EP Exam Projects - LESE Projects - Project #17 - Results of Examinations of Plans with Self-Employed Individuals

Overview:

The reason for this project was to obtain a snapshot view of qualified plans where the Form 5500 noted the plan covered self-employed individuals and the employer cash contribution was greater than or equal to $20,000. One goal of this project was to give an indication of potential problem areas involving plans covering self-employed individuals.

This project commenced late in 2008 and utilized the focused examination concept to perform our examinations. As such, the pre-identified issues required to be considered were 1) Plan Qualification - Compliance with current tax law in form; 2) Allocation or Accruals; and 3) Deductions. Under the focused examination concept upon which the examination was performed, the scope of the examination required the agent to determine compliance in three pre-identified areas. However, the agent had the discretion to expand their examination beyond the three pre-identified areas to any other areas based on their independent judgment as they deem warranted.

An initial sample of 49 plans (Form 5500 returns) was examined. Due to issues discovered, agents picked-up an additional 14 Form 5500 returns (either subsequent plan years or related plans) and three Form 5330 returns (minimum funding). We also pursued two Form 1040 income tax adjustments due to failure to make timely contributions to the plan.

Project Results/Findings:

The most common plan errors noted during this project were 1) inadequate or insufficient fidelity bonding and 2) improper allocations (contributions and/or forfeitures).

• Inadequate or insufficient bonding: Fourteen plans failed to provide adequate bonding of plan fiduciaries and persons who handle pension funds. In fact, inadequate bonding was the sole failure discovered in eight of the plans examined.
  
  Title I of ERISA §412 requires qualified plans to be bonded, unless one of the limited exceptions is met. The amount of bonding should not be less than ten percent of the amount of funds handled, but in no event less than $1,000, nor more than $500,000. However, with respect to a plan that holds employer securities, the upper level of the amount of bonding is increased from $500,000 to $1,000,000.
  
  
• Allocation Errors: There were five plans that involved operational errors related to the allocations of employer contributions and/or forfeitures.
  
  Four plans involved allocation failures due to failure to use the correct definition of compensation as defined in the plan document. Underlying causes included two instances of improper calculation of the owner’s self-employment (SE) income, failure to properly include IRC §125 compensation as part of total plan compensation, and another compensation error. In addition to the compensation errors, one of these plans also failed to make the allocation pursuant to the plan’s allocation formula. It is important to know the plan terms and ensure that plan administrators, including third party administrators, have the most current copy of the plan document.
  
  The two instances above pertaining to improper calculation of an owner’s self-employment (SE) income involved errors relating to the earned income calculation, resulting in an improper allocation of both employer contributions and forfeitures (contrary to plan terms). For plans that cover self-employed individuals, as defined in IRC §401(c), allocations made to self-employed individuals must be based on their “earned income”, as defined in IRC §401(c)(2). It is important to calculate the self-employed individual’s earned income correctly for purposes of applying the plan’s allocation formula.
  
  Another error involved the failure to allocate forfeitures within the correct plan year. Plan administrators need to be aware of plan terms and adhere not only to the method specified when allocating forfeitures, but also the timing of the allocations. It is not permissible to maintain a “ suspense account” with amounts attributable to forfeitures retained from one year to the next. Refer to the plan terms for the specific provisions relating to the timing and the allocation of plan forfeitures. For further detail, refer to IRC §414(i) and Revenue Ruling 80-155.

Less common non-compliance issues found include:

• Late Deposit of Employee Deferrals (IRC §401(k) plans): This involved the failure to remit elective deferrals to the trust as soon as administratively feasible, as required by the DOL regulations. The employer is responsible for contributing to the trust the amounts of the elective deferrals made by plan participants. If the employer does not make the deposits timely, the failure may constitute both an operational mistake, leading to plan disqualification (if the plan specifies a date by which the employer must deposit elective deferrals), as well as a prohibited transaction (subject to excise tax under IRC §4975). Refer to the 401(k) Plan Checklist (Publication 4531), Item #8 for details on how to find, fix and avoid this error.
  
  You may correct failures to follow the terms of the plan document under the IRS Employee Plans Compliance Resolution Program (EPCRS). Correction of a prohibited transaction is not one of the correctable mistakes under EPCRS. However, the Department of Labor’s Employee Benefits Security Administration maintains a Voluntary Fiduciary Correction Program (VFCP) which may be able to resolve this specific prohibited transaction.
  
  
• Participation or Eligibility Failures: Eligibility failures occurred due to failure to cover or inform employees in a timely manner that they were eligible to participate, as provided per plan terms. Errors involved the failure to include eligible employee(s) as covered participants and failure to inform certain eligible employees of their right to make elective deferrals. Refer to the explanation and tips contained in the 401(k) Plan Checklist (Publication 4531), Item #6.
  
