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IRS compliance projects identify common errors in small plans and top-heavy 401(k) plans

The IRS has released results and findings from two examination projects under the Learn, Educate, Self Correct and Enforce (LESE) compliance initiative. The projects, which focused on defined contribution plans with less than $250,000 in assets and top-heavy 401(k) plans, highlighted compliance problems among small plans, such as the inadequate bonding of plan fiduciaries.

CCH Note: LESE is a compliance initiative started by the IRS in FY 2007 to test and measure compliance levels in retirement plans. Under LESE, the IRS looks to: Learn about retirement plan compliance issues through small examinations; Educate by alerting targeted groups to what has been found and IRS expectations about the correction of errors; allow groups to Self-correct plan errors using the Employee Plans Compliance Resolution System (EPCRS); and Enforce compliance by taking a firm position with parties that have not corrected errors. The project results were reported on the LESE Webpage.

DC plans with less than $250,000 in assets

The IRS examination of defined contribution plans with less than $250,000 in assets (but more than $100,000) highlighted (based on approximately 50 examinations of Form 5500 filings) two major problems: (1) Failure to secure adequate bonding and (2) Failure to timely amend plans to comply with current law and regulatory guidance.

Failure to secure adequate bonding. ERISA 412 specifies that the amount of the bond not be less than 10% of the amount of funds handled, but in no event less than $1,000, nor more than $500,000. The amount of the fiduciary bond must be fixed at the beginning of each calendar, policy, or other fiscal year which constitutes the reporting year of the plan. Note, the bond may never be less than $1,000, even if 10% of the amount of funds handled is less than $1,000.

Generally, a bond may not exceed $500,000. However, the Department of Labor (DOL) may impose a bond in excess of $500,000, after due notice and opportunity for hearing to all interested parties. Specifically, ERISA Reg. 2580.412-11 states that no bond shall be required in excess of $500,000, although the DOL may prescribe a bond greater than $500,000, but not greater than 10% of the funds handled.

ERISA does not require that the fidelity bond state a specific dollar amount of coverage, as long as the bond covers at least 10% of the funds handled, with minimum coverage of $1,000 for each plan official covered under the bond. For example, the bond may state that a specific plan official is covered under the bond for the greater of $1,000 or 10% of funds handled, up to $500,000.

The amount of the fidelity bond is fixed annually. Specifically, the bond must be fixed or estimated at the beginning of the plan's reporting year (i.e., as soon after the date when such year begins as the necessary information from the preceding reporting year can practicably be ascertained). However, the amount of the bond must be based on the highest amount of funds handled by the person in the preceding plan year.

Note, because the bond is fixed annually, in the event the amount of funds handled increases during the plan year after the bond is purchased, the bond need not be updated during the plan year to reflect the increase.

Additional bond requirement of plans investing in employer securities. The Pension Protection Act of 2006 (P.L. 109-280), effective for plan years beginning after 2007, increased the maximum bond required of fiduciaries under plans that invest in employer securities to $1 million.

The Employee Benefits Security Administration (EBSA) has issued a Field Assistance Bulletin that provides guidance on fidelity bonding requirements under ERISA 412 that apply to fiduciaries and other individuals handling plan funds or other property. The guidance clarifies: actions that constitute the handling of funds or other plan property that will subject a party to bond; the calculation of the bond amount when multiple plans are covered under a single bond; the application of the $1 million bond maximum to plans that hold employer securities solely as a result of investments in pooled investment funds; and whether third party service providers are subject to the bonding requirements if they handle plan funds.

Failure to timely amend plan to comply with current law and regulatory guidance. The IRS advises that, because the failure to amend affects the qualified status of the plan, care should be taken to ensure that timely amendments are made. The failure to amend may be resolved, as a last resort, during the examination process through the Audit Closing Agreement Program, which requires the payment of a negotiated sanction. Accordingly, IRS advises that small employers establish operating procedures and internal controls to ensure compliance. In the event a compliance issue is detected on self-audit, the matter should be corrected under EPCRS, prior to examination.

Top-heavy 401(k) plans

The Top-Heavy LESE Project involved approximately 50 examinations of 401(k) plans covering from three to eight participants which were expected to potentially be subject to the top-heavy requirements of Code Sec. 416.

The top six issues revealed by the project were:

Generally, a 401(k) plan is top-heavy if, as of the last day of the preceding plan year, the sum of the account balances of key employee participants ( i.e., an officer of the employer with annual compensation in excess of $160,000 (for 2010); a 5% owner of the employer; or a 1% owner of the employer with an annual compensation from the employer of more than $150,000) for the plan year exceeds 60% of the sum of the account balances of all employees under the plan, or the plan is part of a top-heavy group. In the event that the plan is top-heavy, the employer will be required to make a minimum contribution to non-key employees and not merely return elective deferrals to key employees.

The amount of the additional contribution to each non-key employee is generally equal to at least 3% of the employee's compensation for the entire plan year. The 3% contribution is in addition to elective contributions made on the non-key employee's behalf.

Employer matching contributions may be credited in satisfaction of the top-heavy contribution obligation. However, elective contributions made to a 401(k) plan on behalf of non-key employees may not be treated as employer contributions for the purpose of meeting the top-heavy minimum contribution requirement.

The IRS identified the following leading causes behind a plan's failure to provide the required top-heavy contribution:

The IRS advises plan sponsors to ensure with the plan administrator or pension professional that the plan is being properly tested each year for top-heavy status. In the event the plan is top heavy, all eligible participants should be identified and the employer should ensure that plan terms are followed in complying with the Code Sec. 416 rules, including accelerated vesting and the required top-heavy contribution.

Source: IRS Employee Plans News, Winter 2010/Volume 9.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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