Gardner said the objectives of IRS audit are to promote voluntary compliance with the 403(b) regulations, help sponsoring organizations understand and comply with the regulations, protect participants and the public interest, and promote consistency between plan administration and the terms of the plan.
Rather than a police raid, sponsors should expect a professional and courteous experience, according to Gardner. Prior to the audit, sponsors are referred to Publication 1-EP cat. 39708R which explains sponsor rights during the audit and what to expect. A flow chart describing the process is at http://www.irs.gov/pub/irs-pdf/p4324.pdf.
Common mistakes the IRS has found during audits include:
- Universal availability violations – Gardner said collectively bargained employees could have been excluded previously, but can no longer be, as with visiting professors. For governmental employers, they could have excluded employees offered participation in governmental plan at date of hire, but that’s no longer the case.
- Excess contributions – Gardner said the area that seems to be problematic is with public schools and health and welfare organizations which can offer a special catch up of up to $3,000 for folks with at least 15 years of service and who average less than $5,000 in contributions over the course of their participation. There is a lifetime limit of $15,000 for this special catch up, and audits have found some exceeding this lifetime limit.
- Early withdrawals/hardship distributions – Withdrawal limits and the requirement to stop deferrals for six months have often been violated because participants previously went straight to vendors to request the withdrawals.
- Loans – Gardner said that especially in a multiple vendor environment, sponsors have to be careful not to exceed limits. He reminded attendees that if they offer loans, they must have a loan policy document explaining limits on amount and number of loans and procedures for obtaining and repaying a loan.
According to Gardner, it’s a little too early to determine the consequences of the new regulations on plan administration among 403(b)s because right now the IRS is auditing 2008 plan years, but soon it will start with 2009 years, when the regulations became effective. He said the IRS will not call out document errors in 2009, but will only look to see if sponsors have a plan document and are complying with it. Gardner says the agency has seen improvement in information sharing and will see improvement in documents with the coming pre-approved/prototype program.
To prepare for an IRS audit, Gardner recommends sponsors:
- Perform a self audit using the checklist at http://www.irs.gov/pub/irs-tege/pub4546.pdf;
- Seek advice on representation – Gardner recommends enlisting the help of vendors, advisers, attorneys, and accountants ahead of time;
- Be organized and ask questions ahead of time;
- Be prepared to describe systems – Gardner said there will be a pre-audit interview for describing systems and processes; and
- Make responsible parties available.
Gardner also advised attendees to timely respond to any follow up requests by the auditor.What triggers an audit? Gardner said plans are typically selected from filed returns such as Form 5500s, but for plans that don’t have to file returns, the IRS downloads data from W-2 employer’s report and look for things such as exceeding contribution limits. However, the agency often randomly selects plans among different types of sponsors and different industries.
Gardner told Webcast attendees that IRS Rev. Proc. 2008-50 offers correction methods for many of the mistakes 403(b) plans can make. For a universal availability violation, the sponsor must restore the lost deferral opportunity for a left out participant. He said a new Revenue Procedure will allow sponsors to assume a certain deferral percent for the participant. This money comes out of the sponsor’s pocket, and sponsors not only must restore the benefit, but also the interest the benefit would have accrued.
Excess contributions can be corrected by returning the money to participants by April 15 of following year, otherwise the money will be returned and double taxed, both at the time of distribution and at the end of the tax year as income. This is why it is important for sponsors to run a test before the end of the year to check deferral limits, Gardner said.
According to Gardner, it is hard to retrieve early withdrawals that violate statutory or plan limits, so usually the correction is to make sure there are practices and procedures going forward to avoid this happening again. Excess loans must be treated as deemed distributions and taxed.
Gardner said if a correction method is not spelled out in the Revenue Procedure, sponsors can use same methods approved for 401(k)s.
Gardner told attendees there are three prongs of the IRS correction program:
- SCP – Self Correction: sponsors can correct mistakes without involving the IRS, even for an error going several years back. Gardner said this is the most favorable for sponsors because there is no sanction or user fee.
- VC – Voluntary Correction: sponsors can request help from the IRS, pay a user fee usually based on number of participants, and will get an opinion from the agency on how to correct.
- CAP – Audit Closing Agreement: in this instance sponsors come to an agreement with the IRS on the violation and correction method. Gardner said this is the least favorable for employers because it involves a sanction, usually tax exposure.
For help with compliance and preparing for an audit, an IRS 403(b) plan checklist is available at http://www.irs.gov/pub/irs-tege/pub4546.pdf, and more information, including Pub 1-EP, Understanding the Employee Plans Examination Process can be found at www.irs.gov/ep.In addition, MetLife offers a white paper on preparing for an audit, at http://www.metlife.com/mlr.