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Avoidance of IRS Employee Plans Monetary Sanctions

April 2000
By Jeffrey D. Mamorsky, Greenberg Traurig, New York Office

Under the IRS Closing Agreement Program ("CAP"), if an IRS auditor identifies any failures in the plan’s operational compliance with the qualification requirements of the Internal Revenue Code ("Code"), the auditor will require retroactive correction of the failures and ask the plan sponsor (i.e., the employer or the trustees in the case of a multi-employer plan) as "responsible fiduciaries" to make a non-deductible payment to the IRS (the "CAP monetary sanction"), the amount of which is generally based on the total amount of tax that would be imposed on the contributing employers, trust and participants if the plan were disqualified. In many instances this will be a substantial amount (possibly millions of dollars).

Sanctions can be imposed by the IRS even if the failures are unintentional administrative errors that result in no harm to plan participants. Also, the IRS has emphasized that sanctions will be imposed for failure to follow the terms of the plan document even if the plan operation otherwise complies with the Code’s qualification requirements. The IRS has already concluded over 5,000 CAP Audits and has imposed monetary sanctions of at least $26 million on just one employer ($10 million in the case of a large multiemployer plan) for failure to comply operationally with the Code’s qualification requirements. Hundreds of additional cases are currently being negotiated with IRS under the CAP Program.

The issues identified by the IRS on audit rarely constitute intentional or blatant violations of the Code’s qualification requirements. The majority of the problems appear to involve failures which often occur in the administration of qualified plans and are of the type which can easily be discovered on an audit by IRS.

Although IRS relief from CAP monetary sanctions is available through various remedial programs (discussed below), the way to comply with such programs is by identifying and correcting operational and document failures through a self-audit process prior to an audit by IRS. The Fiduciary Audit® Operational Review, which is exclusively available through Greenberg Traurig, enables employers and trustees in the case of multiemployer plans, to establish self-audit internal control procedures that are designed to assure operational compliance on a cost effective basis. This will help to avoid litigation and the imposition of draconian monetary sanctions under the IRS’ CAP Program. The Fiduciary Audit® Operational Review, which is the basis for indemnification against IRS liability (eg, CAP monetary sanctions) under the Qualified Plan Insurance Program offered by Lloyds of London and other major insurers, is also invaluable in structuring solutions that facilitate mergers and acquisitions and enhance their value by identifying and eliminating qualified plan liability from the balance sheet and providing protections on the representations and warranties and opinions necessary with respect to the operation of qualified plans in accordance with plan documents and the requirements of ERISA and the Code.

CAP Monetary Sanctions

Although much of the information regarding IRS audits of qualified plans under CAP is protected from public disclosure and therefore cannot be revealed by the IRS, we have been able to obtain some general information from various IRS personnel and other sources. For example, we are aware of one instance where the trustees of a large collectively bargained defined benefit plan paid in excess of $5 million dollars in CAP monetary sanctions plus the cost of correction of various service crediting failures which resulted in vesting and benefit accrual violations. The service crediting problem resulted from the failure of the employers and plan administrator to maintain a system to track "covered employment" (i.e., employment covered under the terms of the collectively bargained agreement). The case involved an industry in which union shops went in and out of business frequently and there was no system in place to keep track of union members as they moved from one shop to another or from employment status to unemployment status and vice versa. Another case involved a large collectively bargained defined benefit plan that did not track service properly and as a result a large number of employees did not receive service credit under the plan. Moreover, as a result of a failure to adjust employer contribution rates the plan became vastly overfunded. This resulted in the assessment and collection of a multi-million dollar CAP monetary sanction upon audit by the IRS.

You may already be aware of a case in which a corporate employer paid between $20 million to $35 million in CAP monetary sanctions. An IRS audit of a large 401(k) plan identified operational failures that included a failure to (i) timely enroll employees in the plan, (ii) obtain spousal consent witnessed by either a plan representative or notary public, (iii) satisfy the participant consent requirement for lump sum distributions in excess of $3,500 by not complying with certain IRS disclosure requirements to insure "informed" consent (e.g., joint and survivor and tax explanations, etc.) and (iv) keep track of the current mailing address of terminated vested participants who were owed benefits from the plan. The IRS assessed CAP monetary sanctions on the plan sponsor employer as if the plan were disqualified. In addition to the CAP monetary sanction, it is our understanding that the IRS also required the employer to retain an independent auditor at a cost of approximately $3 million to report operational compliance to the IRS for a two year period and to retroactively correct all operational defects. Correction of operational defects included the mailing of letters to approximately 55,000 former participants "inviting" them to recontribute their lump sum distributions to the plan.

