TOP ADMINISTRATIVE MISTAKES AND HOW TO CORRECT THEM September 12, 2014 2014 Midwest Conference Vicki Graft ESOP Partners LLC vgraft@esoppartners.com Brian L. Anderson Dewitt Ross & Stevens S.C. bla@dewittross.com
WHY BE CONCERNED ABOUT CORRECTING ERRORS? ESOP fiduciaries could be sued by participants Tax qualification of ESOP could be jeopardized DOL and IRS could impose penalties
STATUTORY AUTHORITY Both IRS and DOL have authority to: 1. Perform on-site audits 2. Inspect books and records 3. Question individuals regarding investigation 4. Subpoena records and testimony in connection with investigation
STATUTORY AUTHORITY Open Years DOL ERISA has a 6 year statute of limitations, but generally DOL audits will not go back further than 2 or 3 years IRS Code generally allows for 3 year statue of limitations Both DOL and IRS may attempt to bootstrap prior years to obtain information from those years
IRS CORRECTION PROGRAMS Employee Plans Compliance Resolution System (EPCRS) Revenue Procedure 2013-12 Type of Failures Plan document failure Demographic failure Operational failures Employer eligibility failure
IRS CORRECTION PROGRAMS Self-Correction Program (SCP) No IRS fee, but cost of correction Only for insignificant failures (or significant failures corrected by last day of second plan year after year of failure) Voluntary Correction Program (VCP) Application to IRS for compliance statement Cost IRS fee (based on headcount), preparation of application, and cost of correction Audit Closing Agreement Program (CAP) Cost IRS sanction generally negotiated.
IRS CORRECTION PROGRAMS Correction Principles Full correction should be made for all participants for all years The correction method should restore plan to no-failure position Correction should, if possible, resemble an approved method Correction generally should keep assets in the plan Correction should not violate other legal requirements Corrective allocations should be adjusted for earnings Absent precise calculations, reasonable estimates are acceptable
IRS CORRECTION PROGRAMS Correction Principles Document the steps used to correct the errors Revise administrative procedures, if necessary, to prevent likelihood of error occurring again
PROBLEMS OUTSIDE OF EPCRS Form 5500 and Form 8955-SSA delinquencies Breaches of fiduciary duties Prohibited Transactions Deductibility and/or funding issues Section 409(p) violations
DOL CORRECTION PROGRAMS Voluntary Fiduciary Correction Program Fiduciary violations only 19 categories of covered transactions (e.g., ESOP purchase of assets from party in interest at more than fair market value) Delinquent Filer Voluntary Compliance Program (DFVC) For waiver of DOL penalty for late filing of Form 5500 Even IRS will waive late-filing penalty if DFVC used
(VERY) COMMON ERRORS Eligible Compensation Incorrect compensation used for allocation purposes. Common exclusions are overtime, bonuses, fringe benefits, compensation earned before entry date Example: ABC Company s plan document states that bonuses and overtime are excluded from eligible compensation. ABC Company provides gross compensation on year end census file. What happens?: Contribution and forfeiture allocations incorrect. Distributions based on incorrect balances.
How to prevent? 1. SCP 2. VCP How to fix? 1. Re-do the allocations 2. Corrective contribution 1. Retroactive plan amendment 1. Be familiar with the basic features in plan document. Provide TPA with specific excluded compensation amounts on census file 2. Reconcile compensation payroll records 3. Does your TPA verify census file includes or excludes compensation? 4. Watch when plan is restated or prepared by another provider Additional consideration if compensation definition is discriminatory
COMMON ERRORS Vesting Issues Incorrect definition of year of service it may not be the same definition as other provisions in the plan (eligibility, allocations, etc.) Example: ABC Company s document requires 1,000 during the plan year for one year of vesting service. Suzie Q. works 800 hours from June 1, 2013 (date of hire) to December 31, 2013 and 2080 hours from June 1, 2013 to May 31, 2014. Does she have a year of vesting service for 2013? Computation Period Plan year or Anniversary year; does it revert to plan year after initial year? Other years of service considerations: Elapsed time vs hours method? Actual hours vs 45 hours per week? What happens?: Incorrect vesting applied to account balance. Possible over or under payment for distributions.
How to fix? How to prevent? 1. SCP 1. Additional distribution to terminated participants (if shortfall) 2. Correction contribution from Plan Sponsor or fund from current year forfeitures (if excess). Very difficult to retrieve distribution money once it is in the hands of the former participant 1. Review years of service on employee eligibility report (census) and compare to prior year report 2. Provide TPA with complete census information (hours etc.) for all employees 3. Double check vested balances before distributions are processed 2. VCP - same process
COMMON ERRORS 409 (p) Issues Synthetic Equity (SE) not included on 409(p) test. Common SE include warrants, options, phantom stock, stock appreciate rights, split dollar life insurance, etc. Example: S-Corporation ESOP has Stock Appreciation Rights (SARs) for key managers. TPA is unaware of the SARs and excludes from 409 (p) test. (TPA didn t ask? Plan sponsor left question blank on annual form? Person completing annual form wasn t aware of SARs?) What happens?: Test is not correct and could result in 409(p) failure.
