Qualified Plan Correction Programs

THIS PAGE HAS BEEN UPDATED. See 401(k) EPCRS Overview for the most current information.

If there is an error in maintaining and operating a 401(k) plan, there are options available for plan sponsors to make corrections without sacrificing the qualified status of the plan.  The steps necessary to correct an error and the potential cost impact are dependent on the type of error and the timing of the correction.

Prompt correction is best:  Despite the efforts of plan sponsors and plan administrators, mistakes will likely happen. Conducting periodic reviews of the 401(k) plan’s operation and promptly fixing operational failures after they are discovered can reduce the costs of correction.

The Employee Plans Compliance Resolution System (“EPCRS”) is the IRS program that can be used to correct both operational errors and plan document errors.  EPCRS includes the following three different methods for correcting plan errors:

1. Self-Correction Program (“SCP”)
2. Voluntary Correction Program (“VCP”)
3. Audit Closing Agreement Program (“Audit CAP”)

A proper correction under one of these methods preserves a 401(k) plan’s tax-favored status. Plans that lose their tax-favored or “qualified” status have significant costs that directly affect the plan, its participants, and the plan sponsor’s business.  For more information regarding the tax consequences of plan disqualification, click here.  A tax-favored 401(k) plan will generally lose its tax-favored status if certain “failures” occur, generally meaning that the plan sponsor fails to:

• Maintain a valid, up-to-date plan document, that includes all required provisions,
• Follow the terms of the plan document while operating the plan, and
• Follow the requirements of federal tax laws while operating the plan.

1.  Self-Correction Program (“SCP”)

SCP allows plan sponsors to self-correct many retirement plan errors without contacting the IRS or paying a fee. If an error is eligible for self-correction, there is no application, and the error is not reported to the IRS. However, the plan sponsor must maintain adequate records of the corrective actions taken.

Most corrections under SCP are made to correct “operational errors.” An operational error occurs when the written terms of the plan are not followed. The following are examples of “operational errors:”

• failure to follow the terms of the plan
• excluding eligible participants
• not making contributions promised under the plan terms
• not making distributions correctly under the plan terms
• loan failures

As a first step in determining whether an operational failure is eligible to be corrected under SCP, the plan sponsor must determine whether the error is “significant” or “insignificant.”

Determining Whether Failures are Significant or Insignificant

Significance is determined based on the facts and circumstances. Factors to consider include:

• other failures in the same period (not how many people are affected)
• percentage of plan assets and contributions involved
• number of years it occurred
• participants affected relative to the total number in the plan
• participants affected relative to how many could have been affected
• whether correction was made soon after discovery
• reason for the failure

No single factor is determinative. Failures are not significant just because they occur in more than one year.

Timing for Correction Errors under SCP

An operational error that is determined to be “insignificant” may be self-corrected at any time to preserve the tax-favored status of the plan. However, an operational error that is determined to be “significant” will generally only be eligible for self-correction if corrective action is completed (or in limited circumstances is substantially completed) before the end of the second plan year after the operational failure occurred.

If self-correction of significant operational failures has been completed or substantially completed at the time the IRS notifies a plan that it has been selected for audit, the IRS may allow the self-correction process to continue.  “Substantially completed” generally means that correction has been completed for at least 65% of the participants affected by the mistake, provided that correction for the remaining affected participants is being completed in a diligent manner.

Other Eligibility Requirements for Self-Correction

• The plan sponsor must have established procedures to operate the plan in compliance with the law. A plan document alone is not evidence of established procedures.
• The failure occurred because:
  • an oversight or mistake occurred in applying the plan’s procedures, or
  • the procedures that were in place, while reasonable, weren’t sufficient to prevent the occurrence of the failure.
• In general, correction of an operational error through plan amendment is not permissible under SCP. However, EPCRS allows a corrective amendment under SCP for the following four specific types of failures:

• • failing to limit compensation as required under Code Section 401(a)(17),
  • making hardship distributions to employees under a plan that does not provide for hardship distributions,
  • permitting plan loans to employees under a plan that does not provide for plan loans, and
  • including an otherwise eligible employee in the plan before the employee meets the plan’s age and service requirements or before the employee’s applicable entry date for participation.

