10 Lessons Learned from Others’ Mistakes

Heed these warnings to stay unscathed

When the Internal Revenue Service (IRS) launched a series of “LESE [Learn, Educate, Self-correct and Enforce] examinations” last year, one of its intentions was to discover trends in compliance failure among qualified retirement plans.

The IRS also hoped the projects, in which auditors reviewed 50 qualified plans with similar characteristics to measure compliance across certain subsets of plans, could educate the public about these trends and thereby stall their growth.

Derrin Watson, an attorney in Santa Barbara, California, who works with SunGard on the Relius line of recordkeeping solutions, says the LESE projects had another outcome—giving plan sponsors an inside look into strategies the IRS uses to identify audit targets.

To demonstrate the point, Watson highlighted LESE projects in which auditors examined compliance among plans with an invalid business code on their Form 5500. Auditors found that more than 20% of the plans were not being amended in a timely fashion and lacked adequate fidelity bonds. The lesson for the IRS, Watson says, is that if a company cannot use the right business code, it may be likelier to commit more serious violations.

Here is a list of compliance errors cited frequently in the 17 completed LESE projects. By avoiding these mistakes, compliance experts say sponsors can go a long way toward navigating—or avoiding—IRS audits.

1. Failing to amend plan design to comply with current law in a timely fashion. Plan amendments typically come in three flavors—two that sponsors seem to have an easier time managing and one that causes many errors, according to Watson.

First is what is known as a restatement of plan documents, which is required every fifth year for individually designed plans and every sixth year for pre-approved plans.

Second is an amendment that an employer enacts independently—for example, an amendment to change eligibility provisions or add loan features to a plan. Generally, the deadline for these amendments is the last day of the plan year in which the change takes effect.

“The final type of issue—one that I think is triggering most errors—is usually referred to as an interim amendment,” Watson explains. This is an amendment required by a new law or a non-legislative regulatory change, such as those issued by the IRS or Department of Labor (DOL). The general deadline for adopting these amendments is the last day of the plan year or the extended due date of the employer’s tax return, whichever comes later.

2. Failing to procure adequate fidelity bonding. All “plan officials” need to be bonded under IRS qualification standards, and that includes anyone who has one or more of the following characteristics:

• Physical contact with cash, checks or other plan property;

• Power to transfer or negotiate plan property for a price;

• Power to disburse funds, sign checks or produce negotiable instruments from the plan assets; and

• Decisionmaking authority over any individual described above.

Regulations state that the fidelity bond must be worth no less than 10% of plan assets, with a minimum of $1,000 and a maximum of $500,000. Like many rules within the Employee Retirement Income Security Act (ERISA), though, there are exceptions. For instance, if a plan sponsor offers employer stock within the plan, $1 million of bonding is needed.

According to Lisa Barton, a partner specializing in qualified retirement plans at the law firm Morgan, Lewis & Bockius LLP, in Pittsburgh, plan sponsors often confuse fidelity bonding and fiduciary insurance—which may lead a plan to purchase either inadequate or excessive coverage.

“The fidelity bonding really only covers specific items and investments under ERISA,” Barton explains. “If the fiduciary committee is sued or there is some kind of fiduciary breach claimed against the company, the company should make sure it has a fiduciary policy in place, separate and apart from the bonding, that could cover those types of issues.”

Watson stresses one other caveat to the bonding rules, noting that if plan sponsors have fewer than 100 plan participants and want to avoid a plan audit, “you should either have 95% of plan assets in qualified assets or you need to have a bond for at least the amount of nonqualifying assets,” he says.

Watson stresses one other caveat to the bonding rules, noting that if plan sponsors have fewer than 100 plan participants and want to avoid a plan audit, “you should either have 95% of plan assets in qualified assets or you need to have a bond for at least the amount of nonqualifying assets,” he says.

3. Not following plan terms for loan and distribution processing. Barton says one of the most common mistakes for loan processing arises out of plan provisions that allow loan payments to be suspended for up to one year when an employee goes on leave. If an employee is on leave longer than a year or fails to return to the company, plan sponsors must default or reclassify the loan. “With employee leave, it’s always a unique situation, so it’s hard to follow a set process,” Barton says.

Barton also sees problems with cure periods—grace periods that allow a participant to make up for missed loan payments without triggering penalties. Under ERISA, a cure period cannot go beyond the end of the second quarter following the quarter in which the missed payment was due.

“Sometimes I see the recordkeepers administering the cure period as it’s spelled out by ERISA, or [to] the maximum length, but the plan documents actually specify something shorter,” Barton explains. It can be a similar situation with new loans, when repayments fail to start according to time specifications, she says.

4. Neglecting to allocate contributions and forfeitures in keeping with the plan terms. “It’s really important to make sure that the administration is matching up with what the plan documents say,” notes Barton, adding that this applies in many areas.

Jim Rowley, president and CEO of NFP Lincoln Benefits Group, in Fort Washington, Pennsylvania, says it is critical for plan sponsors to make sure they coordinate effectively with recordkeepers and custodians on things such as contribution and forfeiture processing.

