Rev. Proc. 96-23 and Correcting Retirement Plan Errors

The Internal Revenue Service (IRS) provides a safety net for sponsors of retirement plans, like 401(k)s, allowing them to fix mistakes that could otherwise lead to plan disqualification. This system, the Employee Plans Compliance Resolution System (EPCRS), offers official procedures for correcting plan errors to preserve the plan’s tax-favored status. The program’s rules were updated by the SECURE 2.0 Act of 2022 and subsequent IRS guidance, building on Rev. Proc. 2021-30. The system encourages voluntary and timely correction to protect employees’ retirement benefits and provides programs tailored to different circumstances, from self-correction to more formal submissions.

Understanding Plan Failures

To use the correction programs, a plan sponsor must first identify the specific type of error, known as a qualification failure. These mistakes fall into several distinct categories, and properly classifying a failure determines the appropriate resolution path.

Operational Failures

An operational failure, the most common error, occurs when a plan sponsor does not follow the written terms of their retirement plan document. Any deviation in day-to-day administration is an operational failure, even if the plan document is compliant. For instance, if the plan defines compensation as total pay, but the employer calculates 401(k) contributions using only base salary, an operational failure has occurred.

Other examples include failing to admit eligible employees into the plan or making plan loans that violate the plan’s rules on loan amounts or the number of loans permitted.

Plan Document Failures

A plan document failure is a flaw within the written plan document, such as a provision that violates the Internal Revenue Code or the absence of a required provision. A primary example is failing to amend the plan document by the legally mandated deadline to reflect changes in retirement law. When Congress passes new legislation, the IRS provides a specific timeframe, a remedial amendment period, for sponsors to update their documents. Missing this deadline creates a plan document failure, even if the plan was operated in compliance with the new law.

Demographic Failures

Demographic failures involve a plan’s inability to pass annual nondiscrimination tests required by the Internal Revenue Code. These tests ensure a plan does not unfairly benefit highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). The most common are the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests for 401(k) plans. The ADP test compares the average deferral rates of HCEs to those of NHCEs, while the ACP test compares employer matching and employee after-tax contributions. If the disparity between the two groups is too large, the test fails.

Employer Eligibility Failures

An employer eligibility failure occurs when an employer adopts a retirement plan it is not legally permitted to sponsor. Certain plans are restricted to specific kinds of employers; for example, a 403(b) plan is available only to public schools and certain tax-exempt organizations. If a for-profit corporation established a 403(b) plan, it would be an employer eligibility failure. This is a fundamental error because the employer lacks the legal standing to maintain that type of plan.

The Self-Correction Program

The Self-Correction Program (SCP) allows plan sponsors to correct certain plan failures without notifying the IRS or paying a fee, provided the sponsor has practices in place to ensure compliance. Recent legislation expanded a sponsor’s ability to self-correct most common operational errors, known as “eligible inadvertent failures.” These can be corrected at any time, regardless of significance, as long as the IRS has not identified the failure during an audit.

Although no filing is sent to the IRS, a requirement of SCP is to maintain thorough internal documentation of the correction to demonstrate that a proper correction was made. The documentation should identify each failure, the years it occurred, and the number of participants affected. It must also detail the correction method used and describe changes made to internal procedures to prevent future errors.

Preparing a VCP Submission

When an error is not eligible for SCP, sponsors can use the Voluntary Correction Program (VCP), which requires a formal application to the IRS. VCP is available for a wide range of failures, including those that are significant or were not corrected within a required timeframe. Preparation involves gathering information, determining a correction method, and completing specific forms.

First, compile all relevant details, including the plan’s name, Employer Identification Number (EIN), plan number, and the total number of participants. A narrative must be developed that describes the failure, explaining how and why it occurred, the period it covered, and the number of employees affected.

Next, the sponsor must propose a correction method. The EPCRS revenue procedure provides general principles and specific safe-harbor corrections for common errors. For example, if an employee was improperly excluded from making 401(k) deferrals, the standard correction is an employer-funded Qualified Nonelective Contribution (QNEC) equal to 50% of the employee’s missed deferral.

EPCRS provides safe harbors that can reduce this cost. If a failure in a plan with automatic contributions is fixed within 9.5 months after the plan year ends, a QNEC may not be required. For other deferral failures, the QNEC may be reduced to 25% if corrected within a specific period.

The VCP Submission Process

The formal VCP submission is handled electronically through the Pay.gov website. The sponsor or their representative must create an account, locate, and fill out the interactive Form 8950, Application for VCP Submission. This form captures plan information and details about the failures being corrected.

The Pay.gov system uses the information from Form 8950, such as the number of plan participants, to automatically calculate the required compliance fee. The next step is to upload a single PDF file (not to exceed 15MB) containing all required attachments. This PDF must include the narrative describing the failure and correction, supporting calculations, relevant plan document provisions, and a signed penalty of perjury statement.

If a representative is filing, a Form 2848, Power of Attorney, must also be included. After the PDF is uploaded, the compliance fee is paid through the portal. The system generates a confirmation receipt with a tracking ID for the sponsor’s records.

Following submission, an IRS agent will review the case and may request additional information. Upon approval, the IRS issues a formal Compliance Statement, which provides assurance that the plan will not be disqualified over the corrected failure.

The Audit Closing Agreement Program

The Audit Closing Agreement Program (Audit CAP) is used when the IRS discovers a significant retirement plan error during an audit that was not previously corrected under SCP or VCP. A plan sponsor does not choose to enter Audit CAP. The program provides a path for the sponsor to correct the failure and pay a sanction to avoid plan disqualification.

When an error is found during an audit, the plan sponsor and the IRS negotiate a resolution. The result is a formal closing agreement, which is a binding contract detailing the correction terms and the monetary sanction. The sanction reflects the seriousness of a failure discovered by the IRS rather than being voluntarily disclosed by the sponsor.

The sanction is a negotiated amount based on the “Maximum Payment Amount” (MPA), which is the total potential tax liability from full plan disqualification. This includes tax on trust earnings, lost employer deductions, and income inclusion for participants. The final sanction is a percentage of the MPA and is greater than the fee that would have been paid under VCP for the same error. Several factors influence the final amount, including:

• The strength of the plan’s existing internal controls
• Steps the sponsor took to prevent and identify errors
• The extent of the sponsor’s cooperation during the audit
• The nature, extent, and severity of the failure