Overview of Steps to Self-Correct

1. Make sure that the plan is eligible to self-correct. Is the failure eligible for self-correction, and did the plan have appropriate practices and procedures?
2. Make any necessary corrections to put the participants in the position they would have been in if the error had not occurred.  EPCRS includes general correction principles, as well as examples of reasonable and appropriate self-correction methods that may be used to make the corrections.
3. Adjust the plan’s administrative procedures, if necessary, to make sure the mistake does not happen again.
4. Document the steps taken took to correct the error.  A best practice is to prepare a “self-correction memorandum” which documents how the plan sponsor determined the error was eligible for self-correction, as well as the steps taken to complete the correction.  This self-correction memorandum, including any exhibits demonstrating corrective calculations made, should be provided to the IRS in the event of a plan audit.

Document Failures Not Eligible for Self-Correction

Document failures are not eligible for self-correction. A document failure occurs when the plan document is not up-to-date or the plan document doesn’t fully comply with the tax law.

2.  Voluntary Correction Program (“VCP”)

Generally, any 401(k) plan that is not currently being audited by the IRS can apply under VCP for IRS approval of the correction methods proposed to be used to correct errors in the plan document or its operations that, if not corrected, could result in the plan losing its tax-favored status. To correct an error under VCP, the plan sponsor must mail the IRS a written submission and pay a compliance fee.

VCP allows the plan sponsor to:

• Obtain a written agreement, called a “compliance statement,” showing that the IRS has approved the proposed correction method,
• Bring the plan back into compliance with federal tax law,
• Provide the benefits communicated to employees in the written plan document,
• Protect plan sponsor tax deductions,
• Ensure that participants’ retirement savings continue to accumulate tax-deferred,
• Avoid unfavorable tax consequences that would normally result from the disclosed failures (provided that the plan sponsor timely completes all corrective actions described in the compliance statement),
• Avoid paying the larger audit compliance fees or audit closing agreement sanctions that would apply if the failures are corrected after being discovered in an IRS audit or review of a determination letter application (see Audit CAP below), and
• Request relief from certain federal income or excise taxes associated with some plan errors.

VCP may be used instead of SCP for the following reasons:

• Some failures are not eligible for SCP, such as “significant” failures not corrected by the end of the second plan year after the operational failure occurred.
• Plan sponsors may prefer the comfort of a written IRS approval even for failures that are eligible for SCP.
• A VCP submission may ask the IRS to waive certain excise taxes or certain additional income taxes that a plan sponsor or participant would be liable for because of either a failure or a correction method being applied. This type of tax relief is not available under SCP.

Under VCP, the plan sponsor generally must fully correct the failure for all years (not just the last three or four years). Usually this means that the plan and the participants must be placed in the same position they would have been in if the failure had not occurred.

Example: The plan sponsor did not make a contribution required by the plan document. Full correction would be to make the required contribution, plus an additional amount to reflect the lost earnings during the period from the date the contribution should have been made through the date the corrective contribution is made.

