Failing to follow the plan terms in its operation: When can a plan amendment be used to correct a mistake in the operation of the plan under the Self-Correction Program?
EPCRS is a system of correction programs that can be used to correct plan mistakes that, if left uncorrected, could result in a retirement plan losing its tax-favored benefits. EPCRS includes the Self-Correction Program (SCP), where correction can be made without paying a fee or contacting the IRS. SCP is only available for correcting operational failures (i.e., mistakes that are made when terms of the plan are not followed in its operation).
In general, the failure to follow the plan’s terms may be corrected by using one of the following approaches. First, the plan can fix what was done in the plan’s operation by correcting the mistake to match the plan’s terms. Or, the employer may retroactively amend the plan so that its provisions match the way the plan was operated. In general, SCP is only available if correction is made using the first approach. However, in very limited circumstances an operational failure may be corrected by making a plan amendment under SCP. See Rev. Proc. 2018-52, section 4.05.
SCP may be used to correct an operational failure by amending the plan to match the terms of the plan to the plan’s prior operations only for the three operational failures listed in Rev. Proc. 2018-52, Appendix B, section 2.07. The failures that can be corrected by plan amendment in accordance with the correction methods set forth in Appendix B are described as follows:
Maximum Compensation (§401(a)(17)) Failures. A defined contribution plan that allocates contributions or forfeitures based on a participant’s compensation that exceeds the Section 401(a)(17) limit may be corrected by amending the plan. The affected participant’s allocation rate (after taking into account only compensation up to the §401(a)(17) limit) must be recalculated and extra amounts contributed to the other employees. The following example shows how this is done:
Company A maintains a money purchase pension plan. Under the plan, John, an eligible employee, is entitled to an employer contribution of 8% of his compensation up to the §401(a)(17) limit ($220,000 for 2006). During the 2006 plan year, John earned $250,000 and was credited with a contribution in the amount of $20,000 (8% of $250,000). Under the terms of the plan, John’s contribution should have been $17,600 (8% of $220,000). John received $2,400 too much.
Company A may correct the failure by giving extra amounts to eligible employees (other than John) and amending the plan to reflect the higher contribution percentage that was allocated to John. The plan’s corrected contribution percentage (and the additional amount that must be contributed to all other eligible employees) is determined by dividing John’s contribution ($20,000) by the §401(a)(17) limit ($220,000). Therefore, the plan must be amended back to the first day of plan year 2006 to increase the contribution percentage to 9.09% ($20,000/$220,000). In addition, each eligible employee (other than John) receives an extra contribution of 1.09% (9.09% - 8%) multiplied by his/her 2006 compensation. The extra contribution must be adjusted for earnings.
Hardship Distribution and Plan Loan Failures. The operational failure of making hardship distributions or plan loans to employees under a plan that does not allow them may be corrected by retroactively amending the plan to provide for the hardship distributions or plan loans that were already given. The retroactive plan amendment is permissible provided that the plan loans or hardship distributions were mostly made to individuals who were not highly compensated employees, loans were made according to the limits in §72(p), and, in the case of a 401(k) plan, hardship distributions complied with the applicable 401(k) rules relating to hardship distributions.
Early Inclusion of Otherwise Eligible Employee Failures. The operational failure of including an otherwise eligible employee in the plan too early may be corrected by retroactively amending the plan. This would apply to an employee who either (i) has not completed the plan’s minimum age or service requirements, or (ii) has completed the plan’s minimum age or service requirements but became a participant in the plan earlier than the plan entry date. The amendment, permitting the ineligible employee’s inclusion, serves to reflect the plan’s actual operations. In order to be entitled to make this retroactive amendment, employees affected by the amendment should be mainly nonhighly compensated employees.
Making Sure It Doesn’t Happen Again
The failure to operate the plan in accordance with its terms can be prevented by ensuring that all of the parties involved with plan administration are familiar with the plan’s terms. Periodic plan reviews should be performed.
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.