(b)lines Ask the Experts – Failure to Suspend Contributions After Hardship

April 23, 2013 (PLANSPONSOR (b)lines) – “In preparation for our annual 5500 report audit for our Employee Retirement Income Security Act (ERISA) 403(b) plan, we discovered that, due to a error in the payroll interface with the plan vendor, there was not a six-month suspension of elective deferrals for two individuals who were making elective deferrals and then received a hardship distribution (our plan utilizes the safe harbor definition for hardship distributions and thus requires such a suspension).

“How do we correct this error? Do we return the elective deferrals (plus earnings) to the employee, or do we simply commence the six-month suspension period at the present time?”  

Michael A. Webb, Vice President, Retirement Plan Services, Cammack LaRhette Consulting, answers:  

Interestingly, the current Employee Plans Compliance Resolution System (EPCRS) program to correct plan defects does not address this particular defect. However, at several IRS phone forms (see page 42 of this EPCRS Phone Forum IRS Slide Presentation, for example) this specific defect has been addressed. As described in the presentation, the best method of correction is to return the deferrals (adjusted for earnings) for the six-month period that deferrals should have been suspended to the employee.   

The Internal Revenue Service (IRS) also states that, though it is possible that simply ceasing deferrals for six months from the present time might be an acceptable alternative to returning deferral amounts, they do not recommend this alternative as the best method of correction, since it might not put the participant in the same position he/she would have been in had the failure not occurred, which is the goal of all EPCRS corrections (e.g. if there is a matching contribution, that amount may have changes due to changes in compensation or formula, or the employee may quit during the current six-month suspension period). It is important to note that comments at a phone forum do not provide the same level of reliance as formal guidance would, but in the absence of formal guidance, such comments are as illustrative as possible as to how the IRS views correction of such a plan failure.  

As for implementation of the recommended method of correction (return of elective deferrals to the employee), your plan vendor should be able to provide the earnings calculation and issue the refund if you can provide the deferral amounts and dates. We note that earning calculations can be a complex process.  And, of course, you should inform the participant in advance that this transaction will be taking place.  If there is not enough in the account to do the refund (for example, due to subsequent distributions or loans), then you may need to consider the alternative of ceasing prospective deferrals.

Because your particular defect appears to be insignificant under EPCRS (you stated the defect involved a “couple” of individuals, and by definition there must be more than 100 participants in your plan since it is subject to the 5500 independent audit and accountant’s opinion), it would appear that is can be self-corrected under the Self Correction Program (SCP) program without formal notification of the IRS. However, in order to utilize the principles of self-correction  under EPCRS, you must document the practices and procedures that were in place to prevent this defect in the first place (i.e. your operating and payroll system protocols with respect to suspension of elective deferrals following a hardship distribution) and the violation of those procedures that resulted in the defect (i.e., was it a simple failure of the vendor to notify payroll of the date of the hardship distribution, or some other payroll interface issue?).     

And finally, we would always recommend that, when there is an issue involving a potential plan failure, that benefits counsel with expertise in this area be consulted, since the specific fact pattern of your particular situation might warrant a different correction method than the general information that is provided here. This is especially the case where there is no formal guidance regarding the correction of such a defect in EPCRS, as is the case here.  


NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.