If an Eligible Employee is Overlooked How is That Fiduciary Breach Corrected?

Generally, correcting this type of oversight concentrates on making the employee whole, i.e. make up for the missed deferral opportunity in a 401(k) plan and/or the missed employer contribution in a profit sharing plan in addition to earnings on the missed deferral or contribution.  In a 401(k) plan the correction is accomplished by an employer “Qualified Nonelective Contribution” (QNEC) equal to 50% of the employee’s group Actual Deferral Percentage (ADP).  The group refers to either a Highly Compensated Employee (HCE) or a Non-Highly Compensated Employee (NHCE).  If we assume that the ADP is 6.0% for the HCEs and 4.0% for the NHCEs an employee in the HCE group would receive a 3% QNEC and an employee in the NHCE group would receive a 2.0% QNEC.  Under the circumstances below the 50% can be reduced to 25%:

The employee must be employed by the employer at the time of correction; the period of failure exceeds three months; the correct deferrals begin in accordance with IRS timing guidelines.

If corrective contributions are required those contributions must be paid to the plan no later than the second plan year beginning after the initial year of the failure.  If the period of failure is less than three months the corrective QNEC is not required.  There are also additional requirements and guidelines for auto-enroll plans (See IRS 401(k) fix-it Guide).

To correct for the exclusion of an eligible employee from participating in employer contributions in a profit-sharing or stock bonus plan, an allocation amount is determined for each excluded employee on the same basis as the allocation amounts were determined for the other employees under the plan’s allocation formula, for example, the same percent of compensation. The Plan Sponsor makes a corrective contribution on behalf of the excluded employee that is equal to the allocation amount that would have been made for the excluded employee. The corrective contribution is adjusted for earnings based on the plan’s earnings or, if self-directed, on the employee’s chosen funds. If the employee had not made a choice of investments a default investment may be used. If, as a result of excluding an employee, an excess amount was improperly allocated to the account balance of an eligible employee who shared in the original allocation of the employer contribution, no reduction is made to the account balance of that employee.

Depending on the circumstances of the defect the error can be corrected through the IRS Self-Correction Program (SCP) without fees; the Voluntary Correction Program (VCP) with scheduled fees; or the Audit Closing Agreement Program with fees based on facts and circumstances.  

The Self-Correction Program (SCP), can be used to self-correct an insignificant operational error at any time to preserve the tax-favored status of the plan. An operational error occurs when you don’t follow the written terms of the plan. Even where the operational error is significant, you may still be able to self-correct if action is taken in a timely manner.  If the retirement plan isn’t currently being audited by the IRS, and the plan has errors with either the language in the plan document or how the plan was operated in accordance with the plan document, you can apply to correct the mistakes under the Voluntary Correction Program (VCP).  This approach is different than the SCP above in that you send a written submission to the IRS and pay the user fee charged for VCP applications.  The IRS will review your application and if your proposed correction is approved by the IRS the plan will retain its tax-favored status.  Using the SCP does not provide the plan sponsor with an IRS written approval of the correction method used and there are some errors that cannot be corrected through SCP, e.g. a plan document that has not been updated for current legislation.  Under Audit CAP, the plan error is uncovered while the plan sponsor or the plan are already under examination.  To correct the error the plan sponsor makes the correction, pays the required sanction and then enters into a Closing Agreement with the IRS to preserve the tax qualified status of the plan.

Stephen Abramson, CPC          APS Pension Services Inc.        steve@apspension.com