Qualified Retirement Plans and Missed Deadlines

On May 23, 2022, the IRS issued an Employee Plans Newsletter that appears to soften the consequences when an employer misses a deadline for restating its qualified retirement plan.  This Employee Plans Newsletter raises a number of questions.

What is an Employee Plans Newsletter?

An Employee Plans Newsletter is a regular publication of the IRS that provides information about qualified retirement plans.  It is directed to attorneys, accountants, actuaries and other practitioners who deal with qualified retirement plans.  While a publication of the IRS, it is not an official statement of the law regarding qualified retirement plans.  It is simply an indication of where the IRS stands on certain issues related to the administration of qualified retirement plans as of the date of the Employee Plans Newsletter.

What is a Qualified Retirement Plan?

A qualified retirement plan is a program sponsored by an employer to provide retirement benefits to its employees.  There are essentially two types of qualified retirement plans.  The first is a defined benefit plan, better known as a pension plan.  A defined benefit plan provides an eligible employee with a predetermined benefit at retirement based on a formula in the plan documents.  The formula can be based on a combination of age, service and income during employment.  The benefit is generally expressed as a monthly payment commencing at retirement and lasting for the life of the employee or the joint life of the employee and spouse.  An employer that adopts a defined benefit plan is required to make annual contributions to the plan in an amount sufficient to provide the plan’s defined benefit for each eligible employee at retirement.  The amount of an employer’s annual contribution may vary from year to year depending upon the investment performance of the plan’s assets.  Defined benefit plans are the most expensive type of qualified retirement plan for an employer but also provide the largest retirement benefit for the employee.

The second type of qualified retirement plan is a defined contribution plan.  The best known defined contribution plan is the 401(k) plan.  A defined contribution plan provides for annual additions to an employee’s account.  The retirement benefit provided to the employee upon retirement depends solely on the investment performance of the assets in the employee’s account.  In a defined contribution plan, the employer has made no promise to the employee of a certain retirement benefit.  Contributions to the employee’s account can come in the form of elective deferrals made by the employee.  An employee who elects to contribute to their account defers a percentage of their salary each pay period.  Contributions can also be made by the employer.  However, even where the employer elects to make contributions to the employee’s account, the employer has made no guarantee of any particular benefit to the employee.

There are a number of advantages to a qualified retirement plan.  The most obvious is that a qualified retirement plan provides a stream of income to an employee when it is time for the employee to stop working.  There are also tax advantages to a qualified retirement plan.  Contributions, whether through employee-deferrals or made by the employer, are generally tax-deductible.  In addition, the assets of a qualified retirement plan grow tax-free.  Income tax is not paid by an employee until the time of distribution.  However, in order to qualify for these tax advantages, a retirement plan must satisfy the requirements of section 401(a) of the Internal Revenue Code and obtain a determination letter from the IRS.  That is where the word “qualified” in the name “qualified retirement plan” comes from.

How Does a Retirement Plan Become Qualified?

In order to become qualified, the plan documents must pass IRS inspection.  The IRS reviews a plan’s documents to ensure that its form and provisions comply with the requirements of section 401(a).  If the IRS finds that the plan fully complies with the law, it issues a determination letter.  There are two ways that a plan can pass IRS muster.  The first is if the plan is a pre-approved plan.  The second is if the plan is an individually-designed plan.

What is a Pre-Approved Plan?

A pre-approved plan is a plan that uses plan documents that have already been approved by the IRS.  Pre-approved plan documents are drafted by a third-party, retirement plan specialist.  For example, RMC has access to pre-approved plan documents.  The third-party service provider will have submitted its plan documents to the IRS for review and received a determination letter confirming that the plan documents comply with the requirements of section 401(a).  It will then offer its plan documents for purchase to unrelated employers.

An employer adopts the third-party service provider’s plan documents, as written, by signing an Adoption Agreement.  Because the employer adopts plan documents that have already been approved by the IRS, the employer does not have to submit its plan to the IRS for review and obtain a separate determination letter directed to the employer.  The employer essentially borrows the third-party service provider’s determination letter and, as a result, is deemed to have a qualified retirement plan.

