procedure is described scribed in section IV. The standards for the application of APRSC with respect to insignificant operational violations are set forth in section V. In order to be eligible for the self-correction procedure in section IV or to be considered insignificant under section V, the eligibility requirements of section III must be satisfied.

II. Background

APRS was established on March 26, 1991, and added to the Employee Plans Examination Guidelines Handbook to provide a procedure under which the district offices have discretion not to pursue the sanction of disqualification of plans with minor operational violations. Under the original guidelines, sponsors of qualified plans with operational violations that satisfied six narrowly drawn criteria were eligible for relief under APRS.

A qualified plan must satisfy § 401(a) of the Internal Revenue Code (Code) both in form and in operation. § 403(b) plans are not qualified plans under § 401(a) but are subject to their own special requirements under § 403(b). Many of these requirements, if violated, result in the loss of the exclusion allowance for participants in the affected annuity contracts or all annuity contracts under the plan (the term "annuity contracts" includes custodial and retirement income accounts).

As a technical matter, claims that a plan is qualified under § 401(a) or that a plan satisfies the requirements of § 403(b) simply because operational violations are insubstantial, de minimis in amount, or resulted in no harm have no legal merit. Such a plan is nonqualified, or, in the case of a 403(b) plan, not entitled to the exclusion allowance.

As an administrative matter, however, certain operational violations may not rise to the level where it would be productive or consistent with pension policy to pursue the sanction of disqualification in the case of a § 401(a) plan, or to recommend loss of the exclusion allowance in the case of a 403(b) plan. For purposes of these guidelines, such violations are referred to as "nondisqualifying events." To best utilize Service resources, the districts have the discretion to recognize the continued qualification of a § 401(a) plan or the continued validity of a 403(b) plan in the case of a nondisqualifying event involving the plan. A violation may be considered a nondisqualifying event under either section IV or section V of these guidelines.

III. APRSC Eligibility

A. Eligibility

APRSC is available to correct operational violations with respect to plans intended to be qualified under §§ 401(a) and 403(a) of the Code and arrangements described under § 403(b). It is not available to correct violations that can be cured only by plan amendment. Thus APRSC is not available for plans with disqualifying provisions (as defined in the regulations under § 401(b)) for which the remedial amendment period has expired. Under no circumstances should a plan sponsor's failure to timely amend its plan for any change in law (for example, TEFRA, DEFRA, REA or TRA 86) be considered a nondisqualifying event under these guidelines.

For purposes of APRSC, an operational violation of a § 401(a) plan arises solely from the failure to follow plan terms. An operational violation that arises because of a shift in the demographics of the employer's workforce and that would require a plan amendment for correction will not be considered under APRSC. Note that failure to follow the terms of the plan, even if the operation of the plan would otherwise satisfy the qualification requirements, is an operational violation.

For purposes of these guidelines, an operational violation of a 403(b) plan is a violation that would otherwise result in the loss of the exclusion allowance under § 403(b) and not a violation resulting solely in income inclusion for affected participants. Violations involving contributions to 403(b) plans in excess of the § 415 limit or the maximum exclusion allowance are not eligible for APRS because they result solely in the inclusion in income for affected participants.

Finally APRSC is not available for exclusive benefit violations relating to the misuse or diversion of plan assets (cases in which the Department of Labor may also have jurisdiction).

B. Established Practices and Procedures

In order to be eligible for APRSC the sponsor or administrator of a plan must have established practices and procedures (formal or informal) reasonably designed to promote and facilitate overall compliance with the requirements of Code § 401(a) or section 403(b). For example the plan administrator might use a checksheet for tracking allocations and indicate on that checksheet whether a particular employee was a key employee for top-heavy purposes. A plan document alone will not constitute evidence of established procedures.

These established procedures must have been in place and routinely followed, but through an oversight or mistake in applying them, or because of an inadequacy in the procedures, an operational violation occurred.

C. Correction

The sponsor of the plan must make full correction of all violations for all years for which the defects exist. The correction method should restore to both current and former participants and their beneficiaries the benefits and rights they would have had had the defect not occurred. The correction method should restore the plan to the position it would have been in had the defect not occurred.

IV. Self-Correction Procedure

Any operational violation, whether or not the violation would be considered insignificant under section V, that is corrected by the plan sponsor by the end of the plan year following the plan year in which the operational violation occurred is a nondisqualifying event. There are no limitations on the number of years a sponsor of a plan can use this self-correction procedure.

In the case of a plan qualified under § 401(a) of the Code, this self-correction procedure is available only to a sponsor of an individually designed plan (including a volume submitter plan) with a current determination letter, an adopter of a master or prototype plan with a current opinion letter, or an adopter of a regional prototype plan with a current notification letter.

This self-correction procedure will not be available, however, for correcting any violations in a plan for any plan year that is under an Employee Plans or Exempt Organizations examination (that is, an examination of a Form 5500 series, a Form 990 series, or other Employee Plans or Exempt Organizations examination). This includes any plan year for which the plan sponsor, or a representative, has received verbal or written notification from the EP/EO Division of an impending Employee Plans or Exempt Organizations examination for that plan year, or of an impending referral for Employee Plans or Exempt Organizations examination, and also includes any plan year that has been under an Employee Plans or Exempt Organizations examination.

