Retirement Plan Correction Solution
Self-Correcting Improperly Included Participants… Thanks a Lot, Jerry.

 By: Hayden Speed

The Pawnee Parks and Self-Correction Store (the “Store”) offers a retirement plan, the Li’l Sebastian 401(k) Plan (the “Plan”), to its employees who attain the age of 21 and have six months of service. In January of 2022, the Store hired two new employees, Andy and April. Both are over the age of 21. Jerry, the director of Benefits, was so excited to have new people in the office that, on their first day, he mistakenly told Andy and April that they were immediately eligible to enroll in the Plan. They both enrolled and began making deferrals, which were properly matched by the Store according to the Plan.

While preparing the testing in January of 2023, Donna, the TPA, discovered Andy and April had entered the Plan before completing the required eligibility of six months of service. Donna informed Jerry of this mistake. Jerry was shocked. The Store had in place what he believed to be foolproof practices and procedures to prevent such an error. Before Jerry was promoted to his current position, his predecessor Leslie had put together a detailed binder that instructed Jerry to set up a calendar reminder five months after hire date to send out enrollment materials.

Unfortunately, while reviewing the binder when he first took the position, Jerry dropped a donut, and those important pages were stuck together. As a result, he never saw those great instructions, and mistakenly assumed enrollment paperwork was supposed to be given out as soon as a new employee was hired. Jerry reluctantly notified his boss, Ron (the VP of HR), who frightened Jerry into thinking this was going to cost the Store too much money to fix and the Internal Revenue Service (“IRS”) would be knocking on their door any minute.  How can Jerry get back on Ron’s good side and fix the Plan?

Is Jerry doomed?

Don’t fret, Jerry! There is a way to correct this failure without having to notify the IRS or even paying a fee. The Employee Plans Compliance Resolution System (“EPCRS”), currently prescribed in Revenue Procedure 2021-30, allows Plan sponsors to independently correct certain operational failures through the suitably named Self-Correction Program (“SCP”).  If a failure is eligible for SCP, the Plan sponsor need only make and document the appropriate correction and, if necessary, amend the practices and procedures to prevent another mistake.

What is an eligible failure?

Prior to the passage of SECURE 2.0, SCP was only applicable for operational failures and some specific plan document failures. However, SECURE 2.0 (as explained in IRS Notice 2023-43) opened up self-correction for most failures, so long as there are established practices and procedures in place. Improperly including Andy and April in the Plan before they reached the service requirement constitutes an operational failure because it is contrary to the Plan’s terms. Eligible inadvertent failures (“EIFs”) are self-correctible if self-correction is not explicitly forbidden by the law or by the IRS guidance, so long as they are either insignificant or if they are corrected in a reasonable period of time after discovery of the failure. However, a significant EIF may not be self-corrected once it has been identified by the IRS, which usually means that the Plan has received notice that it is to be audited by the IRS.

An EIF is a failure that occurs despite sufficient administrative practices and procedures intended to keep the plan operating properly. This means the operational failure occurred through an oversight or mistake in applying the procedures. Formal or informal practices and procedures are sufficient if they are reasonably designed to promote compliance with the IRS Code and IRS guidance and are routinely followed. The presence of these procedures must be demonstrated as part of the self-correction process.  As noted above, an EIF can be corrected at any time before it is identified by the IRS. Once it has been identified, it can only be corrected under SCP if it can be demonstrated that a specific commitment to self-correction was already underway and that it is being corrected within a reasonable time. The IRS says that the “reasonable time” requirement is deemed to be met if correction is completed within 18 months of when the failure was identified by the plan sponsor.

The Store’s failure falls into the EIF category. Luckily for Jerry, the Store did have sufficient practice and procedures; unfortunately, they were just hidden behind glazed donut residue.  Because this mistake was caught in time, the Plan has practices and procedures in place, and is not under IRS audit, he can appropriately self-correct.

The Correction

There are two methods of correction Jerry can use to fix the early inclusion of an employee to the Plan. He can either conform the terms of the Plan to the operations that actually occurred (via an amendment) or conform the operations of the Plan to the terms that were in place at the time of the failure (by returning the improper amounts).

Option One: Plan Amendment

The most favorable option – at least, as far as Andy and April are concerned, is to retroactively amend the Plan to conform to current operations by changing the eligibility requirements. The amendment can be drafted to change the eligibility requirements permanently for the future, or can apply only to the improperly included participants, provided it doesn’t create a coverage issue.  It is important to note that, to retroactively amend the Plan to match operations, the employees affected by the amendment must be mostly non-highly compensated employees. Correcting the Plan in this manner will allow Andy and April to stay in the Plan, keep the money they have contributed in the plan, and they keep any matching contributions that have already been made. Everybody wins!

Option Two: Return of Funds

The less favorable option for Andy and April is to remove them from the Plan, if they haven’t yet met eligibility, return any deferrals and earnings to them from the period that they were ineligible, and then forfeit any matching contributions made to which they were really not entitled during the period of ineligibility. This can be an unpopular method of correction because it confuses the affected participants and may be bad for their morale.

In this case, by the time Donna identified the issue, Andy and April had surpassed the six-month service requirement, and any deferral they made after that point would’ve been valid. However, this method would only remove any money that was deferred early, while leaving any deferrals made after Andy and April were eligible (and the associated matching contribution) in the Plan.

When Would Option Two be the Better Choice?

There are times when a company may want to choose Option Two.  One situation would be when so many employees were permitted to enter the plan early that the matching contribution was much larger than could be afforded by the plan sponsor.  Another situation would be if the included participants are not U.S. citizens, so that their deferrals may create out-of-country tax impact.  Finally, if April and Andy were residents of Puerto Rico or another U.S. territory, the Li’l Sebastian 401(k) Plan would need to be “dual qualified” under the tax code of Puerto Rico.  The costs of amending the Plan to accomplish this, as well as the administrative processes necessary to support the participation by territory residents, would likely be more expensive than the Store would want to bear.  In that case, the Store could choose Option Two to the mistaken plan entrants rather than undergoing this disruptive process.

Documenting the Correction

It is equally important to properly document your correction steps. If the IRS does come knocking, proper documentation will provide a clear demonstration of the correction used and the appropriate timing. Furthermore, Notice 2023-43 requires this documentation to qualify for SCP.  This can be done in a memo, which should include the date the failure was identified, how the failure was identified, what years the failure occurred, an explanation of how the failure occurred, a demonstration of the practices and procedures at the time, and an explanation of how the failure was corrected. Besides fulfilling the IRS’s requirements, having this memo readily available avoids any potential lapses in memory that Jerry may have in the future.

Changes should also be made to update the policies to prevent a repetition of the failure. For Jerry, he will likely need to re-create the pages that were destroyed by his rogue donut.

Conclusion

Once Jerry adopts the amendment and properly documents his correction, all will be well again in the Pawnee Parks and Self-Correction Store. Ron does not have to worry about IRS intervention, or an expensive fee, and Jerry does not have to worry about Ron. Most importantly, Andy and April can remain participants and keep their money in the Plan.

For more information on the recent guidance from Notice 2023-43 on EIFs and practices and procedures, click here.

If you have questions about improperly included employees or proper practices and procedures for your retirement plan, give us a call.  We are your ERISA solution!