What You Should Know When Establishing a 401(k) Plan: A Guide for New Plan Sponsors

Setting up a new 401(k) plan seems like it should be simple. Many companies offer a 401(k) plan to their employees, and prospective plan sponsors appear to have a substantial variety of vendors to choose from, ranging from large financial institutions that have served the qualified retirement plan market for years to newer, less expensive online services. However, a company that wishes to set up a new 401(k) plan should be aware that there are many pitfalls to be aware of. Obtaining a correctly drafted document that reflects the plan sponsor’s design, and then successfully operating the plan in compliance with that document, are complicated processes. Inadvertent errors by the plan sponsor in both stages are quite common.

Installing a 401(k) plan is a challenge whether the company is a startup, or an established firm that has not previously grappled with the numerous and complex rules that apply to 401(k) plans. A 401(k) plan sponsor must be ready to deal with challenging compliance issues at the plan’s inception, throughout the life cycle of the plan, and when a decision is made to terminate the plan.

To explore all the rules and regulations that apply to 401(k) plans would require a lengthy book—or a series of books. This article will attempt to give an overview of some of the most common practical issues and compliance problems that plan sponsors should be aware of when first establishing a 401(k) plan.

Phase I: Establishing a 401(k) Plan

1. Exercise care when choosing the 401(k) plan vendor. Unfortunately, all qualified plan vendors are not created equal. This is a particularly challenging problem for small companies that often do not have much leverage in the 401(k) marketplace.

Plan sponsors have a fiduciary duty to act in the best interest of the plan’s participants and beneficiaries, and that duty extends to the selection of reputable, qualified plan vendors. Such vendors can include the company that provides the plan document and related plan materials, the plan’s third-party administrator and record keeper, the plan’s trustee, the custodian of the plan’s assets, the plan’s consultants and legal counsel, and the accounting firm that perform the required plan audit once the number of plan participants has grown large enough to require one.

A large, established qualified plan vendor may offer many advantages, such as a well-drafted prototype plan document, an adoption agreement that its sales representatives understand and are able to explain clearly, a knowledgeable plan testing and legal compliance group, a diverse menu of investment funds, and the willingness and sophistication to help clients solve complicated 401(k) operational or documentation problems. However, such an established vendor may not have an entry-level program for small companies at all, let alone a long-term strategy of actively helping small companies establish and grow their retirement plans into larger ones. In fact, some established vendors will not accept a new client unless it already has an existing 401(k) plan with substantial assets.

A startup or other small company that wishes to set up a new 401(k) plan may have to choose a less expensive, possibly less proactive vendor during the early years of the plan’s existence. Unfortunately, such a vendor is often unable to offer sophisticated advice regarding plan legal and compliance issues. Only after the plan has amassed a substantial level of assets may it be able to “graduate” to a more capable vendor.

Because of this problem, when a company decides to establish a new 401(k) plan, the company employees who are responsible for developing the plan should reach out to friends and colleagues at other comparable employers, as well as to their accountants, attorneys, brokers and other advisers, and ask for recommendations for satisfactory small plan vendors. They should also conduct a thorough online search for feedback on prospective vendors. Articles appear from time to time in business publications that discuss the best 401(k) providers for small employers.

2. Get well-considered advice when designing the plan’s key features. In most cases, vendors will give a prospective 401(k) plan sponsors a set of documents to review, which may include, among others (i) a service agreement with the vendor, to which it may be possible for the sponsor to negotiate limited changes, (ii) a basic prototype plan document, which often amounts to a hundred or more pages of small print and legalese, and has a favorable approval or opinion letter from the Internal Revenue Service, (iii) in most cases, an adoption agreement, which condenses the provisions of the full-length, basic plan document into a somewhat smaller and more manageable document in “check the box” format, which the sponsor uses to make key plan design decisions, and (iv) a summary plan description for distribution to participants, which must include a plain language description of the important features of the plan.

In most cases, the employer will not have the discretion to alter the terms of the basic plan document, which is pre-approved by the IRS. However, the adoption agreement is another matter. An employer setting up a new 401(k) plan should give the adoption agreement a close and careful review, as it is designed to allow the plan sponsor to choose between various plan design alternatives. The adoption agreement is, in many ways, the most important plan document for the adopting employer to review and understand.