Overview of Steps to Correct Using VCP

1. Review the plan document and operations to determine what failures have occurred
2. Prepare a VCP submission using the prescribed IRS forms and guidelines.  See below for details regarding the items which must be included in a VCP submission.
3. Voluntarily report the failures in the VCP submission filed with the IRS, by describing the failures and the methods that will be used both to correct the failures and to prevent them from happening again.  EPCRS provides general guidance on how failures should be corrected and includes details on some applicable correction methods.
4. Pay the applicable compliance fee.
5. The IRS review is limited to the failures and correction methods that are identified in the VCP submission.  The IRS will not look for failures not described in the VCP submission.  Except under unusual circumstances, the IRS will not audit the 401(k) plan while the IRS is considering the VCP submission.
6. If the IRS needs more information, the IRS will contact the plan sponsor or its representative to ask for the required information.
7. Failures may be corrected before or after the submission is filed. The compliance statement will include a 150-day deadline by which corrective actions must be completed. Note that if failures are corrected before the VCP submission is filed with the IRS, the plan sponsor may have to undo the correction if the IRS does not approve the method used.
8. If the VCP submission includes all of the necessary information and the IRS approves the proposed corrections, the IRS will issue a compliance statement in which the IRS will state that, if the plan sponsor completes the approved corrections within 150 days, the IRS will generally not seek to disqualify the plan because of the disclosed failures.
9. If the IRS does not approve the proposed correction methods, the IRS will work with the plan sponsor and its representative to find an acceptable correction.  Once a correction is agreed on, the IRS will issue a compliance statement to the plan sponsor. The compliance statement is the IRS agreement not to disqualify the plan because of the failures that have been reported and corrected. The compliance statement does not protect the plan from the effects of other failures that may be discovered by the IRS during an audit during review of a determination letter application.
10. Keep the compliance statement issued by the IRS and documentation proving that the corrections were completed before the deadline, and store the documentation with the permanent plan records. The plan sponsor may need to produce a copy if the plan is audited.

Note:  Although it is not common, it is possible that the IRS and plan sponsor will not be able to agree on a reasonable and appropriate correction.  In that event, the IRS will not issue a compliance statement, and the compliance fee paid by the plan sponsor will generally not be refunded.

Items and Information Included in a VCP Submission

As noted above, to request approval of a correction under VCP, a VCP submission must be mailed to the IRS. It is common for legal counsel to assist a plan sponsor in completing and filing the VCP submission.  The submission generally includes the following:

1. Forms 8950 (Application for VCP) and 8951 (Compliance Fee)
2. A document that includes:

• • A description of the failures to be corrected,
  • A description of the corrective actions that the sponsor proposes to take, and
  • A description of the changes in its administrative procedures that the plan sponsor will adopt to prevent the failures from happening again.

3. A compliance fee:  The compliance fee for a VCP application is typically based on the number of participants in the plan, ranging from $750 for plans with 20 or fewer participants to $25,000 for plans with over 10,000 participants. The VCP compliance fee is designed to be lower than the cost of plan disqualification or Audit CAP sanctions (see below). Some submissions are eligible for discounts, depending on the type of failures involved and how many participants were affected. The Form 8951 describes the general compliance fee schedule, as well as the circumstances under which a reduced compliance fee may apply.
4. Various other documents specifically required under EPCRS.  The EPCRS Revenue Procedure states what the submission must contain, how it should be organized, and where it should be mailed.
5. Model submission documents – The IRS has created model documents that prompt the plan sponsor for all the necessary information, including descriptions of the failures, corrections, and changes in administrative procedures. It is recommended that the model documents be used for a VCP submission, including the following:

• • Form 14568, Appendix C – Part I – Model VCP Submission Compliance Statement – this can be used to report any failure.
  • Forms 14568-A, B, C, D, E, F, G, H, and I – these can be used to report some very specific common failures.
  • IRS Letter 5265 – Acknowledgement Letter – if the Acknowledgement Letter is included in the VCP submission, the IRS will mail the letter to the address indicated to inform the plan sponsor or its representative that the VCP submission has been received and the VCP case number assigned to it.

3.  Audit Closing Agreement Program (“Audit CAP”)

A plan sponsor that does not come forward to the IRS, but that instead is discovered through an audit to have significant problems in its plan, can (under Audit CAP) preserve the tax benefits associated with properly maintained retirement plans. Under this program, the plan sponsor pays a sanction that is based on the tax the IRS could collect for open tax years upon plan disqualification.  The sanction imposed will bear a relationship to the nature, extent and severity of the failure, taking into account the extent to which correction occurred before audit, but the sanction will likely be significantly greater than the VCP compliance fee would have been.

Generally, under Audit CAP, the plan sponsor or the plan is under examination and the plan sponsor:

• enters into a Closing Agreement with the IRS;
• completes the correction prior to entering into the Closing Agreement; and
• pays a sanction negotiated with the IRS.