Publication: Bloomberg BNA Compensation Planning Journal
Volume/Issue: Volume 45, No. 5, May 5, 2017
Law Firm “Determination Letters”: Are They Valuable?
By: Ilene H. Ferenczy, Esq.
One of the newest products being offered to plan sponsors and administrators in the qualified retirement plan arena is the so-called “Private Determination Letter” (or PDL). These letters are intended to give the qualified plan sponsor some comfort that the plan document complies with applicable legal requirements and will not be found wanting if the Internal Revenue Service audits the plan.
Understanding the value of a PDL requires a little understanding of the history of the IRS vis-à-vis plan documents.
PLAN “QUALIFICATION” — RETIREMENT MONEY CAN BE ELIGIBLE FOR SIGNIFICANT TAX BENEFITS
Qualified retirement plans enjoy significant tax advantages, including immediate deductibility of employer contributions, tax deferral to employees of amounts contributed for their benefit to the plan, tax deferred growth, and the ability to roll over the benefits for further tax deferral after the employee leaves the sponsoring company’s employ. [See I.R.C. §401(a), §501(a). See also Reg. §1.401-1.] To obtain these advantages, the plan must comply with the Internal Revenue Code of 1986, as amended (I.R.C.), regulations promulgated thereunder, and the IRS’s guidance in both operation and form—that is, the plan must be in writing and the written document must contain certain specific language and provisions.
IRS FAVORABLE DETERMINATION LETTERS—ASSURANCES OF PLAN DOCUMENT COMPLIANCE
Historically, because the form requirements are so numerous and detailed, the IRS permitted plan sponsors and practitioners to submit the documents for approval (called a “favorable determination letter”). The IRS’s review would confirm that the documents met all these form requirements for a qualified retirement plan. If the plan document did not come up to snuff, the procedure for this review would permit the plan sponsor or practitioner to present the IRS with a corrective amendment, and the IRS’s favorable determination letter would be issued, contingent on the actual adoption of the amendment. This process was initially provided for free; later, the IRS began charging user fees for this review.
The effect of a favorable determination letter from the IRS was to preclude the ability of the IRS to raise form issues on audit. Over the years, this has been very important, as the IRS’s view on what language was or was not required or permissible has changed over time, not just because the law changed, but because the agency’s beliefs about various provisions have evolved. The determination letter process gave the IRS and industry practitioners and plan sponsors a chance to “reset” the rules every five or six years, and have a plan that complies with the current policies of the IRS.
PREAPPROVED PLANS—HELPFUL, BUT NOT NECESSARILY A PANACEA
Over the years, the IRS has become more willing to encourage the use of so-called preapproved plans. These plans, called prototypes and volume submitter documents, contain a combination of boiler-plate language and variables. The IRS preapproves the boiler-plate language and the various options available for the variable sections, and declares the preapproved plan to be compliant. Adopting employers can then rely on that mass approval provided by the IRS as being a preapproval of their plans, and a reasonable substitute for a determination letter.
The problem has been—and continues in some measure to be—that the IRS does not allow all plan provisions that are permitted by law to be included in a preapproved plan. While the amount of flexibility permitted in a preapproved document is at an all-time high, there are still many types of plans or features that do not fit into a preapproved document. For example, certain types of employee stock ownership plans (ESOPs) and cash balance or other hybrid plans cannot use a preapproved document (and, while the IRS has given its thumbs-up to have some cash balance and hybrid plans and ESOPs on preapproved documents, those documents have not yet been preapproved by the IRS for use by consumers). [Effective June 8, 2015, the IRS opened up opinion and advisory letters for preapproved plans to cash balance and other hybrid benefit plans and released listings of required modifications for cash balance plans. Rev. Proc. 2015-36, 2015-27 I.R.B. 20, modified by Rev. Proc. 2016-37, 2016-29 I.R.B. 136. See Defined Benefit Listing of Required Modifications and Information Package, Cash Balance Supplement, http://src.bna.com/kDp.] As a result, those kinds of plans are currently drafted on individually designed documents.
IRS DOCUMENT APPROVALS: THEN AND NOW
So, how can a sponsor of a plan that does not fit well onto a preapproved document have any confidence that the plan document is in compliance?
Until recently, the IRS offered a 5-year cycle to individually designed plans. Every five years, the plan would need to be updated for any changes in the law or IRS rules in the interim. Every five years, the document drafters would submit the individually designed plans to the IRS for their stamp of approval, and would get it in the form of a favorable determination letter.
This all changed in 2016, when the IRS instituted its newest procedures, which cut back on the availability of determination letter requests. The IRS has consented to continue to provide determination letters on new plans that have never been submitted previously for approval. However, once a letter is issued, generally, the plan sponsor of an individually designed plan may not file for another determination letter request until the plan terminates—notwithstanding that the law, the plan sponsor’s ability to provide benefits, and the participant make-up may change considerably over the years. [Note that IRS guidance provides that consideration will be given annually to whether determination letter applications will be accepted for individually designed plans in specified circumstances other than for initial qualification and qualification upon plan termination. Rev. Proc. 2016-37, Part II, effective January 1, 2017.]
