The Keys to Crafting a Successful VCP Application to Support Correction Through Reformation

By Marty Heming

The Voluntary Correction Program (“VCP”) permits an applicant to correct operational failures by retroactively amending the plan document to conform it to the plan’s operation — this is commonly referred to as “reforming” the plan to match its operation. This method of correction can be used only if the amendment complies with the requirements of Code sections 401(a)(4), 410(b) and 411(d)(6), which generally prohibit discrimination in favor of highly compensated employees.

What the IRS doesn’t explain about reformation in the Employee Plans Compliance Resolution System (“EPCRS,” as currently stated in Rev. Proc. 2006-27) is that not only must the retroactive amendment not violate these discrimination rules, but also — except in rare circumstances — it will not be permitted unless the IRS is convinced that the plan sponsor intended the plan to be written in the manner operated and the operation is consistent with the reasonable expectation of the participants. This initial intent and reasonable expectation can be established by either circumstantial or written evidence.

The basis for the IRS position regarding intent and expectation is taken from court rulings regarding the rules for reformation of contract. In a nutshell, courts may permit a written contract to be modified to conform to the intent of the contracting parties; however; before granting reformation, the court must be persuaded by clear and convincing evidence that — due to a drafting or “scrivener’s error” — the language in the document does not reflect the intent and understanding of the parties. Thus, by analogizing to the manner in which courts have handled the issue of reformation, the IRS will not permit correction through retroactive amendment of a plan unless there is clear and convincing evidence supporting reformation.

As a general rule, the IRS requires written evidence of the employer’s intent that demonstrates how the document should have been written. An example of such evidence would be a letter from the employer to the plan document provider requesting that the plan be written in a manner consistent with the manner in which the plan was operated. Such a letter should be dated before the plan was written. In our experience, such direct evidence of a scrivener’s error is rare. More commonly we are presented with circumstantial evidence of the intent of the parties, which carries much less weight with the IRS when it comes to persuading the government that correction through reformation is the most appropriate methodology for remedying the defect.

It should be noted that even if the IRS accepts correction through reformation of the plan document, it still may be challenged by the plan participants and/or the Department of Labor (DOL), since IRS ruling are not binding on the DOL.

The following case is not only a good example of how to successfully argue for correction through reformation, but it is particularly noteworthy because we secured the favorable outcome notwithstanding the fact that our case was built on entirely circumstantial evidence!

Employer X restated its 401(k) profit sharing plan as part of a switch from one investment provider to another. Employer X intended that the plan, as restated, would carry forward all of the terms of the old plan. Prior to implementing the new investment provider’s restated plan document, the Employer X’s Human Resources Director conducted a meeting, with the potential investment provider, Company F. Company F’s agent told the Human Resources Director that all of the substantive provisions in the old plan would be “mapped over” to the new plan document.

As a general matter, the new plan reflected the same substantive provisions as were contained in the plan prior to restatement. However unbeknown to Employer X, one of the provisions wasn’t the same. This was not discovered until the ADP and ACP tests were conducted under the new plan document more than a year and ˝ later. When these tests failed, Company F prepared the correction using a Qualified Non Elective Contribution (“QNEC”)for each non-highly compensated employee. Employer X expected them to use the bottoms up QNEC used for the past several years. This didn’t occur and Company F advised that the correction F advised that the correction must be done using a proportionate QNEC for each non-highly compensated. This would have resulted in a $300,000 cost to Employer X, rather than a cost of about $43,000.

Of course, when Employer X was told this by Company F, they were very upset. Company F told them that the restated plan provided for a proportionate QNEC and that this was because the old Plan didn’t contain a bottoms-up QNEC. At this point, Employer X hired our firm to resolve the problem.

Our first step was to examine the provisions of the old plan prior to restatement. It provided in pertinent part that the QNEC needed to correct a failed ADP test may be made to any select group of nonhighly compensated employees (hereafter “NHCEs”) chosen by the Employer. Company F restated the old plan using its prototype document. It provided either (i) a QNEC which was proportional or (ii) a bottoms-up QNEC. According to Company F, they always picked the proportionate QNEC unless the prior Plan document specifically mandated a bottoms-up QNEC. Of course, this wasn’t mentioned to Employer X and they didn’t notice the new provision was different from the old one.

Prior to submitting the Plan for a VCP we took the following action. Obtained an e-mail admission from Company F that they had agreed to map over the same provisions as were in the new plan and an explanation as to why the bottoms up QNEC was not used, and that they had not contacted Employer X to explain this decision prior to the restatement of the Plan. We also had Employer X prepare (i) a letter to Company F demanding that they admit their failure to use the bottoms up QNEC or at least contact Employer X before restating the Plan and (ii) an affidavit under penalty of perjury from an officer of Employer X that she had met with representatives of Company F before the restatement was prepared and was assured orally that they would map over the same substantive provisions into the new plan as were in the old plan. Company F refused to send a letter admitting an error had been made in drafting the new restatement.

We then sent the IRS all of the above as part of the VCP application as well as proof that in operation the correction of the ADP test had been completed using the bottoms up QNEC. After some oral negotiation with the IRS, the VCP application was granted and reformation was accepted as correction of the error.

This case is important to you for two reasons. First, it emphasizes that establishing that retroactive amendment will not violate the non-discrimination rules is not the only IRS prerequisite for granting reformation. More importantly, however, this case demonstrates how to establish - by clear and convincing circumstantial evidence — the intent of the plan sponsor, even when the entity responsible for the drafting error is less than cooperative.

© 2007 Reish Luftman Reicher & Cohen. All rights reserved. The ERISA Audit Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.

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