EMPLOYEE BENEFIT PLANS

January 2000

SELF-CORRECTION OF QUALIFIED PLANS WITHOUT IRS APPROVAL

By J. Michael Bermensolo, Esq., Geller & Wind, Ltd.

Under the Administrative Policy Regarding Self-Correction program (APRSC) as set forth in Revenue Procedures 98-22 and 99-31, a qualified plan sponsor is now permitted to self-correct certain failures in the operation of its plan without IRS approval and without payment of a monetary sanction. An "operational failure" arises solely from failure to follow the plan's provisions (e.g., the failure of a 401(k) plan to pass the ADP test because its terms were not followed).

Implementation

APRSC does not cover plan document failures, demographic defects, egregious failures (a pattern of multiple operational failures), or the misuse of plan assets. A "plan document failure" is a plan provision (or the absence of a plan provision) that, on its face, violates IRC qualification requirements [e.g., the failure of a plan to be amended to reflect new qualification requirements (such as those specified in the Tax Reform Act of 1986) within the remedial amendment period]. A "demographic failure" arises when a plan fails to satisfy the IRC's nondiscrimination, participation, and coverage requirements (e.g., excluding otherwise eligible employees and failing the plan's minimum coverage test).

Under APRSC, a plan sponsor that has established compliance practices and procedures may correct "insignificant" operational failures at any time. Factors to consider when determining whether an operational failure is significant or insignificant include, but are not limited to, the following:

* Whether the failure occurred during the period being examined;
* The percentage of assets or contributions affected;
* The number of years involved;
* The percentage of plan participants that are, or could be, affected;
* Whether the correction was made within a reasonable time after its discovery; and
* The reason for the failure (i.e., erroneous transcription of data, transposition of data, transposition of numbers, or faulty arithmetic).

A plan sponsor may also correct significant operational failures provided the plan has received a favorable determination letter from the IRS. Generally, a plan sponsor with a favorable IRS letter may correct significant operational failures within the two-year period following the year in which the failure occurred. This two-year correction period may be extended for an additional 90 days if the operational failure with respect to 85% of the affected participants has been corrected in a diligent manner. However, such a correction period will end if the plan sponsor is notified that the IRS is auditing the plan. Finally, the plan sponsor must make full correction of all operational failures for all years for which operational failures exist.

Under APRSC, no fees or sanctions are assessed; correction of an operational failure is all that is required from a plan sponsor. Because the IRS is not notified, the possibility of triggering an audit is greatly reduced. However, with APRSC, the IRS neither approves in advance the correction method used nor issues a letter providing reliance to the plan sponsor.

The rules for determining whether or not an operational failure is significant are not bright-line rules. Thus, under APRSC, a plan sponsor could correct an assumed insignificant operational failure only to have the IRS subsequently deem the failure significant. It is not known whether the IRS will treat such a failure as an operational failure discovered during an audit, with all of the attendant fees and sanctions.

Conclusion

The APRSC is an ideal program for correcting certain types of relatively minor or generic operational failures, as described in Revenue Procedures 98-22 and 99-31.

If there is a question as to whether an operational failure is insignificant, it may be prudent for the plan sponsor to apply to the IRS under the Voluntary Compliance Resolution (VCR) program for a favorable letter of determination. The plan sponsor would pay the required fees and sanctions in order to gain reliance that an operational failure would be properly corrected under the VCR program.

It is expected that the IRS will provide additional guidance in the near future to help plan sponsors make a proper determination of an operational failure and take the corrective measures necessary to preserve tax-favored qualification and tax exemption. *