Almost every tax qualified retirement plan (as well as 403(b) and 457(b) plan) will experience at least one, and likely several, “qualification failures” over the course of its existence. A “qualification failure” means a failure to meet the detailed requirements for tax qualified status as set forth in the applicable Internal Revenue Code sections and related regulations. See our FAQ on the tax consequences of plan disqualification which can be found at FAQ – Plan Disqualification.
Fortunately, the Internal Revenue Service (“IRS”) offers a comprehensive voluntary correction program called the “Employee Plans Compliance Resolution System” (“EPCRS”) ¹. It provides three levels of correction options: (1) self-correction of qualification failures under the Self Correction Program (“SCP”) (for more information about SCP, see our FAQ regarding the SCP program which can be found at FAQ - Self Correction of Operational Defects); (2) voluntary correction of qualification failures with IRS approval under the Voluntary Correction Program (“VCP”); and (3) correction of qualification failures while under IRS audit called the “Audit Closing Agreement Program” (or “Audit CAP”). For issues that are not covered by EPCRS, the IRS also offers a more informal “walk-in” closing agreement program that is similar to, but not exactly the same as, the VCP program. A VCP application can be converted to a “Walk-in CAP” request. Each option has its own benefits and trade-offs.
When a plan sponsor discovers that a qualification failure has occurred outside of the examination process, the plan sponsor must decide whether to self-correct without IRS involvement under SCP, voluntarily bring the matter before the IRS under VCP or Walk-in CAP (and as described below whether to file that VCP or Walk-in CAP application on a fully disclosed or “John Doe” basis) or to deal with the issue of plan qualification when and if it is discovered by the IRS (which could be through an examination or other voluntary ruling request such as a request for a favorable determination letter).
With the exception of rare circumstances, prompt correction of a qualification failure after discovery will be in the best interests of the company that offers the plan. First, voluntary correction prior to the plan sponsor receiving notice of an IRS examination takes those failures that were corrected “off the table” in the examination. Second, prompt correction will limit the period of the failure and generally limit the cost of restoring lost earnings going forward. Third, it is usually easier to correct a failure that happened recently because data will be current and presumably payroll and other plan records will be more accessible. One of the biggest challenges to qualified plan correction is getting the data needed to analyze and correct the failure. Finally, in most cases, fewer affected participants will have left the plan sponsor’s employment and locating those who have left will be simpler than trying to locate them years later.
Another reason to correct promptly is that at least one court has held that plan fiduciaries have a duty to act prudently in the administration of the plan and can, in some circumstances, be held personally, jointly and severally liable for the costs of plan correction.
Myths about VCPs
There are some myths about VCP submissions that could cause a plan sponsor to have some concerns about filing a VCP submission. Such as:
Myth 1: “It seems crazy to voluntarily tell the IRS we messed up. We should just wait to see if we get audited.” As discussed above, a failure that is discovered on audit is nearly always going to cost more to correct than correcting under VCP. The IRS’s stated position is that the negotiated non-deductible penalty that will be required as a part of the settlement process in an examination will always be more expensive than the upfront filing fee under VCP. In addition, if the IRS discovers during the course of the audit that the plan sponsor knew of the failure but chose not to correct, that fact could be weighed against the plan sponsor when negotiating the penalty amount.
Myth 2: “Filing a VCP will put a target on our back and the IRS will be more likely to audit us in the future or refer us to the Department of Labor for audit.” Although the IRS reserves the right to make a referral in an egregious situation, the IRS has a general policy not to refer VCP filers to the audit division or the Department of Labor. If a situation is egregious, the taxpayer will want to weigh their options with counsel carefully before moving forward with a VCP filing.
Myth 3: “Once we file the VCP, we are stuck with correcting the failures, even if the IRS makes us use a more expensive correction method than we propose.” It is true that once a VCP is filed, the plan sponsor is generally committed to correcting the failures in some manner, although it may be possible to withdraw the submission. However, VCPs can be filed anonymously, with the plan and plan sponsor’s identity revealed only after both sides have agreed to the final correction. If no mutually agreeable terms are reached, the submission can be withdrawn and identities are never revealed. This is called a “John Doe” submission. The downside of a John Doe submission is that the plan does not have audit protection until identities are revealed.
¹ See Rev. Proc. 2016-51
© Boutwell Fay LLP 2017, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of April 30, 2017.