I've Improperly Excluded Employees from Designated Roth Contributions - What Do I Do Now?

By Nick White

There is a new methodology under the Employee Plans Compliance Resolution System (EPCRS) for correcting the defect of improperly excluding employees from a 401(k) and/or (m) arrangement. The new guidance, contained in Revenue Procedure 2006-27 (the "Rev. Proc.") is helpful and addresses obvious inequities under the prior guidance. However, noticeably absent from the discussion of this topic in the Rev. Proc. is guidance on how to correct the improper exclusion of employees from designated Roth contributions.

So, how do you handle these situations in a manner acceptable to the IRS. There's no single answer at this point; however, based on our extensive experience in working with the IRS' remedial programs, we have some advice on how to proceed in this new area, pending the issuance of further guidance.

By way of background, it should be noted that one of the most common defects in the qualified plan world is the improper exclusion of eligible employees from a 401(k) and/or (m) plan. Since the inception of the IRS' remedial programs, the required correction for this defect has been for the employer to make a qualified nonelective contribution (QNEC) on behalf of the affected employee equal to the employee's compensation for the period of improper exclusion, multiplied by the average deferral percentage (ADP) or average contribution percentage (ACP) of the employee's group -- that is, the ADP and/or ACP of either the highly compensated employee ("HCE") group or nonhighly compensated employee ("NHCE") group. The corrective contribution amount was then adjusted for earnings during the relevant period.

The problem with this correction methodology is it assumed the affected employee would have contributed at the ADP of his or her group. And, of course, there is no way to know whether that would have been the case. Furthermore, the affected employee did not have to give up any pay as part of the correction. This means the improper exclusion always worked out as a "win-win" proposition for the employee, at the expense of the employer! There is nothing in the correction principles underlying EPCRS that condones such a windfall. Rather, the most fundamental of EPCRS' correction principles is that the remedial methodology ensure - as best and as reasonably possible under all the facts and circumstances of the case - that the plan, participants and beneficiaries wind up in the position they would have been in absent the defect. For this reason, the retirement plan community has long believed the IRS-mandated form of correction was at odds with the philosophy and purposes underlying EPCRS.

To address this problem, Appendix A to the Rev. Proc. was substantially revised to provide for what the IRS describes as a "new correction method that estimates the economic loss to an employee excluded from participating in a 401(k) or 401(m) plan." Under the new rules, the "lost opportunity" cost for making the elective deferral is valued at a rate of 50% of the applicable ADP, rather than 100%. In the case of employee voluntary after-tax contributions, the lost opportunity cost is valued at 40% of the applicable ACP - again, as opposed to the old rule which required use of 100% of the ACP. If these contributions should have been matched, the corrective matching contribution is determined by applying the plan's matching contribution formula to the corrective elective deferral and voluntary after-tax contribution amounts. The only caveat is that, in determining the corrective matching contribution for missed elective deferrals, a deemed deferral amount equal to 100% of the ADP - and not 50% of the ADP - is used. For safe harbor 401(k) plans, the deferral percentage is assumed to be 3% (or higher, if the plan provides for a 100% or more favorable match for a higher percentage of deferral). As is always the case under EPCRS, all corrective contributions must be adjusted for earnings.

Conceptually, the new procedures appear reasonable and relatively straightforward. But, there's a "hole" in the guidance. What if your plan provides for both regular elective deferral and designated Roth contributions? Do you base the correction on the 50% QNEC for missed deferrals, the 40% QNEC for missed voluntary employee after-tax contributions or something else?

What we know for certain at this point is that the IRS didn't simply miss this issue. In fact, the IRS has been clear about the fact that new guidance is not intended to apply to plans providing for designated Roth contributions; however, the IRS is actively soliciting recommendations on the proper correction method in this instance. This necessarily means there would be at least some risk in correcting for missed Roth contributions under the IRS' Self-Correction Program (SCP), because there would be no way to obtain "reliance" that the methodology used would be acceptable to the IRS. Thus, if the IRS were to examine a plan that self-corrected for missed Roth contributions and disagreed with the correction methodology, the plan's qualified status would be at risk, and could be preserved only by implementing an alternative form of correction and paying a potentially large sanction under the Audit Closing Agreement Program (Audit CAP).

At various national conferences and in informal discussions, the IRS has stated that "reasonable approaches [to correcting this defect] will be considered." The IRS has also suggested that plan sponsors and their advisors look to the "existing guidance, including examples in the appendices" to formulate correction methods that meet the spirit, principles and purposes underlying EPCRS. At this time, it appears the only reasonable interpretation of the IRS' statements is that the closer the correction method is to one of the existing pre-approved methods, the better the chances are it will be determined to be acceptable. This means implementing a correction method under SCP that deviates significantly from existing guidance, no matter how well reasoned and intended, would likely place the plan at a significant risk for disqualification - or at least serious risk of having to correct under Audit CAP.

This doesn't mean, however, that there is no room for "out-of-the-box" and otherwise creative correction in this case. Rather, it simply means that correction methods significantly different from those appearing in the current guidance should be submitted for approval through the IRS' Voluntary Compliance Program (VCP), so the plan sponsor has an opportunity to obtain a written determination that the method of correction is acceptable to the IRS. Depending on how aggressive the correction position is and the amount of money at stake, the plan sponsor may want to submit and obtain a tentative ruling on an anonymous basis and, thus, test the waters before deciding to disclose its identity to the IRS.

Finally, regardless of whether the improper exclusion from designated Roth contributions is being corrected under SCP or VCP, the absence of formal guidance at this time means plan sponsors should weigh the relevant issues with qualified counsel before implementing the correction. Furthermore, even if it is determined that correction under SCP is a reasonable alternative, the plan sponsor should make certain the correction methodology is properly documented - this would include a discussion of eligibility under SCP and a detailed explanation of the rationale behind the corrective actions taken.

© 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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