We are also aware of an IRS audit of a large 401(k) plan in which the IRS identified an inadvertent delayed enrollment of rehired employees whose prior period of employment was not properly taken into account when determining eligibility for participation in the plan upon rehire. IRS imposed a $7.5 million CAP monetary sanction on the employer plan sponsor. The penalty was assessed even though the failure was inadvertent and affected less than 1% of plan participants.

In another case involving a company’s qualified plan, the IRS imposed CAP monetary sanctions in the amount of $9 million. The CAP sanction was imposed even though the principal issue raised by IRS was the company’s failure to obtain spousal consent from only 1% to 2% of plan participants.

In another case, a 401(k) plan failed to pass the ADP nondiscrimination test for two consecutive years. In order to avoid this problem in the future, the plan was amended to eliminate coverage of highly compensated employees ("HCEs"). In spite of the plan amendment making HCEs ineligible, HCEs were allowed to make salary deferrals. Subsequent to an IRS audit identifying this operational failure, the employer plan sponsor "agreed" to correct the operational defect by making an additional contribution of over $400,000 to the plan on behalf of non-highly compensated employees plus payment to the IRS of a substantial amount of CAP monetary sanctions.

IRS Relief From CAP Monetary Sanctions

Fortunately, the IRS has provided relief from these draconian monetary sanctions. On January 24, 2000, the IRS released Revenue Procedure 2000-16 which updates and consolidates the comprehensive system of correction programs for sponsors of retirement plans (i.e., employers or trustees in the case of multiemployer plans) that are intended to satisfy the requirements of Sections 401(a), 403(a) or 403(b) of the Internal Revenue Code ("Code"), but that have not met those requirements for a period of time. This system, the Employee Plans Compliance Resolutions System ("EPCRS"), permits plan sponsors to correct failures under Code §§401(a), 403(a) or 403(b) and thereby continue to provide their employees with retirement benefits on a tax-favored basis.

The components of EPCRS are the Administrative Policy Regarding Self-Correction (APRSC"), the Voluntary Compliance Resolution ("VCR") program, the Walk-in Closing Agreement Program ("Walk-in Cap"), the Audit Closing Agreement Program ("Audit CAP") and the Tax Sheltered Annuity Voluntary Correction ("TVC") program.

Revenue Procedure 2000-16 contains a self correction program, APRSC, which allows plan sponsors to identify violations in plan operation and correct the failures without any involvement of the IRS and without the payment of any CAP monetary sanctions provided that corrections are made prior to an IRS audit and within two years following the year in which the failure occurred.

APRSC is only available to correct operational failures and not plan document errors. In this regard, it is important to note that the IRS emphasizes that failure to follow the terms of the plan is an operational violation even if the operation of the plan would otherwise satisfy the Code’s requirements. APRSC is not available to correct violations that can be corrected only by plan amendment (e.g., failure to timely amend the plan), exclusive benefit failures relating to the misuse or diversion of plan assets, failures relating to plans which do not have a current IRS determination letter, and violations relating to any plan under IRS examination or plans which have been notified of an IRS examination.

If APRSC is not available (e.g., the plan document needs to be amended to conform with operation or the plan does not have a current determination letter), all is not lost. Revenue Procedure 2000-16 also includes a "Walk-in CAP" program in which plan sponsors voluntarily submit failures and corrections to the IRS for approval. The Walk-in CAP program permits correction of a plan document or operational failure that does not comply with APRSC if the plan sponsor agrees to pay a compliance correction fee and to correct the failures identified in accordance with a closing agreement with IRS. The Walk-in CAP Compliance Correction Fees for plans with assets of less than $500,000 are $500 to $4,000 with a presumptive fee amount of $2,000 for plans with 10 or fewer participants; $500 to $8,000 with a presumptive fee amount of $4,000 for plans with 11 to 50 participants; $500 to $12,000 with a presumptive fee amount of $6,000 for 51 to 100 participants; $500 to $16,000 with a presumptive fee amount of $8,000 for 101 to 300 participants; $500 to $30,000 with a presumptive fee amount of $15,000 for 301 to 1,000 participants. The minimum fee of $500 is replaced by a fee of $1,250 for plans with assets of at least $500,000 and no more than 1,000 participants, $5,000 for plans with 1,001 to 10,000 participants, or $10,000 in the case of plans with 10,000 or more participants. For plans with more than 1000 participants, the maximum fee is $70,000 with a presumptive fee amount of $35,000.