How to prevent? How to fix? Re-run 409(p) test and hope for the best! No retroactive correction available! 1. Plan Administrator should review annual information form. TPA should inquire each year if any changes in SE have occurred (or other factors included in 409(p) test such as family relationships) 2. ESOP Trustee and Board of Directors should review test annually 3. Confidential information requires special handling 4. If your company is an S-Corporation make sure the test is being performed and reviewed annually! TIP: the 409(p) test is a daily test so make sure test passes BEFORE the SE plan is in place.
COMMON ERRORS Issue Separate Stock Accounts not maintained Example: ABC Company ESOP acquired shares in 3 transactions in 1985, 1992 and 2001 but there is only one stock account maintained for each participant What happens?: Cost basis incorrect for stock distributions, pre-1986 shares not required to be diversified, potential for Section 1042 shares to be reallocated to restricted participants (family members or 25% shareholders) possible income tax to the 1042 seller
How to fix? How to prevent? 1. SCP Generally not available since error spans more than a couple of years 2. VCP Re-do all prior year allocations using separate shares accounts; recreate cost basis; exclude 1042 restricted participants. Create the account balances that should have been and then compare to what actually happened. May require a plan amendment 1. Special handling when 1042 involved; review allocations to verify no allocations to restricted participants. Must know selling shareholders and their relationships to other plan participants 2. Provide ESOP s K-1 to TPA (S- Corporation) for cost basis especially if plan allows for lump sum distributions in the form of stock 3. Check for cost basis adjustment each year
COMMON ERRORS Issue - Shares redeemed but no mid-year appraisal obtained. The sale of shares is between parties in interest which is a prohibited transaction under Code Section 4975(c)(1)(A) and ERISA 406(a)(1)(A) unless ERISA exemption rules followed Example: Company uses Section 80-26 loan to fund distributions from the ESOP trust. Four months later the company redeems a portion of the shares associated with the distributions using the prior year market value (i.e. the market value on the distribution forms) What happens?: The ESOP cannot rely on the prior year-end appraisal to satisfy the exemption
How to fix? How to prevent? 1. SCP - not available 2. VCP Annual 15% excise tax on the amount involved until the transaction is corrected 1. If the stock price would have increased, the Company owes the ESOP a trueup contribution 2. Is there an issue if the stock price would have decreased? 1. Obtain appraisal for any transaction between parties in interest 2. If Company knows it will redeem shares at time of distribution, distribute shares and redeem at time of distribution (assuming plan document and Distribution Policy provide for distributions in shares)
(VERY) COMMON ERRORS Issue Erroneous allocation to participant not otherwise eligible Example: ABC Company fails to include dates of termination for 5 out of the 10 employees that terminated during the year. A participant must be employed on the last day of the year to be entitled to an allocation. Erroneous allocation was not corrected before vested balances were distributed What happens?: Plan allocated contributions to the 5 participants not eligible for an allocation. Distribution was overstated and other participants balances understated
How to fix? How to prevent? 1. SCP Re-do the allocations and place the accounts in the position they should have been and Company must retrieve (or contribute) the excess distribution amount. Must make the plan whole 1. Know the plan document 2. Make sure hours and employment history are tracked in a timely fashion 3. Someone familiar with payroll should review census before remitting to TPA 2. VCP Retroactive Plan Amendment
COMMON ERRORS Issue Shares Release Calculation Example: ABC Company s ESOP loan document specifies that the Principal and Interest Method is to be used for the release formula. The interest rate fluctuates with prime rate and is to be computed using 365 days. ABC Company s release was based on 360 days and interest rate was not adjusted even through the prime rate did change. What happens?: Incorrect number of shares released from suspense account for several years, therefore participant account balances are incorrect.
How to fix? 1. SCP not available unless caught in early years 2. VCP Recreate the amortization schedule Determine number of shares which should have been released each year Re-do participant allocations (and compliance testing) for all years affected Notify participants of errors and provide updated participant statements How to prevent? 1. Be familiar with document. 2. Review annual ROS computation.