If the 401(k) plan vendor is knowledgeable and is actively involved with the employer in designing the plan, a thorough discussion of the plan design options in the adoption agreement with the vendor may be sufficient for the plan to get off to a good start. However, if at all possible, the employer should also have a consultant or ERISA counsel review the draft adoption agreement and discuss any questions or concerns.

The following are a few examples that illustrate how customizing the adoption agreement allows the new plan sponsor to make many key plan design choices.

  • Employees allowed to participate in the 401(k) plan. For example, a plan may provide that all employees are eligible to participate, or the plan could impose general restrictions such as an age requirement, so that only employees who have attained age 21 may participate. A plan may also require participants to complete a year of service in which an employee must work 1,000 or more hours to enter the plan. Or, a plan could impose both an age and service requirement.
  • The specific categories of individuals who will be excluded from participation in the 401(k) plan. The plan sponsor may decide to exclude certain specific categories of employees. Examples could include leased employees, collectively bargained employees, non-resident aliens with no U.S. source income, part-time or temporary employees, independent contractors who are misclassified and are later determined to have been actual employees, or employees of a subsidiary or a division. Note that some exclusions are permitted by statute, while the choice of other exclusions, such as a subsidiary or a division, will still require the plan to follow certain procedures or pass applicable nondiscrimination tests.
  • Whether the sponsoring employer will make a contribution to the 401(k) plan. Many 401(k) plans offer an employer contribution feature such as a profit sharing contribution, or an employer safe harbor contribution. The adoption agreement also allows the employer to establish the amount and frequency of the contribution, and whether it will be discretionary or mandatory.
  • Whether the 401(k) plan will utilize the “top-paid group” election. Under certain circumstances, making this election can decrease the number of participants who are considered “highly compensated” for purposes of the plan’s nondiscrimination tests, make it easier for the plan to pass certain nondiscrimination tests, and reduce the number of employees who will be adversely affected by a failed test. See “Phase 2, Section 2,” below.
  • Whether the plan will permit rollovers, in-service withdrawals, and loans. Many plan sponsors allow new employees to roll over their account balance from the 401(k) plan of a previous employer, or to access their current account balance under the current plan through hardship withdrawals, loans, and other in-service distributions.
  • The various forms of benefit distribution that will be available when a participant terminates employment or retires. The most common form of distribution offered by 401(k) plans is a single lump sum. However, some 401(k) plans (especially those offered by insurance companies) may offer installment payments over a number of years, or annuities based on the participant’s life expectancy.
  • Whether the plan will be structured as a “safe harbor” plan. As long as certain criteria are met, a safe harbor 401(k) plan can be exempt from some of the annual nondiscrimination testing applicable to traditional 401(k) plans. See “Phase II: Section 2,” below.
  • Whether the plan is intended to be an “ERISA Section 404(c)” plan. An ERISA Section 404(c) plan is one in which participants are allowed to self-direct the investment of their account balances among an array of funds selected to comply with Section 404(c). In some cases, plan fiduciaries can be shielded from liability for investment losses resulting from a participant’s investment decisions.

3. Timely sign and date the plan document, and keep copies. Many small companies actually overlook this crucial step, just assuming that the plan vendor is taking care of this task for them. Many small companies discover upon IRS audit, or upon acquisition by another company, that they cannot actually prove the plan was validly adopted, because they cannot locate a timely signed and dated copy of the adoption agreement originally establishing the plan. For example, it can be crucial upon audit to prove that the plan was signed and dated before salary deferral contributions began to be withheld from plan participants’ paychecks. In some cases, a small company cannot locate subsequent plan amendments and restatements. If the adoption agreement was signed and dated in hard copy, the company should keep one or more additional hard copies in its files; if the adoption agreement was timely signed with a valid electronic signature, the company should make a paper copy of the signature page or be absolutely certain that it can be located electronically, if necessary. Board resolutions adopting the plan that are timely executed add another layer of protection for the company and the plan.

A new 401(k) sponsor should not rely on the plan vendor to keep these records on its behalf. A low-cost vendor (or even a top-rated vendor, under some circumstances) may sometimes be less than careful about keeping copies of client documents, whether paper or electronic - particularly if the company ever moves its 401(k) plan to another provider/record keeper. If a company changes vendors several years into the 401(k)’s life cycle, the previous vendor may feel little motivation to assist the company in locating documents, even in an emergency.

