With articles provided by the law firm of Sonnenschein Nath & Rosenthal
August 1999, Vol. I, Issue I
Rev. Proc. 99-31 Provides Model Correction Methods Under EPCRS
By Leslie A. Klein, Esq. and William F. Lee, Esq.
On August 6, 1999, the IRS issued Rev. Proc. 99-31, 1999 I.R.B. 1, which provides model correction methods for use when correcting qualification failures under the Employee Plans Compliance Resolution System ("EPCRS"), as described in Rev. Proc. 98-22, 1998-2, I.R.B. 11. The Revenue Procedure provides model correction methods that are not the exclusive means of correcting qualification failures but may be used to correct certain types of qualification failures. The model correction methods cover:
Rev. Proc. 99-31 also provides earning adjustment methods for making corrective contributions and allocations. Rev. Proc. 99-31 is generally effective January 1, 2000, but a plan sponsor may use any of the model correction methods on or after March 9, 1998 (i.e., the effective date of Rev. Proc. 98-22).
ADP/ACP Failures
An employer may use the "one-to-one correction method" to correct a plan's failure to satisfy the ADP and/or the ACP tests. Under the one-to-one correction method, excess Section 401(k) contributions and matching contributions (adjusted for earnings) are distributed to the highly compensated employees ("HCEs") and the employer is required to make a contribution to the plan in an amount equal to the aggregate amount of the distributions made to the HCEs. The employer's contribution to the plan is required to be allocated to the accounts of the nonhighly compensated employees ("NHCEs"). If an "excess amount" has already been distributed to a HCE, the employer is required to notify the employee that the excess amount is not eligible for the favorable tax treatment accorded to distributions from qualified plans, and must specifically notify the employee that the excess amount is not eligible for tax-free rollover. Correcting ADP/ACP failures under the one-to-one method will generally be less expensive for employers than correcting under the SVP correction method (which requires an employer to make qualified nonelective contributions to the NHCEs).
The Exclusion of Eligible Employees from Participating in Section 401(k) and (m) Plans
For eligible employees who have erroneously been excluded from participating in a Section 401(k) or (m) plan for all or part of a plan year, the employer may correct this failure by making a contribution to the plan in an amount equal to the ADP/ACP for the employee's group (i.e., HCE or NHCE) multiplied by the employee's compensation for the portion of the plan year he or she was excluded from participating in the plan. An employer is permitted to prorate the employee's compensation for the portion of the plan year he or she was improperly excluded. In addition, an employer will not be required to make a corrective contribution for Section 401(k) contributions if the employee has been provided with the opportunity to make Section 401(k) contributions under the plan for at least 9 months during the plan year in which the employee was excluded and during that period the employee had the opportunity to make the maximum amount of Section 401(k) contributions he or she would have been permitted to make under the plan had the failure not occurred.
The Exclusion of Eligible Employees from Receiving an Allocation of Nonelective Contributions to a Profit Sharing or Stock Bonus Plan
An employer may correct a failure associated with the exclusion of eligible employees from nonelective contributions to a profit-sharing plan or a stock bonus plan under either the SVP correction method (which Rev. Proc. 99-31 clarifies) or under the "reallocation correction method." Under the SVP method, the employer is required to make a corrective contribution on behalf of the excluded employee in an amount equal to the same percentage of compensation that was contributed to other employees' accounts. The amount of the contribution must be adjusted for earnings. Under the reallocation correction method, a portion of the employer contribution (adjusted for earnings) that was allocated to the accounts of the included employees is reallocated to the account of the improperly excluded employee. Employers may, however, be reluctant to use the reallocation correction method after the benefit has been communicated to the employees because it creates the appearance that the employer is reducing benefits that have already accrued under the plan.
Improper Forfeitures
In the case of a defined contribution plan's failure to apply the proper vesting percentage to an employee's account that ultimately results in a forfeiture of too large a portion of the employee's account balance, the employer may use the "contribution correction method" or the "reallocation correction method" to correct this failure. These correction methods are similar to the correction methods that may be used to correct a failure associated with excluding eligible employees from a profit sharing plan or a stock bonus plan. Under the "contribution correction method," the employer is required to make a corrective contribution to the employee's account in an amount equal to the improper forfeiture (adjusted for earnings). Under the "reallocation correction method," the accounts of the employees who shared in the allocation of the improper forfeiture are reduced by the forfeiture amount (adjusted for earnings), and this amount is reallocated to the account of the employee whose account incurred the improper forfeiture.
Section 415(b) Failures
There are two model correction methods for correcting Section 415(b) failures. Under the "return of overpayment correction method," the employer must take "reasonable steps" to have the employee return the amount of the Section 415(b) overpayment, plus appropriate interest, to the plan and all future benefit payments, if any, to the employee may not exceed the maximum Section 415(b) limit. To the extent that the full amount of the overpayment is not returned to the plan, the employer or another person must contribute the difference to the plan. Finally, the employer must notify the employee that the overpayment amount is not eligible for the favorable tax treatment accorded distributions from qualified plans, and the employer must specifically notify the employee that the overpayment amount is not eligible for tax-free rollover.
If distributions from the plan are being made in the form of periodic payments, the employer may use the "future payments correction method" to correct a Section 415(b) violation. Under this method, the amounts currently being distributed to the employee must be reduced so that they do not exceed the maximum Section 415(b) limit, and the plan must recoup from future distributions the amount of the Section 415(b) overpayment (plus interest at the rate used by the plan to determine actuarial equivalence). If the employee is receiving payments in the form of a qualified joint and survivor annuity ("QJSA"), any reduction of future payments to recoup a Section 415(b) overpayment may be made from the benefits payable over the lives of the employee and spouse, but any reduction to recoup a Section 415(b) overpayment may not reduce the amount of the spouse's survivor benefit under the QJSA.
