The 401(k) plan you offer your employees is valuable to them and you because it allows money to be saved for retirement tax-free until your employee receives it. Your plan can provide these tax benefits because it satisfies the qualification requirements of federal tax law.
Those requirements are complex and it is easy to make mistakes. Even simple mistakes, such as failing to timely update the plan document for recent law changes or incorrectly allocating contributions to accounts, can put your plan at risk of losing its qualified status.
What Happens if the IRS Discovers Mistakes with My Plan?
In theory, the IRS could disqualify your plan if it discovers qualification violations. Disqualification would almost certainly lead you to dissolve your plan because of the immediate tax consequences to your employees, the plan's trust and your business.
Recognizing that disqualification destroys the ability of a plan to provide retirement benefits, the IRS has established an Employee Plans Compliance Resolution System, which has three methods to address errors in your plan:
- Audit Closing Agreement Program (Audit CAP)
- Self-Correction Program (SCP)
- Voluntary Correction Program (VCP)
Correcting Under Audit CAP
Under Audit CAP, the IRS will re-qualify your plan if you:
- Fix the problems the IRS has discovered.
- Pay a sanction to the IRS.
- Enter into a closing agreement.
Fixing mistakes generally means adjusting the accounts of plan participants or plan distributions so that there are no consequences resulting from the errors.
For certain types of mistakes, the Audit CAP sanction is a fixed amount that ranges from $2,500 to $80,000, depending on the number of participants and the particular violation. For other kinds of errors, the sanction is negotiated based on a reasonable percentage (in light of the nature and severity of the failures) of the total amount of taxes that would be due if the plan were disqualified.
While correction under Audit CAP can be expensive, it is almost always better than actual disqualification of the plan. Disqualification could severely damage employee relations and may leave your business vulnerable to lawsuits by disgruntled employees.
Luckily, you can avoid the sanction expense of Audit CAP if you catch and promptly fix errors with your plan.
Correcting Under SCP
The least costly method of correction is SCP. There is no sanction to pay and no filing to make. The only cost of this method is the correction expense of restoring the position of participants in the plan. This program is available only for failures in the operation of the plan, such as including an ineligible employee in your plan. SCP is not available to correct mistakes in your plan documents. Most operational failures can be corrected under SCP, but not all errors are created equal.
Different rules apply to operational failures that are considered "insignificant" and those that are considered "significant." Factors that determine the classification of an operational failure include the number of years the failure occurred and the percentage of plan assets, contributions and participants involved. Errors deemed "egregious" cannot be corrected by using SCP.
To use SCP, you fix the mistakes. The IRS provides examples to follow for many types of errors. Insignificant violations can be corrected by using SCP at any time, even after the IRS discovers the error. Significant mistakes you discover can be corrected under SCP if you substantially correct those errors during a limited period (generally the last day of the plan year following the year in which the error occurred). SCP is not available for significant errors discovered by the IRS before correction.
Correcting Under VCP
To fix mistakes not covered by SCP, you can usually use VCP if you catch the errors before coming under review by the IRS.
Use of VCP requires IRS approval. You obtain approval by submitting a properly completed request to the IRS and paying a compliance fee. The fee ranges from $750 to $25,000, depending on the number of participants in your plan. In some cases, it may be necessary to include an application for a determination letter on your plan with the VCP filing.
By using VCP, your business pays a significantly smaller fee than under Audit CAP to address problems with your plan.
Conclusion
Your business can save money by paying attention to the administration and operation of your plan. It is less costly to promptly correct mistakes that are discovered. Due to the complexity of the rules applicable to your plan and the details that are involved in using the IRS Employee Plans Compliance Resolution System, you will want to discuss any errors you discover with your employee benefits lawyer or other plan advisor.