By: Sara A. Liva, Esq.

Horizon, Inc. is a company that cares about its employees, who enjoy the ability to defer a portion of their regular pay to the Life After Work 401(k) Plan (the “Plan”). Earlier this year, the company’s Director of Human Resources, Aleesha Morrison, trained her AI virtual assistant (“Owen”) to do the company’s payroll for her. Everything appeared to be going well until shortly after the close of the fiscal quarter, when Aleesha received a call from one of the company’s accountants. The accountant explained to Aleesha that she must be doing something wrong because there was too much money left in the company’s payroll account. Aleesha looked over the payroll and deposit records and discovered that employee elective deferrals were not being deposited into the Plan. Shocked, Aleesha confronted Owen and demanded to know why he was so incompetent. Owen politely informed her that any activities related to Plan compliance were not included in the basic AI virtual assistant subscription package and that, if she wanted those features, she would have to upgrade her subscription to the super deluxe package. Now panicking, Aleesha calls the Plan’s former TPA, the real person Horizon replaced with Owen, and begs for help. The latest deposits are now more than 60 days overdue!

The Rule

Department of Labor (“DOL”) Regulations require employers to deposit elective deferrals “as of the earliest date on which such contributions or repayments can reasonably be segregated from the employer’s general assets.” Labor Regulation §2510.3-102(a)(1). The Regulations state further that, in no event shall this “earliest date” occur later than the 15th business day of the month following the month in which the elective deferrals have been withheld from employee pay.  Do not confuse this for a safe harbor rule. This is the deadline under extreme circumstances – think Hurricane Katrina. The DOL expects employers to be able to deposit employee deferrals within mere days, and ideally on the same day as they are withheld from employee pay. The “15^th business day” only means that, after the 15^th day of the following month, the deposits are late, no matter the circumstances.

For small plans (defined as having fewer than 100 participants at the beginning of the plan year), employers will be in compliance with this rule if deposits are made within seven business days. This is a safe harbor rule, but it only applies to small plans. There is no similar safe harbor for larger plans (i.e., with 100 or more participants).  As a general benchmark, if you can remit your federal taxes within 2 days, you should be remitting the employee deferrals within 2 days.

Consequences of Violation

Late deposit of elective deferrals is considered a breach of fiduciary duty because the moment the elective deferrals are withheld from employee pay, they become plan assets. Keeping plan assets commingled with employer assets is considered by the DOL to be a loan of those assets to the employer, which is a prohibited transaction under § 406(a) of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).

The IRS applies a 15% excise tax on all prohibited transactions under Internal Revenue Code (the “Code”) §4975. In this type of prohibited transaction, we would calculate the 15% on the earnings owed for the late deposits, not the deposit itself.  If the prohibited transaction is not corrected within the tax year, the tax in subsequent years is equal to the total of the first year tax, plus an additional 15% of the subsequent year’s interest.  This causes the tax to pyramid or go up significantly in each subsequent year, continuing until the breach has been corrected. If the original principal amount of the late deposits is made before the end of the tax year, but the employer does not deposit the earnings thereon, the earnings that should have been paid will continue to be a prohibited transaction in the following tax year. The outstanding earnings will then incur an additional 15% excise tax each year until they are deposited.

Like any other prohibited transaction, late deposits could also result in the imposition of a civil penalty under ERISA §502(l). This penalty is equal to 20% of the prohibited transaction.  In extreme circumstances, it can result in criminal charges levied by the DOL.

Late deposits are reported on the Form 5500, so they can also increase the plan’s chances of becoming subject to a DOL investigation.  No fun.  If the prohibited transaction covers multiple plan years, it must be reported on Form 5500 for those years until the problem is resolved. 

Excise taxes on prohibited transactions are paid using Form 5330. When used to pay excise taxes due under Code §4975, the Form 5330 is due by the last day of the 7th month after the end of the tax year of the plan sponsor. This deadline can be extended by filing Form 5558 (there is a box to check that is separate from the box for Form 5500 extensions), but the filing the extension does not extend the deadline for paying the excise tax.

Correction

Because the late deposit of elective deferrals constitutes a prohibited transaction and is usually unrelated to the plan’s tax-qualification, it cannot be corrected through IRS Employee Plans Compliance Resolution System (“EPCRS”). The Voluntary Fiduciary Correction Program (“VFCP”) is the DOL’s program for correcting the fiduciary breach associated with certain eligible prohibited transactions. Many plan sponsors choose to correct late deposits fully, as described above, without making a VFCP submission in relation to the fiduciary breach. Failing to file under VFCP seems to present minimal risk for one-time (or infrequent) errors.  The first word in VFCP is “Voluntary,” which means you do not need to use the program to correct, but if you do, you will get a letter back confirming that the DOL will take no further action in relation to the fiduciary breach issue. 

There are two big advantages to using the VFCP.  First, you get to calculate earnings using the DOL Online Calculator.  Absent VFCP, Horizon will need to calculate earnings using the EPCRS earnings rules.  Likely, this will mean the highest rate of return of any investment option in the plan will need to be applied and, if there are no funds with a positive rate of return (thank you, 2022), you get to use the DOL Online Calculator for that year only.

The second advantage is that, in limited circumstances (including a requirement that all late deposits have been corrected within 180 days of occurrence), the VFCP filing can result in a waiver of the excise taxes that would otherwise have been due. Instead of paying the tax, the employer may deposit the amount that would have been paid in tax to the plan as an additional contribution.  This may be particularly attractive to an employer who would prefer to give money to his or her employees, rather than the government.

In the meantime, we might recommend VFCP for Horizon, where deposits are several months late, relate to all payrolls for a significant period of time, and affect all currently eligible employees. In situations where the error is recurrent or particularly egregious, the DOL might be motivated to investigate the issue and perhaps take action against the plan fiduciary.  In that case, the Plan Sponsor should consider whether to submit a VFCP application to the DOL to obtain the “no action” letter. Further, if the employer prefers the payment of the excise tax amount to the participants, rather than the government, and the requirements for this treatment are met, a VFCP filing would be advantageous.

VFCP submissions are more tedious than IRS Voluntary Correction Program submissions. The process requires completion of the VFCP Model Application Form, VFCP Checklist, a penalty of perjury statement of plan official, authorization of preparer, copy of most recently filed Form 5500, narrative describing the breach, and documentation showing how the breach was corrected. The documentation piece of this is the real challenge. It will need to include each payroll report, the corresponding bank statement showing the payment going out, and each trust statement showing the deposit going in.  The VFCP process is also less forgiving than the IRS’s VCP procedures; if you don’t prepare your application correctly, it can be kicked back without action, forcing you to start over.  On the positive side, there is no submission fee for a VFCP application.

Conclusion

Horizon’s TPA should advise Aleesha to make the late deposits immediately, prepare the earnings adjustment as soon as possible thereafter, and engage ERISA counsel to advise on whether a VFCP submission should be prepared. If the VFCP option is declined, Aleesha must ensure that Form 5330 is filed and the excise taxes are paid.  Additionally, Aleesha needs to make sure that established written procedures are created so that this never happens again, including monthly or quarterly reviews by a secondary individual to ensure deposits are going through timely and accurately.  She might also want to reconsider her relationship with Owen.

If you have questions or issues with a late deposit, call us.  Remember: we are your ERISA solution!