Failure to timely sign and date a new 401(k) plan can have serious consequences for the plan, up to and including loss of the plan’s tax-qualified status if the IRS disqualifies the plan. For example, in one recent case, a small company intended to adopt a new 401(k) plan in Calendar Year 1, but inadvertently failed to sign the adoption agreement until Calendar Year 2. When the IRS audited the plan several years later, the plan faced disqualification; the IRS proposed to levy a penalty on the company roughly equal to the amount of taxes participants would have paid on their total account balances, had the plan lost its tax-qualified status. The company was not thriving, and the amount of the proposed penalty might have forced the company to shut down business operations. Eventually the company’s counsel was able to negotiate the penalty down to a more manageable level, but at no time was this outcome certain.

4. Always keep in mind that the plan must be operated in strict accordance with its written terms. The company should also keep in mind that once a design choice has been made and the plan has been established, the plan must be operated in accordance with its terms, or the company could face severe penalties, including disqualification by the IRS. This requires a certain amount of vigilance on the part of the company sponsoring the plan.

There are many ways in which a plan sponsor may fail to operate the plan in accordance with the plan’s written documents. For example, one very common operational failure occurs when the terms of an employer’s plan do not actually exclude employee classes such as part-time or temporary employees, but the employer excludes them anyway, under the belief that such an exclusion is permissible. Or, the plan may validly permit the exclusion of part-timers and temporary employees unless, so long as such employees do not work 1,000 or more hours of service in a plan year -- but the company fails to actually monitor the hours of these employees, and some who do reach 1,000 hours are not permitted to enter the plan.

Another common mistake involves the date a new plan actually allows employee salary deferrals to be withheld from paychecks and deposited in the trust established under the 401(k) plan. For example, the plan may be executed on May 1, but the company does not get around to permitting salary deferral elections until September 1.

Yet another common error occurs when a company mistakenly assumes that the plan contains a cap or limit on the amount of company contributions, such as matching contributions or profit-sharing contributions, when in fact there is no cap set forth in the document. Or, the plan does provide for a cap, but the wrong limit is used in practice.

Another example is the employer’s failure to correctly apply the plan’s definition of compensation (along with applicable inclusions and exclusions) when salary deferrals are withheld from participant paychecks. A plan may provide that a participant’s salary deferral amount should be based on his or her W-2 compensation, including bonuses, but the employer fails to deduct salary deferral contributions when bonuses are paid.

There are many other possible examples. These can include an employer’s failure to allow rollovers from other plans in conformity with the plan document, the exclusion from the plan of an individual who has elected to make salary deferrals, or even the exclusion of a group such as all employees from a specific division in the plan, even though the plan document did not provide for the division’s exclusion.

While it is often possible to change the terms of the plan, the change usually must be made on a prospective basis, and requires an amendment to the adoption agreement or to the plan document. If this is done, benefits accrued under the prior terms of the plan must usually be monitored and protected. In some cases, if the plan’s operation does not conform to the terms of the plan document, and the plan sponsor believes the document was drafted in error, an expensive and time-consuming corrective filing must be prepared and submitted to the IRS before the terms of the plan can be reformed.

Phase II: Operating and Maintaining an Ongoing Plan

1. Filing Form 5500 annual reports. Depending on the size of a 401(k) plan, the plan sponsor is required to electronically file Form 5500 (Annual Return/Report of Employee Benefit Plan) or Form 5500-SF (Short Form Annual Returns/Reports of Small Employee Benefit Plan, for plans with fewer than 100 participants) with the Department of Labor and the IRS. The Form 5500 series was developed by the DOL and the IRS for use by employee benefit plans to satisfy the annual reporting requirements of the Employee Retirement Income Security Act of 1974 and the Internal Revenue Code.

Employers who sponsor 401(k) plans must generally file the Form 5500 on the last day of the seventh month after their plan year ends. For plans that use the calendar year, this means July 31 of the year following the end of the plan year. However, before that deadline, the plan sponsor may obtain an extension of up to two and one-half-months using Form 5558. Larger plans (generally, those with more than 100 participants at the beginning of the plan year) must also attach the report of an independent qualified certified public accountant to their Form 5500s, often called an audit report.