Section 415(c) Failures
For Section 415(c) violations, an employer may correct the failure under both the SVP method or the "forfeiture correction method." The forfeiture correction method applies to a NHCE who made Section 401(k) contributions or employee after-tax contributions, has received either matching or nonelective contributions in an amount that equaled or exceeded the Section 415(c) limit and has terminated with no vested interest in the matching and nonelective contributions. Under this method, the Section 415(c) excess is deemed to consist solely of matching and nonelective contributions. If the Section 415(c) excess (adjusted for earnings) has not already been forfeited, it must be placed in an unallocated suspense account to be used to reduce future employer contributions to the plan or, if the amount would have been allocated to other participants in absence of the failure, it must be allocated to the accounts of other participants.
If a Section 415(c) excess was previously distributed to the employee, the employer may use the "overpayment correction method" to correct the failure. This method is similar to "return of overpayment correction method" that may be used to correct Section 415(b) failures. Under the overpayment correction method, the employer must also take "reasonable steps" to have the employee return the overpayment amount (plus appropriate interest) to the plan. To the extent that the amount returned to the plan is less than the overpayment amount (adjusted for earnings at the plan's earnings rate), the employer or another person must contribute the difference to the plan. The overpayment amount must be placed in an unallocated suspense account to be used to reduce future employer contributions to the plan or, if the amount would have been allocated to other participants in absence of the failure, it must be allocated to the accounts of other participants. The employer is also required to notify the employee that the overpayment amount is not eligible for the favorable tax treatment accorded distributions from qualified plans, and must specifically notify the employee that the overpayment is not eligible for tax-free rollover treatment.
Other Overpayment Failures
If a failure involves an overpayment (as defined in the Rev. Proc.) from a defined benefit plan (other than an overpayment attributable to a Section 415(b) excess), the employer may use the correction methods discussed above for Section 415(b) failures. If a failure involves an "overpayment" from a defined contribution plan (other than an overpayment attributable to a Section 415(c) excess), the employer may use the "overpayment correction method" discussed above to correct Section 415(c) excesses.
Section 401(a)(17) Failures
There are two model correction methods for correcting Section 401(a)(17) failures under a defined contribution plan. Under the "reduction of account balance correction method," nonelective contributions (adjusted for earnings) that have been made to an employee's account which takes into account compensation in excess of the Section 401(a)(17) limit is reduced from the account. The reduced amount is used to reduce future employer contributions to the plan (if such amount would not have been allocated to other participants absent the failure) or is allocated to the accounts of other participants (if the reduced amount would have been allocated absent the failure). Under the "contribution correction method," which is only available under Walk-in CAP, the employer contributes an additional amount on behalf of each employee with compensation below the Section 401(a)(17) limit who received an allocation during the year of the failure in an amount sufficient to cause each such employee's contribution as a percentage of his or her compensation to equal the same percentage as the percentage of compensation contributed for the employee having the 401(a)(17) failure (determined with regard to the 401(a)(17) limit). The plan may be amended if necessary to provide for the additional allocation. It is not clear why the IRS chose to limit the availability of this correction method to Walk-in CAP filings. In our view, limiting the availability of the contribution correction method to Walk-in CAP submissions will only impair its usefulness while increasing the cost to employers who wish to use it.
Hardship Distributions
Where hardship distributions have been made but the plan document does not authorize such distributions, the employer may correct this failure by retroactively amending the plan to permit hardship distributions so long as the amendment would satisfy the requirements of Section 401(a) of the Code (including the hardship distribution requirements under Section 401(k) of the Code, if applicable) had the amendment been adopted before the hardship distributions were made to participants. Again, for some unexplained reason, this correction method is only available under Walk-in CAP.
Earnings Adjustment Methods
When there is an operational failure in a defined contribution plan that involves a corrective contribution or allocation, the contribution or allocation must be adjusted for earnings and forfeitures. Section 5 of Rev. Proc. 99-31 provides several methods for making earnings adjustments to corrective contributions and allocations. (These methods do not apply to corrective distributions or reductions.) In order to make an earnings adjustment, the employer must (1) determine the period of the failure, (2) determine the applicable earnings rate, and (3) apply an allocation method.
Generally, the period of the failure is the period beginning on the date the failure began through the date of correction. For employees who were excluded from a Section 401(k) or (m) plan, the date of the failure begins on the date the Section 401(k) and/or (m) contributions were made for the other employees for the year of the failure. For purposes of determining earnings on the Section 401(k) and/or (m) contributions, the contribution may be deemed to have been made at the midpoint of the plan year in which the failure occurred. The earnings rate used should be based on the investment results that would have applied had the failure not occurred. If the plan permits employees to direct the investment of their accounts in several investment funds, there are several rules of administrative convenience an employer may use in determining the earnings rate. The earnings rate may be based on the employee's investment choices for the period of the failure. If most of the employees who are receiving a corrective contribution or allocation are NHCEs, the employer may use the fund with the highest rate of return. If the employee did not make any investment choices during the period of the failure, the employer may use the plan's earnings rate (i.e., a weighted average of the return of all of the plan's funds). Rev. Proc. 99-31 provides four earnings allocation methods that an employer can use.
Conclusion
The model correction methods the IRS provided in Rev. Proc. 99-31 should be particularly helpful to those employers who wish to self correct under APRSC. However, the correction methods provided in Rev. Proc. 99-31 are relatively limited in their scope and do not address many of the operational failures practitioners frequently encounter.
Copyright 1999 by Professional Practice Insurance Brokers, Inc., a Hilb, Rogal & Hamilton Company. Reprinted with permission from The Benefits Professional Special Issue, August 1999 (vol I, issue I).