Last week, at a Joint Meeting of the IRS's top officials with ERISA/tax attorneys and accountants from across the country, the IRS announced a pilot program that targets companies with at least 2,500 participants.  Colleen Patton, the IRS's Area Manager for the Pacific Coast, says the pilot program has rolled out in her region, and the IRS expects to expand the program across the nation's remaining four geographic areas (Northeast, Mid-Atlantic, Great Lakes, and Gulf Coast). 

Under this program, the IRS hones in on a large plan sponsor (greater than 2,500 participants), rather than one specific qualified retirement plan. Thus, whereas a company usually worried about whether the IRS would audit a qualified retirement plan it sponsored, that same company, if targeted, will now have to worry that the IRS will audit all of the company's qualified retirement plans in just one examination.  Indeed, it is not atypical for one company to sponsor several 401(k) plans and several defined benefit plans and perhaps an ESOP too . . . in this case and under this pilot program, the IRS would examine all those plans together.  

Large companies: brace for FULL IRS audit of all retirement plans at once

A targeted company should expect the IRS to conduct an extensive review of all of its qualified plans' procedures, processes, and systems (e.g., how various company payrolls feed data to plans; how the various TPAs coordinate testing across plans; how money moves from the employee paychecks to the plan trusts).  The IRS hopes that after reviewing these procedures, etc., it can then use data-driven factors to surgically target a company's compliance weaknesses. 

Based on recent exam and survey activities, it seems large companies confront these types of compliance weaknesses:

• control group issues,
• deficient plan amendments,
• employees who are not collectively bargained improperly participating in a plan,
• minimum distribution failures,
• improper loan provisions,
• failure to adjust actuarially if termination is after normal retirement age,
• misclassification of employees as higher- or lower-paid,
• misclassification of employees as part-time, temporary, foreign national, independent contractor, etc.

Large companies must brace for this super-enhanced IRS audit of retirement plans.  It will be thorough and comprehensive; indeed, an IRS audit can easily last over two years.  Consider the effect on in-house counsel, HR, and payroll personnel.

Employers should not rely on the annual TPA testing or annual accountant's audit to vet out   these compliance issues.  Many of the compliance problems identified above are outside the limited engagement of the TPA's end-of-year testing or the annual accountant's audit.  Employers who sponsor retirement plans should consider performing a very compliance review to determine if tax qualification failures exist (plan document? operational? demographic?) with each of their qualified plans. 

If failures are found, companies should consider applying under the IRS compliance program to voluntarily identify and correct them, with the hope that the plan would receive an IRS letter confirming continued tax qualification.  Self-correcting and/or applying under the IRS program might postpone an IRS audit and certainly would help ameliorate any sanctions that the IRS would impose if it were the IRS instead who vetted out these compliance issues on audit.   

Welcome to the Worker Classification Casino!

First, the IRS is scrutinizing the employ/independent contractor issue -- and offering a very nice settlement program to encourage companies to prospectively classify as "employees" workers who they improperly classified as "independent contractor."  See our earlier blog piece about the IRS's new program at 2011 Voluntary Amnesty Employee Classification.pdf.

Second, the Department of Labor and 11 state governments (Connecticut, Hawaii, Illinois, Maryland, Massachusetts, Minnesota, Missouri, Montana, New York, Utah and Washington) are working together to fight improper classification of workers as "independent contractors." 

And now, California -- who is NOT a state listed above -- has enacted legislation effective for the new calendar year that imposes as high as a $25,000 per violation penalty for companies  who willfully misclassify "employees" as "independent contractors."   See CA Penalties.pdf. 

The federal government and state legislatures send a clear message:  misclassification is wrong.  

Companies should expect challenges not only from the federal and state governments, but plaintiffs' lawyers who can use "whistle blower" statutes to coax employers to confront the statutory penalties (at least in California), wage-and-hour liability, federal/state employment taxes, and ERISA obligations.  

Companies must grapple with the worker classification issue now.  To not do so is to take a big gamble, with very bad odds.

On Monday, the Fifth Circuit issued its opinion in Brown v. Continental Airlines, Inc., 2011 WL 2780505 (5th Cir.), a rather unusual case addressing what a plan administrator’s obligations are with respect to a Qualified Domestic Relations Order (QDRO) when the plan administrator thinks the underlying divorce that produced the order was a sham.

Plan administrators should take note: 

When it Comes to QDROs, Don’t Out-Think Yourself, Even if You Believe The Employee Faked a Divorce

In Brown, Continental alleged that the wives of nine pilots received lump sum distributions of the pilots’ retirement benefits from Continental's defined benefit plan by entering into fraudulent divorces where the couples continued to live together and then remarried once the plan paid out benefits.  The wives were able to obtain these lump sum distributions because the plan provided that an ex-spouse to whom benefits are assigned can elect to receive the same in lump sum form, provided that the participant was at least 50 years old (even if the participant was still working, which was the case for all of the pilots at issue).

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Employers who sponsor a 403(b) tax-deferred annuity plan for their employees need to be aware of the "universal availability" eligibility requirement for employee pre-tax deferral contributions.  This rule requires that all employees must be eligible to make deferral contributions to the plan as of their first day of employment.

The universal availability requirement for 403(b) plans is significantly different from the rules applicable to qualified retirement plans.  For example, a 401(k) plan can require employees to wait for up to a year before becoming eligible to make deferral contributions.

One of our tax-exempt clients who sponsors a 403(b) plan ran afoul of the universal availability requirement by requiring employees to complete a 90-day "probationary" period before being eligible to make deferral contributions.  This service requirement could have been included in a 401(k) plan, but not in a 403(b) plan.

The result? The employer had to go through a costly correction process, involving both a submission to the IRS under the Voluntary Correction Program (including the payment of a significant compliance fee), plus making corrective "deferral" contributions to the plan on behalf of the excluded employees.  The employer had to make this expensive correction even though the employees had been paid the entire amount that they presumably would have contributed to the plan!

During the 2010 summer, the IRS issued its first-ever electronic 401(k) Compliance Check Questionnaire to 1,200 plan sponsors.  According to Monika Templeman, IRS Director, Employee Plan Examinations at a meeting with both IRS officials and tax practitioners last week, some "double digit" (i.e., 10 to perhaps 99) plan sponsors refused to respond.  She signaled that the IRS intends to conduct a full scope audit of those non-responder plans.  As to those who did respond, the IRS will help guide those who might have experienced some compliance issues, as a sort of gesture of gratitude for helping the IRS determine where the ERISA/tax lapses were overall. Compared to the full scope audits, Templeman said the IRS involvement for those who took the time to respond would be "nothing draconian."

The IRS expects to publish the full compilation of the compliance issues revealed through the 401(k) Questionnaire this coming summer.  Templeman listed, though, the issues that seem to pervade:

• Participants obtain loans or hardship distributions, without having met the Internal Revenue Code for allowing such loans or hardship distributions;
• Companies fail to transmit employee elective deferrals timely to the plan;
• Companies fail to amend their plan documents timely and, better yet, fail to execute the documents;
• Companies do not use the proper definition of "compensation" when determining match or other allocations;
• Companies fail to include eligible employees into their plans;
• Companies do not know how to evaluate results of discrimination testing, including the ADP/ACP test (and, if there are failures, companies do not know how to resolve them). 

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