The Internal Revenue Service (IRS) has published details on the top 10 issues identified during examinations of 401(k) plans. These are the issues that the IRS will be focusing on when conducting an audit.
The issues are:
1. Late deposit of 401(k) deferrals. The Department of Labor (DOL) regulations require that employers deposit salary deferrals as of the earliest date on which such amounts can reasonably be segregated from the employer’s general assets. In most cases, the salary deferral amounts can be segregated within 1 or 2 days before the date the employee’s paycheck is issued. In many cases, amounts can be segregated on the same day. Other rules provide that in no event may salary deferrals be deposited later than the 15th business day of the month following the month in which such amounts would otherwise have been payable to the participant in cash.
2. Improper 401(k) accelerated deductions. Employers are improperly claiming a deduction on their current year federal income tax return for 401(k) deferrals made on account of and paid during the subsequent tax year. Rev. Rul. 2002-46 describes this acceleration of 401(k) deductions as a tax avoidance scheme, which constitutes a “listed transaction” for tax shelter purposes, and provides guidance on correcting the problem. IRS Announcement 2002-2 provides information on disclosure requirements.
Employers are also improperly accelerating income tax deductions by contributing amounts in the current year (usually on the last day of the taxable year) that are attributable to subsequent year salary deferrals. There is an exception for bona fide administration considerations only if the contributions are not paid early with a principal purpose of accelerating deductions.
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3. Failure to use correct compensation. Plan administrators are using the incorrect definition of “compensation” when calculating the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, computing the salary deferral and employer-matching contributions, and verifying that contribution limitations are satisfied. Usually, these problems occur when the employer and/or plan administrator are not aware that the plan document contains different definitions of compensation for different plan purposes. Plan administrators are also failing to limit compensation for contribution and nondiscrimination purposes as required under IRC Sec. 401(a)(17).
4. Improper exclusion of eligible employees for purposes of ADP and/or ACP testing. When conducting the ADP and/or ACP tests, plan administrators are improperly excluding eligible employees. For ADP purposes, eligible employees include all employees who are directly or indirectly eligible to make a cash or deferred election under the plan for all or a portion of the plan year. This means that an employee who can defer at any time during a plan year must be included in the testing, including part-time employees who satisfy the eligibility requirements.
When conducting the ADP test, plan administrators are improperly excluding eligible part-time employees, nondeferring employees who begin or terminate participation during a plan year, and/or those employees who simply choose not to defer.
When conducting the ACP test, plan administrators are improperly excluding employees who are eligible under the plan to make employee contributions or to receive an allocation of matching contributions but choose not to make employee contributions or do not receive any matching contributions.
Another problem occurs when the population of eligible employees is different for ADP and ACP testing purposes and the plan administrator does not differentiate when conducting the tests.
5. Misclassification of highly and nonhighly compensated employees for ADP and/or ACP testing. Plan administrators are misclassifying highly and nonhighly compensated employees for purposes of ADP and ACP testing. Misclassification often occurs when the administrator fails to review prior year compensation, fails to consider the attribution rules related to ownership when identifying 5 percent owners, and/or fails to comply with the plan document in instances where it provides for the top-paid election. Problems result when there is a communication gap between the employer and plan administrator about what the plan document provides and what documentation is needed to ensure compliance.
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6. Failure to correct or timely correct ADP and/or ACP failures. Plan administrators are failing to take timely, proper corrective action after finding that their plans fail the ADP and/or ACP test. In many cases, the plan administrator does not receive the information needed to conduct the tests in time to make needed corrections.
In tomorrow’s CED, we present the rest of the IRS’s 401(k) issues.
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It’s worth checking out the full IRS publication on these issues. The agency provides very clear advice on how to address each of these problems and avoid them going forward.