Fixing Common Plan Mistakes - Correction for Exclusion of Employees for Elective Contributions or After-Tax Employee Contributions
A plan must specify how an employee becomes a participant. In other words, what are the plan’s eligibility conditions? IRC §§401(a)(3) and 410(a) establish minimum standards relating to age and service requirements for eligibility purposes. Failure to timely include all eligible employees in a qualified plan will cause the plan to lose its tax-qualified status.
If an employee is improperly excluded from a profit-sharing plan, they miss out on any contributions made (with earnings) during the period of exclusion. Calculating the amount that the employee lost in this situation is simple. The allocations of any plan contributions during the exclusion years are recalculated by including the excluded participant and are adjusted for lost earnings. When a plan allows elective contributions or after-tax employee contributions in a 401(k)/(m) arrangement, the calculation of the loss suffered by the excluded employee becomes more complex. When an employee misses the chance to make a deferral or after-tax contribution, the dollars that would have been contributed are still in the possession of the employee. The affected employee has lost the opportunity to put a certain amount of money into a tax-favored account.
Improperly excluding an employee from making elective contributions or after-tax employee contributions will cause a plan to become disqualified, resulting in adverse tax consequences to the employer and employees under the plan; however, employers may get relief from these adverse consequences through the Employee Plans Compliance Resolution System (EPCRS) by correcting the failures. The Voluntary Correction Program (VCP) and the Self-Correction Program (SCP) can be used to correct these mistakes.
Prior to the issuance of Revenue Procedure 2006-27, the correction for excluding an otherwise eligible employee from making deferrals or after-tax employee contributions into a 401(k)/(m) plan was for the employer to contribute both:
A Qualified Non-Elective Contribution (QNEC) equal to the average deferral percentage (ADP) for the class of the excluded employee (either Highly Compensated Employee (HCE) or Nonhighly Compensated Employee (NHCE)) times the employee’s compensation during the period of the failure, and
An additional QNEC equal to the average contribution percentage (ACP) for the class of the excluded employee (NHCE or HCE) times the employee’s compensation during the period of the failure.
The above amounts would be adjusted for earnings. The average deferral percentage, or ADP, is determined by averaging the deferral percentages separately calculated for the eligible employees in the §401(k) arrangement. A QNEC is a contribution made by an employer that meets certain vesting, distribution and nondiscrimination requirements.
It can be argued that this correction creates something of a “windfall” for affected employees because under the ADP portion of the correction the employee receives both the corrective contribution and the cash compensation upon which the QNEC is made.
Revenue Procedure 2006-27 introduced a new optional correction method based on the principle that the employer should contribute to the plan on behalf of the excluded employee an amount that measures the value of the “lost opportunity” to the employee to have a portion of his or her compensation contributed to the plan. This correction principle applies solely to this limited circumstance. It does not, for example, extend to the correction of:
A failure to satisfy a nondiscrimination test, e.g., the ADP test pursuant to §401(k)(3) and the ACP test pursuant to §401(m)(2).
§414(v) catch-up contributions or Roth contributions.
The method of correction cannot be used until after the correction of other qualification failures. Thus, for example, if in addition to the failure of excluding an eligible employee, the plan also failed the ADP or ACP test, the correction method described cannot be used until after correction of the ADP or ACP test failures.
The new correction for a failure to include an eligible employee in a 401(k) plan is based on the “lost opportunity cost” to make deferrals. For salary deferrals, the required make-up payment is 50 percent of the pre-tax deferrals the employee would have made had the employee been timely included in the plan. This is based on the employee’s compensation times the ADP of the employee’s class (NHCE or HCE). The matching contribution for the excluded employee equals the matching contribution that would have been received had the employee made pre-tax deferrals. However, the corrective matching contribution is based on the full amount of deferrals (ADP) and not the 50 percent lost opportunity cost applicable to employee deferrals. Similar correction rules apply to safe harbor 401(k) plans. However, in calculating the correction amount the plan must apply its safe harbor formula rather than the ADP amounts for the applicable class of employees.
Example: A NHCE has compensation of $40,000 and is incorrectly excluded for a full year from a plan that provides a match equal to 100 percent of the first 3 percent of compensation. The plan has a NHCE ADP equal to 5 percent. The QNEC for lost opportunity cost to make deferrals is $1,000 ($40,000 x 5% x 50%). The QNEC for the matching contribution is $1,200 ($40,000 x 3%).
The correction for after-tax contributions is based on a different “lost opportunity cost” - namely, 40 percent of the after-tax contributions the employee would have made had the employee been timely included in the plan. This amount is based on the employee’s compensation times the ACP for the employee’s class (NHCE or HCE). The applicable ACP in this calculation may be limited to the portion of the ACP that is attributable to after-tax employee contributions (excluding matching contributions).
Making Sure It Doesn’t Happen Again
Employers need to have a system in place to ensure that employees are allowed entry into the plan according to the terms of the written plan. Employers should work with plan administrators to ensure that the administrators have sufficient employee data to calculate the proper entry date and rate of deferrals desired by the employee.
However, keep in mind that, despite all of your good efforts, mistakes can happen. In that case, the IRS can help you correct the problem and retain the benefits of your qualified plan.