A plan that is terminated during the year must also be sure to file a final Form 5500. Form 5500 filing instructions provide a different deadline for a terminated plan, which catches some plan sponsors by surprise. The deadline is not seven months after the end of the plan’s usual full plan year; rather, the form must be filed no later than seven months after the later of (i) the plan’s termination date, or (ii) the date all assets were finally distributed from the plan.

Plan sponsors sometimes fail to file Form 5500 annual reports (or they file a Form 5500, but it contains errors or is incomplete), and the resulting penalties can be significant. Penalties levied by the IRS are $25 per day, up to a maximum fine of $15,000. In contrast, the potential statutory penalties that can be levied by the DOL are much higher – up to $1,100 per day with no maximum. In addition, individuals can face other civil penalties, as well as fines up to $100,000 and prison time up to ten years for willful violations of the duty to file. In addition for failure to file, penalties can also be assessed for filing a Form 5500 after the deadline, or filing an incomplete or incorrect filing.

Fortunately, a correction program is available to 401(k) plan sponsors who failed to file one or more Form 5500 annual reports, so long as the DOL has not yet stepped in and identified a filing as late or missing. Such plan sponsors should file all delinquent returns using the DOL’s Delinquent Filer Voluntary Correction Program. Although fees are payable for using DFVCP, such fees are quite modest, particularly in comparison to the potential penalties. (Please refer to the more detailed discussion of the DFVCP in Section 5 below).

2. Conducting annual nondiscrimination testing and performing any required corrections. Annual nondiscrimination testing must be performed and any test failures timely corrected, or the plan could be vulnerable to disqualification on audit. For example, participant salary deferrals are subjected to the Actual Deferral percentage test to determine if the class of “highly compensated employees” are deferring a percentage of their compensation that is disproportionately higher than the percentage deferred by the class of “non-highly compensated employees.” Similarly, if the plan includes an employer matching contribution feature, the Actual Contribution Percentage test is performed to determine if highly compensated employees are benefitting disproportionately from the employer matching contribution.

Other applicable tests that the plan must satisfy include (i) the coverage test under Code Section 410(b), (ii) the limits on plan contributions under Code Section 415, (iii) the top-heavy test under Code Section 416, and (iv) the individual limit on annual salary deferral contributions set forth in Code Section 402(g).

Safe harbor plans. Some employers choose to design their 401(k) plans as “safe harbor” plans, which can allow the plans to automatically pass the Actual Deferral Percentage test and the Actual Contribution Percentage test. For the 401(k) plan to qualify as a safe harbor plan, the employer must make a prescribed contribution to the plan on behalf of eligible employees, which must be 100% vested. In addition, plan safe harbor notice requirements (involving both notice content and timing) must be carefully observed. Furthermore, once the safe harbor election has been made for the coming plan year, only certain mid-year changes to the plan specified in IRS guidance will then be permitted during the plan year. Employers must also meet certain regulatory requirements to be able to reduce or suspend safe harbor employer contributions mid-year. Employers who want to make a mid-year change will first need to confirm with their plan’s third-party administrator, benefits consultant, or counsel that the proposed change is permissible.

  • Under one safe harbor plan design, the employer must match employee salary deferrals, dollar for dollar, up to three percent of the employee’s compensation. In addition, if applicable, the employer must match fifty cents on the dollar for the employee’s salary deferrals that exceeds three percent, but not five percent, of the employee’s compensation.
  • Another safe harbor plan design requires the employer to make a “nonelective contribution” to the account of each eligible employee equal to three percent of the employee’s compensation.

Not all employers choose to design their 401(k) plans as safe harbor plans, because the required employer contributions can involve significant expense. However, if a company has a large number of highly compensated employees, a safe harbor plan may be the best option for allowing all employees to benefit under the plan.

Top-paid group election. Depending on the overall compensation level of company employees, the employer can make a plan design choice called the “top-paid group” election, which can help a plan pass its nondiscrimination tests and also minimize the number of highly paid employees who will be affected if there is a testing failure. In 2016, any plan participant making $120,000 or above is classified as a highly compensated employee for purposes of 401(k) nondiscrimination testing. If a plan failed its 2016 ADP test, highly compensated participants would be required to receive distributions of excess deferrals from the plan that would then be returned to them as taxable compensation. However, if the plan sponsor had made the top- paid group election, an individual would have to make $120,000 or more AND ALSO be classified in the top 20% of company employees (when ranked by compensation) in order to be considered highly compensated. In companies with a large percentage of highly paid employees, making the top-paid group election would result in fewer employees being classified as highly compensated, and fewer highly paid employees would be affected in the case of an ADP failure.

