When Good Plans Go Bad

Despite the care taken by plan sponsors and their pension advisors, errors occur in qualified plan administration. It is to no one’s advantage to have such errors disqualify a plan or to create penalties so onerous that plan sponsors are discouraged from having plans altogether.

Fortunately, programs are available under the Internal Revenue Service (“IRS”) and the Department of Labor (“DOL”) to correct errors and abate penalties. In general, both agencies reward plan sponsors who discover the errors and report them voluntarily as opposed to errors that are found upon audit or inquiry.

Employee Plans Compliance Resolution System (“EPCRS”)

The EPCRS is a group of voluntary compliance programs used in correcting defects in a qualified plan that would otherwise disqualify the plan. EPCRS can be used to correct many qualification failures, which generally fall into three categories:

Plan Document Failures: Failure of the document to conform with the Internal Revenue Code and IRS regulations. Plan sponsors who fail to timely adopt required plan amendments fall within this group.

Operational Failures: Includes failures to follow the terms of the plan document, such as failure to cover eligible employees, failing to satisfy the top heavy requirements and failing the ADP and ACP tests for 401(k) plans.

Demographic Failures: Failure to meet minimum participation, minimum coverage or nondiscrimination requirements.

EPCRS cannot be used to correct the diversion or misuse of plan assets. It also cannot be used for Section 457 plans, non-qualified plans, welfare benefit plans, IRAs or cafeteria plans.

EPCRS includes two voluntary correction mechanisms, the Self Correction Program and the Voluntary Correction Program, as well as the Audit Closing Agreement Program. An overview of each program follows.

Self Correction Program (“SCP”)

SCP allows qualified plan sponsors to correct operational failures or defects without filing with the IRS or paying any penalty tax. The program allows the correction of both insignificant defects as well as, in limited circumstances, significant defects. Demographic and plan document failures cannot utilize SCP.

Insignificant Corrections

Generally, in order for a correction to be considered insignificant, it must be an isolated incident, and the plan must otherwise have a history of compliance in all other areas. Factors that need to be analyzed include:

  • The number of errors that occurred;
  • The percentage of plan assets and contributions involved in the error;
  • The number of years the error occurred;
  • The number of plan participants affected;
  • The time it took the plan sponsor to correct the error; and
  • The reason the error occurred.

Insignificant defects can be corrected at any time. The program can be utilized even if the plan is under examination by the IRS.

Significant Corrections

Significant defects can be corrected under SCP if they are eligible qualification failures and are corrected before the end of the second plan year after the year in which the failure occurred. A significant defect cannot be self-corrected if the plan is under examination by the IRS. The plan must also have a favorable determination letter and meet the eligibility requirements for SCP.

Corrections under SCP may involve a plan amendment. If an amendment is involved, the amended plan document must be submitted for a determination letter unless it is on a standardized prototype.

Voluntary Correction Program (“VCP”)

Defects that are not eligible for SCP, such as significant operational defects beyond the two- year correction period, plan document failures or demographic failures, may be corrected using VCP. For example, plan sponsors who have failed to timely adopt plan amendments or restate their plans to comply with law changes may utilize VCP. VCP cannot be utilized by a plan that is under examination by the IRS.

The plan sponsor submits an application with a fee to the IRS identifying the defect along with the proposed correction. The IRS, assuming agreement is reached, issues a letter stating that the correction is accepted.

Any correction submitted under a VCP filing must include the steps that will be taken to prevent the error from happening again. The correction must bring the plan and its participants to the point they would have been had the error never occurred. It must conform to the plan document (or the document must be amended to conform to the correction) and not violate any other 401(a) qualification requirements. The correction should resemble corrections already provided for in the regulations or other IRS published guidance, if possible.

It is possible to submit a VCP filing on a “John Doe” basis to see if the correction methodology is approved. In order to get the approval letter, should the IRS agree to the correction, the identifying information is then disclosed to the IRS. The anonymous filing can be withdrawn if no agreement is reached.

The VCP filing fees range from $750 for a plan covering 20 participants or less up to $25,000 for plans that cover over 10,000 participants. The fee for late amenders is 50% of the applicable fee if the VCP filing is within one year of the missed deadline.

Audit Closing Agreement Program (“Audit CAP”)

Audit CAP arises when the IRS discovers the disqualifying defect, and it is not an insignificant operational failure that is eligible for SCP. There are three parts to the program: the failure is corrected, a closing agreement is reached and the plan sponsor pays a negotiated sanction. All disqualifying defects are eligible for Audit CAP except for diversion or misuse of plan assets.