What is an Individually-Designed Plan?

An individually-designed plan is exactly what it sounds like.  It uses plan documents that have been written specifically for the sponsoring employer and have not been previously submitted to the IRS for review.  The employer’s plan must be submitted to the IRS for review and approval.  The IRS reviews the plan documents to make sure that the form and provisions of the plan documents comply with the requirements of section 401(a).

If the IRS finds that the plan documents satisfy the requirements of section 401(a), it will issue a determination letter to the plan.  The determination letter assures the employer that its plan will provide the desired tax advantages of a qualified retirement plan.  If the IRS finds that the plan documents do not satisfy the requirements of section 401(a), a give-and-take ensues between the employer and the IRS, and the employer will have to make changes to the plan documents to satisfy the IRS.

What are Restatements?

The third-party service provider of a pre-approved plan is required to update its plan documents and obtain a new determination letter from the IRS every six years to keep up with any changes in the law since the plan documents were first reviewed and approved by the IRS.  An employer that has adopted a pre-approved plan then has two years to adopt the amended plan documents.  This process is called a “restatement”.

The time period by which a pre-approved plan has to be restated depends upon the type of plan.  There are different time periods for defined benefit plans, defined contribution plans and 403(b) annuity plans.  Each such time period is called a “cycle”.

The most recent cycle for pre-approved 401(k) plans ended July 31, 2022.  This means that an employer that adopted a pre-approved 401(k) plan was required to execute a restatement of its plan by adopting the third-party service provider’s updated plan documents on or before July 31, 2022.  An employer that failed to adopt the third-party service provider’s restated plan documents by July 31, 2022, missed the deadline and has to take corrective action.

What Happens If an Employer Missed the Deadline?

If an employer fails to adopt the most-recent version of the third-party service provider’s pre-approved plan, the employer no longer has a pre-approved plan.  That means that the determination letter issued to the third-party service provider no longer covers the employer’s plan.  It was thought that the position of the IRS was that, under these circumstances, the employer’s plan was no longer “qualified” and was no longer eligible for the tax advantages of a qualified retirement plan.  That was until the IRS issued its Employee Plans Newsletter on May 23, 2022.

In the Employee Plans Newsletter, the IRS said that an employer that misses the deadline to restate its pre-approved plan will not necessarily lose its qualified status.  The adoption of a pre-approved plan is only one way in which a plan can attain qualified status.  The other is as an individually-approved plan.  So, the IRS said that, when a plan loses its status as a pre-approved plan, it becomes an individually-designed plan and can reacquire its qualified status by submitting the plan documents to the IRS for review and approval as an individually-designed plan.

The failure to qualify as a pre-approved plan is not a qualification issue.  Being a pre-approved plan is one method of meeting the requirement to have an updated written plan document.  If the employer who sponsors a plan does not timely adopt a current pre-approved plan, it can still meet the written document requirements as an individually designed plan.

So, Now You Have an Individually-Designed Plan, What Comes Next?

The employer should first contact a retirement plan specialist to help the employer determine whether the employer’s plan is defective in any manner.  The retirement plan specialist will review the employer’s plan documents to spot whether any provisions are contrary to current law and whether any amendments to the plan documents are needed.  A retirement plan specialist can also help the employer navigate the IRS’ Employee Plans Compliance Resolution System (EPCRS) to preserve the plan’s qualified status.

What is the Employee Plans Compliance Resolution System?

The Employee Plans Compliance Resolution System is a program offered by the IRS that enables an employer to fix issues with its plan and avoid the adverse consequences of plan disqualification.  As alluded to above, upon disqualification, a plan loses its tax advantages.  This means that contributions to the plan are no longer tax-deductible, and the investment gains within the plan are no longer tax-deferred.  So, an employer will want to avoid plan disqualification at any cost.

The EPCRS program has three ways to correct mistakes:

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

What is the Self-Correction Program?

