Failing to Adhere to Enrollment Form Designations - How Should This be Fixed?

By Heather Bader-Abrigo

Recently, a 401(k) plan trustee requested our advice regarding a failure of the plan service provider to allocate participant accounts in the manner described in participant enrollment forms. The service provider invested participant accounts in the plan's default fund, rather than in the various funds selected by the participants. This "misdirection" of funds had been going on for a number of months. The plan trustee wanted our advice on how to fix this problem.

Generally speaking, the first step in any correction analysis is to determine the type of problem. Does the error impact the plan's qualified status? Is it a prohibited transaction? Is it a fiduciary breach? This is important because the IRS' remedial program known as the Employee Plans Compliance Resolution System or "EPCRS" can only be used to fix certain types of defects.

For 401(k) plans, EPCRS is available to correct only defects amounting to "qualification failures" - that is, defects that jeopardize the tax-qualified status of the plan. Qualification failures fall into three categories: (1) "plan document failures" - failures to keep the plan document up-to-date with the law and the current requirements of Internal Revenue Code ("Code") qualified plan rules; (2) "demographic failures" - failures to satisfy the non-discrimination, participation and coverage rules; and (3) "operational failures" - failures to operate the plan in accordance with its written terms. In addition, depending on the type of defect(s) at issue, EPCRS may prescribe a specific correction methodology. Finally, not all types of defects are eligible for correction under each of EPCRS' component programs.

So what did we have here? In our case, plan document and demographic failures were clearly not at issue. But did this case involve a failure to operate the plan in accordance with its written terms? It could be logically argued that the answer is no. This is because the defect involved the failure to follow the terms of participant enrollment forms, which are - arguably - documents separate and distinct from the plan document. Thus, the failure to follow the forms could not result in an operational failure, which only occurs if there is a failure to follow the plan document.

However, we also believed it could be reasonably argued that the enrollment forms were extensions of the plan document. And, in fact, the plan document specifically required investments to be made in accordance with the directions specified in participant enrollment forms. This language, in effect, incorporated the enrollment forms into the plan document. Therefore, any failure to follow the terms of the enrollment forms was a failure to follow the terms of the plan document and, thus, an operational failure as defined under EPCRS. We believed this analysis to be a more reasonable interpretation of the defect and, ultimately, the IRS agreed with our position.

Now that we had our operational failure and, thus, our ticket into EPCRS, it was time to move on to the second step of our analysis - determining the proper method of correction.

To accomplish this, we looked to what is arguably the cardinal correction principle under EPCRS: the corrective action should put the plan in the position it would have been in absent the defect. This principle is spelled out in Section 6.02 of Rev. Proc. 2006-27 as follows:

The correction method should restore the plan to the position it would have been in had the failure not occurred, including restoration of current and former participants and beneficiaries to the benefits and rights they would have had if the failure had not occurred.

Using this correction principle as our guide, we determined that the proper method of correction was to credit each affected participant's account with the difference between what the participant would have received had the account been invested in accordance with enrollment form instructions, as opposed to what was actually received in the default fund, plus earnings. We assisted the plan trustee in drafting a notice to affected participants advising them of the error, how it was corrected and the amount that their accounts would be credited as a result of the error.

Once we determined the method of correction, we moved on to the last step in our analysis, which was to determine whether to formally submit the plan to the IRS under VCP or self-correct under SCP.

By submitting an application to the IRS under VCP, the Plan would received a compliance statement. A compliance statement provides formal confirmation that the IRS will not treat the plan as failing to satisfy the applicable requirements of the Code on account of the failures described in the compliance statement, if the conditions of the compliance statement are satisfied.

Under SCP, the plan is not submitted to the IRS for review and supervision, but may nonetheless rely on the same assurances and protections as provided under VCP, so long as certain requirements are met. However, in order to correct under SCP, as distinguished from VCP, the operational failure must be corrected within the first two plan years after the failure occurred, or it must be insignificant. The Revenue Procedure outlines factors to be considered in determining whether a failure is insignificant. Those factors include but are not limited to the following:

(1) whether other failures occurred during the period being examined (for this purpose, a failure is not considered to have occurred more than once merely because more than one participant is affected by the failure); (2) the percentage of plan assets and contributions involved in the failure; (3) the number of years the failure occurred; (4) the number of participants affected relative to the total number of participants in the plan; (5) the number of participants affected as a result of the failure relative to the number of participants who could have been affected by the failure; (6) whether correction was made within a reasonable time after discovery of the failure; and (7) the reason for the failure (for example, data errors such as errors in the transcription of data, the transposition of numbers, or minor arithmetic errors).

By using these factors as a guide, we determined that the error was insignificant. How did we reach this determination? First, this was the first time this error had occurred and the service provider had subsequently placed safeguards in its administrative procedures to make sure it would not happen again. Second, very few participants were affected relative to the numbers of participants in the plan. Third, the error was identified soon after it occurred, and correction would be made within six months after discovery of the error.

Finally, we advised the plan trustee that in order to complete correction, it was necessary to memorialize how the failure occurred and how it was corrected. We advised the trustee of the importance in preparing plan committee minutes detailing not only how the error occurred and how it was corrected, but also how the plan committee now had practices and procedures in place to ensure that this error would not occur again.

Why is this case important to you? Failing to follow the terms of ancillary plan documents, such as participant enrollment forms, can result in serious violations affecting a plan's tax-qualified status. However, all hope is not necessarily lost n these situations. Through proper analysis, it may be possible to correct these types of errors under EPCRS, provided it can be established that the defect meets the EPCRS eligibility requirements, and the proposed method of correction adheres to EPCRS' correction principles and specific rules.