The U.S. Internal Revenue Service (IRS) has completed two examination projects under its "LESE" compliance initiative, intended to test and measure defined contribution retirement plans’ compliance levels. “LESE” stands for:
Learn—Discover retirement plan compliance issues using small examination case samples.
Educate—Let the targeted groups know what the IRS learned and what it expects them to do to correct errors, using outreach and the IRS Employee Plans Compliance Unit’s soft contact notices.
Self-Correct—Give those groups the chance to correct their plan errors using the IRS Employee Plans Compliance Resolution System by offering correction methods through outreach activities and soft contact notices.
Enforce—Re-examine the groups, taking a firm position with those who have not corrected.
For the LESE examinations, the IRS selected Form 5500 returns randomly based on “judgment sampling.” Findings from the two completed LESE projects are available on the IRS web site for:
• 401(k) and other defined contribution plans with less than $250,000 in assets.
• Top-heavy 401(k) plans.
Small Plan Errors
For defined contribution plans with less than $250,000 (but more than $100,000) in assets, the most common errors the IRS found were:
• Failure to secure adequate bonding of plan fiduciaries and persons who handle retirement plan funds. Under the Employee Retirement Income Security Act (ERISA), the amount of bonding should not be less than 10 percent of the amount of funds handled, and in no event less than $1,000, or more than $500,000, unless an exception is met.
• Failure to amend plans on a timely basis to comply with law and regulatory guidance. This includes the timely adoption of interim and discretionary amendments to comply with statutory and regulatory changes.
Other common errors included:
• Failure to file Forms 1099-R timely.
• Failing to deposit elective deferrals into the plan on time.
• Top-heavy failures (see below).
• Joint and survivor waiver failures.
• Impermissible distributions.
• Failure to include, as part of participants' income, Internal Revenue Code (IRC) section 72(p) "deemed distributions" relating to loans from the plan to plan participants.
The LESE project reports contain tips on avoiding the common errors found by the IRS. Among the advice for small plans:
• Discuss with the plan administrator or pension professional whether the plan is up-to-date with recent law changes.
• Set up operating procedures and appropriate internal controls for the plan.
• If a self-audit reveals that the plan was not amended in a timely manner to comply with applicable laws and regulations, or when an operational review of the plan discloses other qualification failures, consider correcting the plan under the IRS Employee Plans Compliance Resolution System.
Top-Heavy Plan Errors
In general, a 401(k) plan is "top-heavy" when it provides more than 60 percent of the present value of benefits to key employees. If a plan is top-heavy, it must satisfy certain accelerated vesting requirements and provide certain minimum contributions to all eligible non-key employees (to learn more about top-heavy requirements, see the SHRM Online article Clearing the Annual 401(k) Compliance Test Hurdle).
The most common errors the IRS found among top-heavy plans were:
• Failure to test for top-heaviness. Not recognizing that the plan was top-heavy meant that minimum contributions to non-key employees were not made.
• Improper exclusion of eligible employees from the plan. Failing to recognize that one or more employees were eligible to participate meant that the plan failed to provide them with the ability to make elective deferrals (and, if applicable, to receive related matching contributions), and that it failed to make required minimum top-heavy contributions as needed.
• Allocation errors. These often resulted from not using the proper definition of compensation or not allocating contributions properly per plan terms.
To avoid or correct top-heavy violations, the IRS LESE project report advises:
• Discuss each year with the plan administrator or pension professional whether the plan is tested properly to determine whether or not it is top-heavy.
• If the plan is found to be top-heavy, ensure that all eligible participants are identified properly and that the plan terms are followed with respect to complying with IRC section 416 top-heavy requirements related in accelerated vesting and minimum contributions and benefits.
Stephen Miller is an online editor/manager for SHRM.
Top 10 Things to Do If Your 401(k) Plan Fails Nondiscrimination Testing, SHRM Online Benefits Discipline, January 2009
Clearing the Annual 401(k) Compliance Test Hurdle, SHRM Online Benefits Discipline, March 2007
IRS Compliance Projects Identify Common Errors in Small Plans and Top-Heavy 401(k) Plans, CCH Aspen Publishers Technical Answer Group, March 2010
SHRM Online Benefits Discipline