The sanction is calculated based on a list of twelve factors and bears a reasonable relationship to the nature, extent and severity of the failure. In the past, one of these factors was what the fee would have been under VCP. This often gave the representative of the plan sponsor a tool to negotiate for much lower sanctions.

Under the current program, the fee under VCP is ignored. The IRS takes the position that the sponsor is fully responsible for failing to find and report the error and should not have the benefit of the low fees available under VCP.

Approved Correction Methods Under EPCRS

Examples of some of the corrections that have been approved by the IRS are discussed below.

Failure to Provide Top Heavy Minimums: Make up the contributions, plus investment earnings, to the current and former participants affected in a defined contribution plan. In a defined benefit plan, the correction is to provide a minimum accrued benefit based on average salary and total top heavy years.

Late Correction of Failed ADP/ACP Tests: Two correction methods have been provided. The first is to make a qualified non-elective contribution (“QNEC”) or qualified matching contribution (“QMAC”) to the non-highly compensated employees (“NHCEs”).

The second is to calculate the excess contribution amount and distribute (or forfeit, if applicable) to the highly compensated employees (“HCEs”) the excess amount which caused the plan to fail the test, and contribute an equal amount to be allocated among the NHCEs as a QNEC.

Failure to Distribute Elective Deferrals in Excess of the Annual Limit ($12,000 for 2003): The excess contribution must be distributed with income. It will be taxable in both the year of distribution and the year of deferral.

Contributions in Excess of Section 415 Annual Additions Limit: If the excess contribution was an employer contribution, it must be placed, with earnings, into a suspense account and used to offset future employer contributions. If the excess was an employee deferral, then it must be distributed with earnings and any related matching contribution forfeited and placed into a suspense account.

Failure to Include an Eligible Employee: The employee must receive the employer contribution that he would have received if he had entered the plan properly, adjusted with investment earnings. In the case of a profit sharing plan, this does not mean that the contribution is reallocated. Rather, the employee must receive the same percentage of pay that the other eligible participants received.

If the employee would have been eligible to contribute to a 401(k) plan, the employer must make a contribution on his behalf equal to the average deferral percentage for his “group.” The participant’s “group” is either the HCEs or NHCEs, depending on his status. This contribution is also adjusted with earnings.

Delinquent Filer Voluntary Compliance Program (“DFVC”)

The Employee Retirement Income Security Act (“ERISA”) requires plan sponsors to file a Form 5500 with the DOL by the last day of the seventh month following the close of the plan year. A 2½ month extension to file the Form 5500 may be obtained by filing Form 5558.

The DOL penalty for the late filing of the Form 5500 for an ERISA plan is $50 per day with no maximum penalty. Non-filers are penalized $300 per day up to $30,000 per year until the forms are filed. The DFVC program was instituted to encourage late and non-filers to file past due forms without bankrupting the plan sponsor.

Under DFVC, an ERISA plan can file past due forms and pay a reduced penalty in advance. To further sweeten the offer, the IRS, who has its own delinquent filer penalty, will grant relief to filers who use this program.

The reduced penalty for a small plan (fewer than 100 participants) is $10 per day with a maximum of $750 per late form. If forms for more than one year are being filed, there is a maximum penalty of $1,500 per plan. If the plan is large (100 or more participants), the penalty is $10 per day up to a maximum of $2,000 per plan year, not to exceed $4,000 per plan.

This program cannot be used if the DOL has already inquired about a late or non-filed form. However, if the IRS makes the inquiry, nothing precludes the employer from filing immediately under DFVC, informing the IRS that this filing has been made and requesting that all IRS penalties be waived.

Plans that do not cover common law employees are not covered by ERISA and there is no DOL requirement for filing Form 5500 timely. Therefore, these plans may not utilize DFVC. Non-ERISA plans, which generally file Form 5500EZ, are still subject to IRS penalties for delinquent filing. However, the IRS has indicated that it will consider any reasonable cause statement submitted by the filer explaining why the return is late and look more favorably upon non-filers who come forward voluntarily.


There are several programs available for correcting plan defects. The least expensive way to correct defects is to discover them early and before the IRS or DOL. Frequent internal audits of all aspects of plan administration can quite possibly prevent insignificant defects from becoming significant. These audits are especially important since the IRS is planning an audit campaign targeting 401(k) plans.

Any EPCRS correction should not be attempted without the advice of an attorney or other professional advisor.


This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.

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