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IRS Getting Better and Better at Selecting and Auditing Noncompliant Plans

According to a report recently published by the Treasury Department's Inspector General for Tax Administration, the IRS has significantly improved its ability to select noncompliant retirement plans for examination and is achieving greater success results in those examinations. The report describes the methods used by the IRS to identify plans that are likely to have compliance problems serious enough to warrant a change in the plan's Form 5500 return or the retirement plan document, and demonstrates how the IRS is applying its Employee Plans enforcement resources more efficiently than ever. For example, in 2006 47% of all retirement plan examinations resulted in a change to the return, but by 2010 that percentage had increased to 63.6%. The report offers valuable insights that practitioners and employers can use to identify and correct problems in retirement plans before those plans are selected for examination.

The report explains that IRS has identified the following priority areas for assigning examinations:

(1) special projects and abusive tax avoidance transaction are given the highest priority ("Special Project Examinations" and "Abusive Transaction Examinations");

(2) referrals received from various sources inside and outside the Service are given the next highest priority ("Referral Examinations");

(3) risk-based examinations, focused on noncompliant market segments, are given the next priority ("Risk-Based Examinations"); and

(4) Examinations for other reasons, such as IRS training cases for new employees, are given the lowest priority ("Other Examinations").

The improvement within each priority level is informative. The percentage of Special Project, Abusive Transaction, and Referral Examinations resulting in changes to returns increased from 67% in 2006 to a whopping 80.4% in 2010. The percentage of Risk-Based Examinations resulting in changes to the returns increased from 42% in 2006 to 53.7% in 2010. The improvement within Risk-Based Examinations is attributed to the IRS's selection of examinations based on market segment data it has developed over the years. For example, the report shows that 55.7% of 401(k) plans examined in the retail market segment result in a change to the return and, therefore, the IRS presumably focuses resources in that area. Nine other market segments are identified in the report.

On the strength of these impressive numbers, the IRS has reallocated it EP examination resources. In 2006 23.1% of its audits were Special Project, Abusive Transaction, and Referral Examinations; by 2010 that number had increased to 42.9%. Meanwhile, Risk-Based Examinations (which produced only modestly better outcomes) have decreased from 74.3% in 2006 to 55.1% in 2010.

What does all this mean? For one thing, it means that if a retirement plan has been selected for examination by the IRS, the IRS probably has reason to suspect that it may have compliance problems and it is likely that the IRS will in fact find some type of noncompliance. That, in turn, puts even more pressure on the employer and its benefits counsel to pull out all the stops in defending the audit. But the report also provides a dramatic reminder about the value of making voluntary corrections under EPCRS. We'll offer a few thoughts on both subjects.

If you receive an examination notice, waste no time in gathering all potentially responsive materials – plan documents and amendments (all signed and dated of course), testing results, meeting minutes, payroll data, and anything else that is relevant – well in advance of the field audit and bringing in experienced counsel to review the materials. These materials should be reviewed by competent benefits counsel to determine whether there are any apparent noncompliance issues and, if there are, what kinds of corrective action may be acceptable to the IRS in audit context. (Forewarned is fore armed.) Then let your counsel determine what should be provided to the IRS. It's not helpful to an employer or to the IRS when irrelevant or incorrect material is provided to the IRS.

Better still, identify and correct compliance issues before an IRS audit letter arrives. The best way to do that is through regular reviews of plan administrative practices focusing on the kinds of things that are known to create compliance risks or compliance problems. Monika Templeman, the Director of Employee Plans Examinations (the person at IRS responsible for overseeing the examinations discussed above), identified several common errors this week at the ASPPA Northeast Area Benefits Conference in Boston. Ms. Templeman noted the following areas and they provide a good checklist for employers wishing to perform a self-audit:

  • Operating the plan using compensation that is inconsistent with the definition(s) of "compensation" in the plan document
  • Noncompliance with the Code Section 415 limits
  • Noncompliance with loan and hardship distribution rules ("It's amazing how many plans that don't allow loans give them," Ms. Templeman told the audience at last month's ERPA conference)
  • Failure to timely deposit contributions (this is really a DOL issue, but a very common problem, especially for academic institutions)
  • Failure to make employer contributions in accordance with the plan document (a 401(k) plan issue)
  • Failure to properly complete or pass ADP and ACP testing (a 401(k) plan issue)
  • Noncompliance with the Code Section 402(g) limits (a 401(k) plan issue)

The recent TIGTA report says a lot about how much better the IRS has gotten at identifying and examining noncompliant retirement plans. It's well worth your time and attention.

Topics: Plan Administration, Retirement Plans