By Maria T. Hurd, CPA, Belfint Lyons & Shuman, P.A.

When it comes to IRS audits, “an ounce of prevention is worth a pound of cure,” as Benjamin Franklin so wisely put it. The cure, in this case, most often requires restitution of deposits to your 401(k) or 403(b) plan, plus earnings, and in some cases, a sanction paid to the Internal Revenue Service (IRS).  

Restitutions make participants whole by putting them where they would have been financially if the error had not occurred, but the deposit to the plan and the penalties often come as a surprise that was not in the plan sponsor’s budget. Avoiding the need for a correction is the best alternative, but how does an employer keep its plan operations compliant in such a complex and regulated environment? 

It takes the collective effort of specialists, both plan sponsor personnel and dedicated specialists such as the third-party administrator; the plan’s financial statement auditor; the investment adviser; and the plan’s Employee Retirement Income Security Act (ERISA) attorney, as applicable. 

IRS Common Errors List

At a minimum, the plan sponsor should ensure that the following 10 items from the list of common errors found by the IRS are administered in compliance with the plan document and the federal tax Code:

1. Plan Document—Has the plan document been timely updated?
2. Census—Is the census information provided to the third-party administrator complete and accurate?
   1. Does the census include all employees, including those who are not yet eligible or who chose not to participate?
   2. Do the gross wages provided in the census reconcile to the total gross payroll?
3. Definition of Compensation—Was the compensation used to calculate contributions consistent with the plan document?
   1. Have the control totals for every type of excluded compensation been reconciled to the original source payroll reports?
   2. Has preeligibility compensation been properly identified?
4. Timely Deposit of Deferrals—Have deferrals been deposited in a consistent pattern and as soon as the dollars can be segregated from the employer’s funds?
5. Contribution Computation and Limits—Have any annual dollar limitations imposed by the plan or by the federal tax Code been exceeded?
   1. Common ownership of separate entities is a risk area
   2. Multiple plans sponsored by one entity is a risk area
   3. Separate payrolls for separate locations of the employer is a risk area
   4. Was a true-up match deposited, if required?
6. Discrimination Testing
   1. Was the discrimination testing performed with accurate payroll and contribution data?
   2. Were highly compensated and key employees accurately identified? Family relationships and attribution are risk areas
   3. Was a top-heavy contribution deposited if required?
7. Eligibility
   1. Have newly eligible employees been identified? Part-time employees and plan mergers are risk areas
   2. Have employees been properly notified of their eligibility?
8. Participant loans
   1. Does the plan permit loans?
   2. Did the repayments start in a timely manner?
   3. Did defaulted loans receive a 1099-R?
   4. Do the terms of the loan follow IRC Section 72(p) and the plan document?
9. Distributions
   1. Required Minimum Distributions
   2. Hardship distributions
      1. Is there sufficient documentation for the hardship reason?
      2. Was the maximum available participant loan taken?
      3. Is there documentation that no other sources of financing were available to the participant?
10. Fidelity Bond
    1. Did the sponsor obtain the required ERISA fidelity bond?
       1. Generally for 10 percent of the plan assets up to $500,000
       2. The fidelity bond is not the same as fiduciary liability coverage

Audit Red Flags

Some plan sponsors are selected for an IRS audit based on red flags that result from the answers on Form 5500. Other IRS examination selection methods include:

• Risk-based compliance audits—based on industry and plan type for market segment-specific examinations;
• Learn, Educate, Self-Correct, Enforce (LESE) Projects—small projects based on judgment sampling;
• Referrals from the U.S. Department of Labor (DOL);
• Employee Plan Team Audit (EPTA)—large-case audit selection; and
• Abusive transaction projects.

Other than the selection methods above, plan sponsors also can be randomly selected. 

Regardless of what you perceive your chance of selection might be, it is always better to be safe than sorry when it comes to IRS examinations.  It takes a village to ensure that your plan is safe and compliant, rather than sorry, so make sure you have the right team in place to ensure this. An ounce of prevention is worth a pound of cure.