The Self-Correction Program is the least painful of the corrective measures that an employer can take to fix a mistake.  It is available when an employer has an “insignificant operational error” that has existed for less than three years.  It is unclear whether plan document failures are eligible for the SCP.  The IRS website says both that certain plan document failures may be eligible for self-correction and that “(p)lan document failures, including late plan amendments, aren’t eligible for self-correction”.  As a result, an employer that has failed to adopt the updated version of a pre-approved plan by the July 31, 2022, deadline may be best-advised to use the Voluntary Correction Program, which is discussed below, instead of the SCP.

In the SCP, the employer simply corrects any mistakes.  It does not require any filing with the IRS or the payment of any fee.  This is why it is the least painful.  However, it is also the least comforting.  The IRS does not review or approve the corrections made by the employer.  If the employer’s plan is ever audited, the employer may find that the changes made through the SCP were inadequate, and the plan may face disqualification anyway.

What is the Voluntary Correction Program?

The Voluntary Correction Program is the next level of the EPCRS.  It can be used to correct both operational mistakes and plan document failures, such as the failure to adopt an updated pre-approved plan document by the deadline.  In order to use the VCP, a plan must not be currently under IRS audit.

A plan sponsor begins the VCP by sending a written submission to the IRS and paying the user fee.  The written submission details the errors in either the plan’s operation or the plan’s documents and describes the proposed corrections.  The IRS will review the plan sponsor’s submission, and, if the IRS determines that the proposed changes are sufficient to bring the plan into compliance, it will enter into an agreement with the employer, called a compliance statement, showing that the IRS has approved the employer’s proposed changes.  A successful VCP will preserve the plan’s qualified status and provide comfort in the event that the plan is subsequently audited.

What is the Audit Closing Agreement Program?

The Audit Closing Agreement Program is used by an employer that either has not discovered plan defects or chooses to not correct the defects whether through the SCP or the VCP.  It is available to a plan that is under audit and for significant problems that are discovered by the IRS during the course of the audit.

Under the Audit CAP, an employer can agree to correct the problems discovered by the IRS during the examination.  The employer will be required to enter into a Closing Agreement with the IRS and pay a sanction negotiated with the IRS.  The sanction will be more than the user fee of the VCP, but, according to the IRS, “it will not be excessive and will bear a reasonable relationship to the nature, extent, and severity of the failures”.  Given that most taxpayers probably have a different understanding of the term “excessive” than the IRS, plan sponsors should try to avoid examination and resolve any plan defects through either the SCP or the VCP.

The IRS Recently Announced a 90-Day Pre-Examination Compliance Program

There is good news for an employer that failed to take advantage of either the SCP or the VCP.  In an Employee Plans Newsletter dated June 3, 2020, the IRS announced a 90-Day Pre-Examination Compliance Pilot program.  This program is available to employers that receive a letter from the IRS informing them that their plan has been selected for audit.

The letter will give the plan sponsor a 90-day period to review its plan documents and operations and determine whether there are any defects or failures.  The plan sponsor can then use the 90-day period to correct any defects or failures, contact the IRS to disclose the defects and failures and detail the corrections made by the plan sponsor.  If the IRS finds that the plan sponsor has addressed the defects and failures, it will issue a closing letter to the employer.  Otherwise, it may pursue an examination.  An employer that takes no action within this 90-day period will be subject to examination.

This pilot program essentially provides a lifeline to a plan sponsor that failed to take advantage of the SCP or the VCP before receiving an audit letter.  It opens up a VCP-like program to the plan sponsor even after the plan sponsor has received notice of an audit.

The Employee Plans Newsletter says that the IRS will evaluate the pilot program to determine whether it should be made permanent.  It does not say how long the pilot program will last.

The Moral of the Story

The moral of the story, like any blog about qualified retirement plans, is that, while they provide tremendous advantages to both employers and employees, they are complicated and contain many pitfalls.  That is why it is imperative that an employer that sponsors a qualified retirement plan or one that is thinking about whether to adopt a qualified retirement plan consult independent, skilled and experienced retirement plan specialists.