Example

Employer Z established a qualified defined contribution plan in 1986 and received a favorable determination letter for the Tax Reform Act of 1986 (TRA '86). In 1995, while doing a self-audit of the operation of the plan for the 1994 plan year, the plan administrator discovered that despite the practices and procedures established by the employer with respect to the plan, several employees eligible to participate in the plan were excluded from participation. The administrator also found that the elective deferrals of additional employees exceeded the § 402(g) limits. Finally, the plan administrator discovered operational violations of the top-heavy provisions of the plan. During the 1995 plan year the plan administrator immediately took corrective action by making contributions on behalf of the excluded employees, distributing the excess deferrals to the affected participants, and making a top-heavy minimum contribution to all participants entitled to such contribution for the 1995 plan year. Each corrective contribution and distribution was credited with earnings at a rate appropriate for the plan from the date the corrective contribution/distribution should have been made to the date of correction. The district found, upon a 1997 examination of the plan, that corrections of the operational defects by the plan administrator by the end of the plan year following the plan year in which the operational violations occurred satisfied the self-correction provisions of APRSC.

V. Nondisqualifying Events Resulting From Insignificant Operational Violations

Operational violations that are not self-corrected within the time described in section IV are nevertheless considered nondisqualifying events and eligible for APRSC if, given all the facts and circumstances of a case, the operational violations are considered to be insignificant.

The factors to be considered in determining whether or not operational violations under a plan are significant include, but are not limited to: (1) the number of violations that occurred during the period being examined (for this purpose a violation is not considered to have occurred more than once merely because more than one participant is affected by the violation); (2) the percentage of plan assets and contributions involved in the violations; (3) the number of years the violations occurred; (4) the number of participants affected relative to the total number of participants in the plan; (5) the number of participants affected as a result of the violations relative to the number of participants that could have been affected by the violations; (6) whether corrections were made prior to examination; and (7) the reason for the violations (e.g, data errors, i.e., transcription of data, the transposition of numbers, or minor arithmetic errors). No one single factor is determinative. The fact that one or more factors are not applicable to a given case will not prevent the plan from being eligible {or APRSC.

A plan with more than one operational violation in a single year may be eligible for APRSC if the violations in the aggregate are considered insignificant. Violations will not be considered significant merely because they occur in more than one year.

The following examples illustrate the application of this section V. Assume, in each example, that the eligibility requirements under section III or these guidelines, including correction of the violations, have been met.

Example 1:

In 1984, Employer X established Plan A, a profit-sharing plan that satisfies the requirements of section 401(a) of the Code in form. In 1995, the benefits of 50 employees of the 250 participants in Plan A were limited by § 415(c) of the Code. However, when the district examined Plan A in 1997 it discovered that during the 1995 limitation year, the annual additions allocated to the accounts of 3 of these employees exceeded the maximum limitations under § 415(c). Employer X contributed $3,500,000 to the plan for the plan year. The amount of the excesses totaled $4,550. Based on data provided by Employer X, the district office did not find any evidence of other violations in the plan. Under these facts, because the number of participants affected by the violation relative to the total number of participants that could have been affected by the violation, and the monetary amount Of the violation relative to the total employer contribution to the plan for the 1995 plan year are considered to be insignificant, the § 415(c) violation in Plan A that occurred in 1995 would be considered a nondisqualifying event.

Example 2:

The facts are the same as in example 1 except that the violation of section 415 occurred during the 1994-1996 limitation years. In addition, the three participants affected by the § 415 violation were not identical each year. The fact that an insignificant § 415 violation occurs during more than one limitation year will not cause the plan to be considered to be ineligible for APRSC.

Example 3:

The facts are the same as in example 1 except that the annual additions of 25 of the 50 employees whose benefits were limited by § 415(c) nevertheless exceeded the maximum limitations under § 415(c) of the Code during the 1995 limitation year and the amount of the excesses totaled $50,000. Under these facts, the number of participants affected by the violation relative to the total number of participants that could have been affected by the violation for the 1995 limitation year is significant. The § 415(c) violation in P1an A that occurred in 1995 would not be considered a nondisqualifying event and is ineligible for APRSC.

Example 4:

Employer J maintains Plan C, a money purchase pension plan established in 1992, that satisfies the requirements of § 401(a) of the Code in form. The formula under the plan provides for an employer contribution equal to 10% of compensation as defined in the plan. During its examination of the plan for the 1995 plan year, the district office discovered that the employee responsible for entering data into the employer's computer made minor arithmetical errors in transcribing the compensation data with respect to 6 out of the plan's 40 participants, resulting in excess allocations to those 6 participants' accounts. Under these facts, the number of participants affected by the violation relative to the number of participants that could have been affected is insignificant, and the violation is due to minor data errors. Thus, the violation occurring in 1995 would be considered to be a nondisqualifying event.

Example 5:

Public School maintains for its 200 employees a salary reduction 403(b) plan (the Plan") which satisfies the requirements of § 403(b) of the Code. The Business Manager has primary responsibility for administering the Plan, in addition to other administrative functions within Public School. During the 1994 plan year, A, a former employee, should have received an additional minimum distribution amount of $278 under § 403(b)(10). Participant B received an Impermissible hardship withdrawal of $2,500. Participant C made elective deferrals of $10,500, $1,000 of which was in excess of the 402(g) limit. Based on data provided by Public School, the district office did not find any evidence of other violations in the Plan. Under these facts, even though multiple violations occurred in a single plan year, the violations will be considered to be nondisqualifying because in the aggregate the violations are considered insignificant.