COMMON ERRORS Issue Missed Required Minimum Distributions (RMDs) Example: Jim Harris, a 10% shareholder and an ESOP participant, attained age 70 ½ in 2013 while still gainfully employed What happens?: TPA firm received census in May 2014 and realized the April 1, 2014 deadline for the 2013 RMD (i.e. 5% shareholder) was missed subjecting Jim Harris to a 50% excise tax on the RMD amount
How to fix? 1. SCP Calculate and distribute the 2013 (and 2014) RMD in 2014. (Remember RMDs are not eligible for rollover) Notify participant of the excise tax which is to be included on participant s 2013 Form 1040 Some companies will pay the excise tax on behalf of the participant Participant may request a waiver (with a good explanation) and potentially receive a refund of the excise tax paid. How to prevent? 1. Be familiar with RMD rules, especially for 5% shareholders, deceased participants and those eligible for delay until actually retired 2. Be proactive in identifying those eligible for RMDs in the next year or two 3. Is your TPA notifying you of potential RMDs for the next year? 2. VCP same process
COMMON ERRORS Issue Dividends and S-Distributions used to repay ESOP loan. Example: SYS, Inc. paid the ESOP it s share of corporate S-Distributions which was then applied to the annual loan payment. The ESOP s S- Distribution was $50,000 and released shares with a market value of $40,000 What happens?: Dividends/S-Distributions on allocated shares used to repay debt must satisfy the Fair Value Rule -- participants must receive the same value in shares as they would have received in cash. Essentially, must receive shares with a value of at least $50,000
How to fix? How to prevent? 1. SCP Use shares released from the dividend associated with unallocated shares to satisfy (subsidize) the failure What happens it there aren t enough shares released on the unallocated shares to satisfy the failure? Additional contribution required 1. Be familiar with regulations TIP: Only dividends paid on shares acquired with the loan can be used to pay down that applicable loan. 2. VCP same process
COMMON ERRORS Issue Diversification Example: TPA firm discovers new takeover client has never offered diversification elections to plan participants even though the plan has been in existence for over 15 years. What happens?: Diversifications were consistently not offered timely
How to fix? 1. SCP not eligible for SCP (longer than 2 years) 2. VCP Identify the participants not provided an opportunity to diversify (and what years, number of shares and stock price involved) Provide participants with six election years as if participant was currently in eligibility period If MV has declined, Company may need to contribute funds if there is lost opportunity How to prevent? 1. Know Plan Document do you have early diversification provisions too? 2. Attend conferences 3. Is this service included in your TPA s engagement agreement? Tips: Pre-1987 shares must be traced separately from post-1986 shares. Eligibility based on years of participation (not years of service). Computation of eligible shares is cumulative. Most firms use Preliminary forms to meet the 90 day rule. Good faith effort needed for both 90/180 day rules.
COMMON ERRORS Issue Distribution Timing Example: Suzie Q. terminated employment in March 2013. She contacts former employer in February 2014, before the 2013 MV is available, and begs for the distribution from ESOP. Plan document allows for distribution in the year following the year of termination. Plan Administrator feels sorry for Suzie Q. and processes the distribution using the 2012 market value. When the valuation is received in May, the value of the stock has declined. What happens?: Suzie Q. s distribution is not based on the current FMV and not done at the same time as other eligible participants
1. SCP How to fix? Determine proper amount that should have been distributed (as if it had been completed with other 2014 distributions) If Suzie Q. does not repay the excess amount, the Company must make the plan whole. 2. VCP Retroactive amendment How to prevent? 1. Know plan s distribution policy and stick to it. 2. Make sure all employees have a copy of distribution policy. Update and recirculate as needed. 3. Do not process distributions after year end on an old value.
HOW TO REVIEW THE TPA REPORTS Census: 1. Compare gross compensation, hours, 401(k), etc. to totals on census file provided 2. Have someone in Payroll/HR review for missing DOT, incorrect hours, etc. 3. Verify that new employees are excluded (included) 4. Are employees hired before June 30 of the prior year reflected as eligible? 5. Did participants working less then 1,000 hours not receive an allocation?
HOW TO REVIEW THE TPA REPORTS Trust Accounting: 1. Cash (other investment) balances should agree with balances on year end trust statements 2. Distributions should agree with 1099-R totals (and distribution checks) 3. Are contributions and/or dividends remitted after year end properly accrued? 4. Number of shares outstanding (and in ESOP) should agree with valuation report 5. Shares reflected at new market value
HOW TO REVIEW THE TPA REPORTS Allocations: 1. Re-compute contribution amount for one or two participants 2. Has gain on other investments been allocated based on plan document? 3. Were forfeitures released when distributions occurred? 4. Has vesting been updated for an additional YOS? 5. Totals on report should agree with Trust accounting (year end balances, contributions, benefits paid, etc.) 6. Cost basis adjusted for current year
QUESTIONS?