While much of that type of work can be farmed out to a third party, plan sponsors still have a responsibility to ensure outsourced processes follow the rules spelled out in plan documents, as well as those in ERISA.

For Barton and her firm, the most common problem in forfeitures relates to their annual use and allocation. IRS guidelines state that a plan must use forfeitures annually, Barton says. “The problem is that we see a lot of clients who are letting their forfeiture accounts spill over from year to year to year,” she says. “You should be using these funds within a reasonable time period.”

5. Failure to properly run nondiscrimination tests. The running of ERISA-mandated nondiscrimination tests, according to Watson, Rowley and Barton, represents one of the tasks for which plan sponsors most often seek outside help. “This is absolutely something that is outsourced in a lot of cases,” Watson says, “but that doesn’t mean there won’t be mistakes.”

A frequent issue cited by both Watson and Rowley is bad data. For instance, a plan sponsor may send either incomplete or outdated plan information to testing consultants, which can lead to delays and improper results.

Watson also points out that those third-party experts, like the plan sponsors they serve, are not immune to errors. That is why it is important for plan sponsors to remain engaged in testing processes, even if the bulk of the work is outsourced to an advisory or accounting firm. “It’s not uncommon that I will give a seminar to experienced professionals, and I’ll see a light bulb go on over someone’s head,” Watson says. “[He’ll] approach me afterwards and say [he’s] been doing something wrong for years. It’s just the complexity of the field.”

6. Failure to deposit elective deferrals into the trust in a timely manner. “The DOL has been very clear that the standard is ‘as soon as possible,’” Watson says of the acceptable time frame for plans to deposit participant deferrals into a qualified plan’s trust.

For larger firms that have automated or outsourced daily oversight of recordkeeping and custodial functions, it is important for sponsors to be sure the work is being done correctly and according to plan terms. Among smaller plans, where there tends to be less automation and outsourcing, plan sponsors must remain proactive and engaged in the day-to-day administration of retirement benefits. The DOL and IRS “have the authority to audit on this issue, and both do,” Watson says.

Barton warns that—especially for larger plans that direct significant dollar amounts into the trust after each pay period—the DOL expects the deferral money to be entered into the plan trust on a regular schedule, as soon as it can be reasonably segregated from company assets.

“If the DOL audits your plan and the time it takes to move deferrals is varying from week to week, that can be a problem,” Barton says. “The department will want to know why it was longer in one week than another week. If it’s just that someone went on a vacation and the plan missed the payment, that might not be an acceptable reason for the DOL.”

7. Using an incorrect definition of compensation per the plan terms. “If you go through the 17 LESE projects on the IRS’s LESE website, compensation failures are at the heart of errors on almost every page,” Watson says.

Part of the reason is that plan sponsors are often working within complex plan designs that utilize four or five different definitions of compensation, making it easy to use the wrong one for the wrong purpose. “Each additional definition of compensation you use exponentially increases the likelihood that you’ll mess up on this,” Watson observes.

He points to a list of reasons why a company may write multiple definitions of compensation into plan documents. For instance, a company might want to exclude bonuses or overtime from pension contributions, or a firm might decide to exclude elective deferrals from its definition of compensation.

“You can do that for some plan governance purposes but not for others,” Watson says. “Part of the problem is that the law says, ‘For certain purposes, we’re going to put you in a straightjacket in terms of what you can do for a definition of compensation; you’ve got to include everything. For other purposes, you can be a little more liberal.’”

8. Failing to monitor plan contributions to ensure they do not exceed dollar limits or the deductible limit for employers. “From my experience, the annual employee contribution limit is something that employers seem to be on top of,” Watson says. Rowley and Barton agree, saying they tend to see more errors when employers either deduct too much or make deductions at the wrong time.

Another common dilemma is when a new hire joins a plan after already contributing to a different qualified plan in a given year. In that case, Barton says, the participant and sponsor have a responsibility to ensure the combined contributions do not exceed the individual limit.

9. Distributions of excess deferrals are incomplete, not timely or improperly calculated. On its website, the IRS lists a number of guidelines for how to deal with excess deferrals. If an employee’s total deferrals are found to be more than the limit for a plan year, the plan will generally be required to pay back the difference.

The plan must distribute the excess by April 15 of the following year—or an earlier date, if specified in the plan. If the excess is withdrawn by that date, it is not reported again as part of the employee’s gross income for the year. When excess deferrals are not withdrawn by April 15, the excess is taxable in the year of deferral. “This is a critical issue for sponsors, as mistakes can lead to contributions being double-taxed,” Watson says.

In effect, an excess deferral left in the plan is taxed twice—once when contributed and again when distributed. Also, if the entire deferral is allowed to stay in the plan, the plan can lose its qualified status.

10. Not filing the final Form 5500. According to Watson, the process and terms of terminating a qualified retirement plan are somewhat different when viewed by the IRS versus the DOL. “From the IRS perspective, a plan is usually considered to be terminated once the decision has been made to close the plan and there won’t be any more contributions,” he says. “From the DOL and Form 5500 standpoint, the plan isn’t officially terminated until the last dollar is gone.”

The final Form 5500 is due seven months after the final distribution. “It’s an important part of the termination process to file that final return,” Watson says. 


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