The IRS has tried to give the practitioner community some level of reassurance that it will not unreasonably subject qualified plans to risk. First, the IRS promises that already-approved language that is unchanged in the plan will not be subject to question on audit, unless the law or the IRS rules have changed. Second, the IRS will advise the community when “something has changed” by issuing annual listings of new documentation or operational requirements, coupled with a 2-year timeframe for effecting any required amendments. Theoretically, any plan that has a determination letter can, at any time after the determination letter is issued, compare the plan with the annual IRS listings that occurred since the letter was issued, identify any plan and rule changes, and ensure that the ephemeral plan documentation qualification has not been lost.
For the squeamish, however, who want something in writing that declares their document to be kosher, the IRS’s current procedures fall short of satisfying that desire.
WHAT’S A PLAN SPONSOR TO DO?
One possibility is for a plan sponsor to have a qualified lawyer review the plan document and the IRS rules for what language must be included in the plan document to determine if any plan language has fallen out of compliance. The lawyer may then provide a letter to the sponsor, reassuring it that there does not appear to be anything about the plan document that is problematic. This is, in essence, the need that the PDLs are intended to fill.
However, there are two threshold questions about the documentation process that should be answered before a sponsor considers paying a law firm to do this review.
First, why is the plan being documented on an individually designed plan? Some lawyers or other practitioners in the field have an aversion to preapproved plans. This aversion can be caused by the need for these plans to work well for a large segment of the plan population, which sometimes removes the finesse of certain provisions. It can also be because, as stated before, the plan’s provisions cannot be accommodated on a preapproved document. However, it is also true that sometimes, the legal practitioner simply prefers his or her own document … and sometimes, that preference is quite personal. In truth, however, while everyone who has gone to law school appreciates pride of authorship, having an individually designed plan may have absolutely nothing to do with the plan sponsor, the participants, and the IRS, but a lot to do with the lawyer’s preference.
If the client does not care about the literary quality of the plan document, and the plan does not contain provisions that cannot be accommodated on a preapproved plan, why maintain the individually designed plan? After all, preapproved plans are almost always cheaper and commonly do the trick.
Therefore, the first question a plan sponsor should be asking the document drafter is why it needs the individually designed document. If there is no easily understandable reason, perhaps restatement of the plan onto a preapproved document would be a good step.
The second question is: why are you considering going to a lawyer for a PDL who did not draft your original document? Perhaps the better way to phrase the question is: why is the document drafter not taking responsibility for the plan’s compliance with the IRS’s form requirements? One would think it would be implicit in the attorney-client relationship that the drafter of the document would be affirming the plan’s compliance with legal obligations. Therefore, the second thing a plan sponsor should do is to find out if the person or firm that drafted the plan is willing to assess and certify to its compliance and to keep the plan up-to-date with changes in the law.
Finally, if neither a preapproved plan nor the drafting lawyer is available (perhaps he or she has given up in frustration at these IRS changes and sworn off drafting plans), using a third party legal firm to review the plan may be a way to achieve the level of confidence that the plan sponsor needs.
When looking for someone to perform this review, it is important to understand the nature of the “guarantee” that is being provided. Is the PDL-provider agreeing to pay any sanctions, fines, or penalties related to an IRS audit that results in a finding that the plan document is not in compliance? Or, is the PDL-provider simply giving the client his or her best understanding as to the plan’s qualification (with no specific guarantee)? Is the PDL-provider issuing a one-time-only how-does-your-plan-look-today review, or is he or she promising to keep the plan in compliance (presumably with periodic charges for a scheduled review and modifications)?
Finally, it may be that the goal of the PDL-provider is to encourage the plan sponsor to abandon its old document and adopt onto the PDL-provider’s own document. This would mean that the IRS determination letter on the existing plan document would become worthless—i.e., none of the language in the PDL-provider restatement will have been in the plan when the IRS determination was issued, so the entire plan document is subject to IRS scrutiny on audit. On the other hand, perhaps the PDL-provider has confidence in its own document (possibly as a result of many, many determination letters received on the document in relation to clients adopting new plans) that exceeds any reassurance that can be created by reviewing an unfamiliar plan.
In short, a plan sponsor should not be overwhelmed by the IRS’s changes in its plan review process. If possible, the plan sponsor should consider a preapproved document, and, where there is pushback, should ask for (and receive) a clear answer as to why such a document is inconsistent with the plan. It may be that the provision preventing usage of a preapproved plan is not near and dear to the sponsor’s or participants’ hearts and can be abandoned if the documentation can be simplified.
If a preapproved document is not in the cards, consider why the current document provider cannot or will not stand by the document he or she drafted.
Finally, if an individually designed plan is a necessity, and the current document provider is shying away from ensuring the value of his or her own work, a PDL just might be the right answer.