As you can see, Revenue Procedure 2000-16 is truly welcome news. Prior to the release of this Revenue Procedure, plan sponsors that conducted an audit of their plan, corrected administrative failures and/or plan document errors, and approached the IRS for amnesty could still face millions of dollars in IRS penalties. Now the maximum penalty plan sponsors face is $70,000 provided that they conduct an operational audit of their plan and correct administrative or plan document failures prior to an audit by IRS.

Additional Relief with the Fiduciary Audit® Operational Review

Circumstances often arise where plan sponsors are unable to make corrections and submit them to the IRS for approval under the "Walk-in CAP" program. This would be the case, for example, in the case of a term or provision in the plan document that is inconsistent with plan operation as the result of a "scrivener’s error" which is ineligible for retroactive amendment under the "Walk-in CAP" program. Also, this could occur in a merger/acquisition transaction where there is not enough time to correct document and operational failures and submit corrections to the IRS for approval under "Walk-in CAP." In either case, the Fiduciary Audit® Operational Review enables plan sponsors to qualify for indemnification against IRS liability (CAP monetary sanctions) under the Qualified Plan Insurance Program offered by Lloyds of London and other major insurers.

In sum, we believe that the Fiduciary Audit® Operational Review provides a cost-effective means of sanction avoidance, balance sheet enhancement and transactional facilitation.


IRS Audits in 2000 Will Target 403(b) Tax-Sheltered Annuity Plans

The IRS recently announced that 403(b) tax-sheltered annuity plans will be the target of enhanced enforcement in 2000 through a significant increase in its examination activities relating to 403(b) school arrangements, public colleges, hospitals and health care organizations.

In light of this new emphasis on 403(b) plan audits, IRS Revenue Procedure 2000-16 is more important then ever. Rev. Proc. 2000-16 extends to 403(b) tax-sheltered annuity plans all of the correction programs covered under the IRS’ Employee Plans Compliance Resolution System ("EPCRS").

EPCRS permits employers to (1) voluntarily correct failures that occur when a tax-sheltered annuity plan fails to met the requirements of Section 403(b) of the Internal Revenue Code and thereby continue to provide employees with retirement benefits on a tax-favored basis and most importantly, (2) avoid the imposition of IRS monetary sanctions.

Voluntary correction is permissible only with respect to 403(b) plans that have not already been selected for an IRS examination. If you are interested in learning more about how to identify and correct 403(b) plan failures under EPCRS, please contact us for more information.

Also it is important to note that the the Fiduciary Audit® Operational Review and Qualified Plan Insurance Program discussed in the previous article apply to 403(b) plans.


Supreme Court Cites Employee Benefits Law Treatise

Citing Jeffrey D. Mamorsky's two volume treatise, Employee Benefits Law, as authority, the U.S. Supreme Court has ruled that ERISA allows an employer to amend a retirement plan to create a new plan structure within an existing plan structure without creating a de facto second plan where the same source of assets is used to pay the obligations of both plan structures [Hughes Aircraft Company et al. v. Jacobson 525 U.S. 432, 119 S. Ct. 755, 22 EBC 2296].

In a decision written by Justice Clarence Thomas, the Supreme Court reversed a ruling of the Ninth Circuit Court of Appeals that had permitted a class of participants in a contributory defined benefit retirement plan to sue Hughes Aircraft Company under ERISA after it had created a noncontributory benefit structure, and had transferred the overfunded plan's surplus, which amounted to almost $1 billion, to this new noncontributory plan structure that included many new employees who had not contributed to the original plan.

In rejecting the class' claim that the plan amendments created a separate noncontributory plan that could not be legally funded with surplus assets which were comprised in part of the investment growth of employee contributions, the Supreme Court emphasized that: "The act of amending a preexisting plan cannot as a matter of law create two de facto plans if the obligations (both preamendment and postamendment) continue to draw from the same single, unsegregated pool or fund of assets."


© 2000 Greenberg Traurig

This GT ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs.