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Avoidance of IRS Employee Plans Monetary Sanctions - 2001 Update

April 2001
By Jeffrey D. Mamorsky and Terry L. Moore, Greenberg Traurig, New York Office

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The Internal Revenue Service ("IRS") determination letter program has always been a welcome relief to employers, trustees and other sponsors of qualified employee benefit plans. Under various revenue procedures issued over the years, the IRS has, in effect, offered "insurance" to plan sponsors by limiting its power to retroactively revoke a plan’s qualified status so long as the plan received a favorable determination letter from the IRS and the request for that letter contained no misstatement of material facts.

Jeffrey D. Mamorsky
"In probably the most significant development in the history of qualified retirement plans, the IRS has established the Employee Plans Closing Agreement Program ("CAP")."

However, it has long been the view of the IRS and the courts that a determination letter relates only to the plan document submitted to the IRS for review and will not protect a plan that fails to qualify in operation. This has put plan sponsors in a classic "catch-22" situation because as a technical matter a qualified plan must satisfy the requirements of Section 401(a) of the Internal Revenue Code ("Code") both in form and operation. As a result, an administrative error or other operational violation of the Code Section 401(a) qualification rules will disqualify a plan even if the error or violation is insignificant, de minimis in amount or results in no harm to plan participants.

Until now this has not been much of a problem because the IRS rarely, if ever, disqualified a plan (particularly large plans). This is because the consequences of disqualification are adverse tax consequences not only to the employer (loss of tax deduction on contributions) and trust (tax on trust income), but also to the employees participating in the plan (immediate income tax on vested benefits and contributions). However, this situation has now changed dramatically. In probably the most significant development in the history of qualified retirement plans, the IRS has established the Employee Plans Closing Agreement Program ("CAP"). This permits the IRS to impose monetary sanctions on the employer plan sponsor or board of trustees (in the case of a multi-employer plan) in lieu of plan disqualification for failure to operate a plan in accordance with the Code’s qualification requirements or in accordance with the terms of the plan document.

In this regard, the IRS requires the plan sponsor to make a non-deductible payment to the IRS (the CAP monetary sanction), the amount of which is generally based on the amount of tax that would be payable if the plan were disqualified. The amount is based on the employer deductions that would have been disallowed and the income tax that would have been owed by the trust and plan participants.

In many instances this will be a substantial amount (possibly millions of dollars). The IRS has already concluded over 5,000 CAP audits and has imposed monetary sanctions as high as $26 million (in the case of a single-employer plan) and $10 million (in the case of a multi-employer 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 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.

"Determination Letter" on Plan Operations

As a result of the establishment of the Employee Plans Closing Agreement Program, IRS for the first time ever established several voluntary compliance self-correction programs that offer plan sponsors a means to avoid the imposition of CAP monetary sanctions and the assurance that their plans will not be disqualified for an operational or administrative error. These landmark programs allowing the correction of qualification failures have been set forth in a series of landmark revenue procedures that have been consolidated in the IRS Employee Plans Compliance Resolution System ("EPCRS") which provides a comprehensive system for the correction of plan document and operational failures in order to retain the plan’s tax-favored benefits under Code Sections 401(a), 403(a) and 403(b) and avoid the imposition of monetary sanctions.

The most recent revenue procedure is contained in IRS Revenue Procedure 2001-17, 2001-7 I.R.B. 589, that updates Revenue Procedure 2000-16 and consolidates EPCRS. Like the IRS determination letter process approving the form of the plan document (which is not required but nonetheless routinely sought by prudent plan sponsors), the IRS through the issuance of an annual Revenue Procedure is encouraging plan sponsors to obtain approval of plan operations through its EPCRS program which is now elevated to the same level of importance as the determination letter process.

The good news is that an actual submission to IRS is not required to obtain approval of plan operations. Under the EPCRS program, relief from CAP monetary sanctions is afforded to those plan sponsors that identify and correct (generally within a 2 year period) 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 (e.g., 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 $10 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 under EPCRS. The basic elements of EPCRS are self-correction ("SCP"), voluntary correction with IRS approval ("VCP") and correction on an IRS audit ("Audit CAP"). The VCP program consists of several elements; voluntary correction of operational failures ("VCO"), voluntary correction of operational failures standardized ("VCS"), voluntary correction of tax-sheltered annuity failures ("VCT"), a special procedure for anonymous submissions, voluntary correction of group failures ("VCGroup") and voluntary correction of SEP failures ("VCSEPs").

EPCRS is not available to correct violations that are considered egregious failures or that involve exclusive benefit failures relating to the misuse or diversion of plan assets, or, with the exception noted below for SCP, violations relating to any plan under IRS examination or plans which have been notified of an IRS examination. VCO and SCP are not available to correct failures relating to plans that do not have a current IRS determination letter.

Revenue Procedure 2001-17 contains a self correction program, SCP, 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 generally within two years following the year in which the failure occurred.

In order to the eligible for SCP, the plan must have established practices and procedures reasonably designed to promote and facilitate overall compliance with the Code’s requirements.SCP 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.

Under SCP, operational failures that are considered "insignificant" can be corrected even if the failures are detected during an IRS examination, and if correction of a "significant" operational failure is substantially completed before the plan is under an examination, the "significant" failure can also be corrected.

If SCP is not available (e.g., the plan does not have a current determination letter), all is not lost. Revenue Procedure 2001-17 also includes the Voluntary Correction Program in which plan sponsors voluntarily submit failures and corrections to the IRS for approval. A plan document or operational failure that is not eligible for SCP may be corrected under VCP 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 VCP 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 1,000 participants, the maximum fee is $70,000 with a presumptive fee amount of $35,000.

For the first time under SCP and VCP, certain kinds of operational failures can now be corrected by a plan amendment that conforms the terms of the plan to the plan’s prior operations, provided that the amendment complies with the Code’s requirements and the amendment is submitted to the IRS for approval under the determination letter program.

Another significant development contained in Revenue Procedure 2001-17 relates to multiemployer and multiple employer plans. Under new VCP procedures, if a VCP submission to the IRS for a multiemployer or multiple employer plan contains failures that apply to fewer than all of the employers under the plan, the plan administrator may choose to have the compliance fee or sanction calculated separately for each employer based on the assets attributable to that employer rather than being attributable to the assets of the entire plan. Thus, the plan administrator may choose to apply the sanction or compliance fee to a particular employer and not to the plan trustees where the failure is attributable in whole or part to data, information, actions or inactions that are within the control of that employer rather than the multiemployer or multiple employer plan, such as attribution in whole or part to the failure of an employer to provide the plan administrator with full and complete information.

Also it is important to note that Revenue Procedure 2001-17 now contains provisions relating to the identification and correction of operational and document failures by prototype plan sponsors and third party administrators. The extension of the EPCRS program to prototype plan sponsors and third party administrators is particularly important in view of the prevalence of administering plans on the basis of internal computer systems rather than plan document provisions in violation of IRS rules.

As you can see, EPCRS is truly welcome news. Prior to the establishment of EPCRS by the IRS, 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 (along with the cost of the IRS–required correction) 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 VCP. This would be the case, for example, 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 VCP. In these cases, 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.

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


© 2001 Greenberg Traurig

Additional Information:

For more information, please review our Executive Compensation & Employee Benefits Group description, or feel free to contact one of our attorneys.

This GT ALERT is issued for general purposes only and is not intended to be construed or used as legal advice. Greenberg Traurig attorneys provide practical, result-oriented strategies and solutions tailored to meet our clients’ individual legal needs. The Firm’s responsive approach to client service often cuts across legal subject matter, applying the right experience and resources to provide cost-effective solutions.