  
• Minimum Funding:  A definite employer contribution and allocation to eligible plan participants are required in money purchase plans. It is important to follow plan terms when making employer contributions as required by the plan’s contribution formula. Failure to make the proper contribution will result in failure to follow plan terms, as well as potential excise tax under IRC §4971(a), depending on tax years involved.
  
  
• Late or Non-Amenders:  Examiners found the failure to timely amend their plan to comply with IRC §401(a)(31)(B), which pertains to the automatic rollover provisions. This law change, effective for distributions made on or after March 25, 2005, applies to employer-initiated mandatory distributions (that would otherwise qualify as eligible rollovers) of more than $1,000. This law change provides that the distribution must be paid as a direct rollover to an IRA if the participant does not make an affirmative election to do otherwise.  For additional guidance related to IRC §401(a)(31)(B), refer to the Q&As contained in Notice 2005-5.
  
  
• Trust Assets Title Failure: This issue involved the failure to ensure that trust assets were properly titled in the name of the trust, not another entity. For example, it is not permissible to maintain a trust checking account in the name of the employer. It is important that all applicable trust assets be held in the name of the trust, not another entity such as the individual or employer.
  
  
• Top-Heavy (IRC §416) Violation:  It is important for the plan administrator to properly test and recognize when a plan becomes top-heavy, especially in small plans. At that time, certain minimum vesting and minimum contribution requirements kick in.
  
  Proper plan administration should have practices and procedures in place to determine annually whether the plan is top-heavy, and then ensure that all participants receive the top-heavy minimum. Refer to LESE Project #4 for additional detail regarding top-heavy plans.
  
  
• Minimum Distribution (IRC §401(a)(9)) Failure:  Plans are statutorily required to make certain minimum distributions to terminated participants after they attain age 70 ½, as provided under IRC §401(a)(9). For additional guidance, refer to A Guide to Common Qualification Plan Requirements, #11.
  
  
• IRC §401(k) Safe Harbor Notice Failure: Plans subject to the IRC §401(k)(12) safe harbor provisions are required, as one component of this arrangement, to timely provide a safe harbor notice.
  
  
• Vesting Error:  Plans are required to make distributions to participants by properly applying the applicable vesting requirements contained within the plan document. It is important to calculate the vested percentage that each participant is entitled to based on plan terms and the employee’s entire service. It is important to calculate each participant’s credited years of service based on his or her entire employment history, including service prior to re-hire dates.
  
  
• Directed investments error:  Plans may provide that participants may direct their own plan investments. Review the plan and/or trust documents to ensure the plan allows directed investments. Otherwise, the plan will fail to operate in accordance with plan terms, which is a qualification requirement.
   
• ADP Testing Errors: IRC §401(k) plans are normally subject to the Actual Deferral Percentage (ADP) tests with respect to IRC §401(k) elective deferrals made to the plan. Common errors include failing to include all eligible employees in the test (in particular those eligible who made $0 deferrals), as well not using the proper definition of compensation (as specified in the plan document) when computing the ADP ratio. Sponsors should correct any excess contributions within 12 months after the end of the plan year.
   
• Deduction Adjustment due to Late Contribution:  In order to be deductible, a contribution made to a qualified plan must be made not later than the due date for filing the employer’s tax return, plus extensions, as required per IRC §404(a)(6). If made late, the contribution is not deductible in that taxable year. For additional rules relating to deductibility, including rules where the plan year and tax year are different, it is recommended that you consult with your pension professional.
  
  
• Excess Deduction:  This involved the failure to reconcile the deduction taken on the plan sponsor’s income tax return with the amount actually contributed to the trust, which could result in a nondeductible excess contribution. Care should be made to reconcile the deduction with the amount contributed to qualified plans, ensure that such contributions were timely made in order to be deductible and verify that any deductions taken were within statutory deductible limits under IRC §404.

Avoiding the Error:

Discuss with your plan administrator or pension professional as to whether the plan is currently up to date with current law changes. Even if up to date, it is important that everyone involved with plan administration be aware of plan provisions. It is important that the plan and trust operate in a manner consistent with the written terms of the plan and trust documents. Setting up operating procedures and appropriate internal controls for the plan is an important first step. If you need help, a benefits professional can help you set up a system that works for you and your retirement plan.

If during a self-audit or other means, you discover that your plan was not operating in accordance with written plan provisions or in accordance with applicable laws and/or regulatory requirements, then you should consider availing yourself of our Employee Plans Compliance Resolution System (EPCRS).