3. A special problem: is the plan top-heavy The top-heavy rules are part of the general nondiscrimination rules that apply to all 401(k) plans. A plan will be considered top-heavy if the value of plan accounts belonging to the class known as “key employees” (a substantially different classification from the highly compensated employees discussed above) is greater than sixty percent (60%) of the value of all plan assets. Key employees include (i) any employee who owns more than 5 percent of the business, (ii) any employee who owns more than 1 percent of the business and also has annual compensation in excess of $150,000, and (iii) an officer who earns compensation in excess of $170,000.

If the plan is top-heavy in any given plan year, then the company must ensure that non-key employees receive a minimum benefit, which can be quite expensive. The employer must generally contribute an amount equal to three percent of compensation on behalf of all non-key employees who are still employed on the last day of the plan year. It is very common for companies with a large percentage of high earners to have problems passing the top-heavy test -- including start-ups, particularly during the early years of the company’s existence.

4. Timely remittance of salary deferral contributions to the 401(k) plan’s trust. A very common problem faced by employers who sponsor 401(k) plans is ensuring that participant salary deferral contributions are timely remitted to the trust established in connection with the plan. DOL rules generally require a plan sponsor to remit employee salary deferral contributions as soon as possible, that is, on the earliest date that it can reasonably segregate the salary deferrals from the general assets of the company. Larger companies that use sophisticated third-party administrators can often remit salary deferrals within a day of the date such deferrals are withheld from employee paychecks.

Employers should note that although the rules provide that salary deferral remittances absolutely cannot occur later than the 15thbusiness day of the following month, this rule is not a safe harbor, but rather an outer limit. Deferrals that do not violate the 15-day rule are still considered late if they occur after the earliest day the employer can segregate the 401(k) salary deferrals from its general assets.

There is a safe harbor, however, for small plans—generally, those that have fewer than 100 participants. Small plans are allowed to use a safe harbor period of seven business days following the date participant salary deferral contributions are withheld by the employer; so long as salary deferrals are remitted by that date, they will not be considered late.

The problem of late salary deferral remittances is so common that it is of great concern to the DOL. The reason is the impact lost time can have on the amount of participants’ future earnings on their salary deferrals, magnified by compounding over time. A question on Form 5500-SF (generally filed by small plans that covered fewer than 100 participants at the beginning of the plan year) asks the sponsor to self-report whether it failed to transmit to the plan any participant contributions within the time frame prescribed by these rules. In the case of large plans, the accounting firm performing the plan audit must identify any failures to timely remit participant deferrals to the 401(k) trust.

If salary deferral remittances are not made timely, then a prohibited transaction has occurred that must be remedied using an amnesty program sponsored by the DOL, known as the Voluntary Fiduciary Correction Program. The plan sponsor must also file Form 5330 with the IRS, and pay a small excise tax for each year in which deferrals were not timely remitted. (Please refer to the more detailed discussion of VFCP in Section 5 below).

5. When things go wrong: IRS and DOL correction programs. Because the rules governing the operation of 401(k) plans are so numerous and complex, it is easy for even the most diligent plan sponsor to make a mistake in operating its 401(k) plan. That said, it is crucial for employers who sponsor 401(k) plans to proactively monitor plan operations, and to detect and promptly correct any plan failures discovered.

Fortunately, in most cases 401(k) plan errors can be fixed. Both the IRS and the DOL have made a number of programs available to plan sponsors for correcting plan failures. These are known by a variety of “alphabet soup” acronyms, including DFVCP and VFCP (mentioned above) and the IRS’ Employee Plans Compliance Resolution System. The type of plan failures involved will determine which program or programs are used.

DFVCP. As discussed above in Section 1, a plan sponsor is required to electronically file a Form 5500 series annual report on behalf of its 401(k) plan for each plan year in which the plan is in existence. A Form 5500 filing cannot be skipped, filed late, be incomplete, or contain erroneous information—otherwise the plan sponsor risks the imposition of substantial penalties by the DOL and additional penalties by the IRS. Fortunately, the DOL sponsors a program for plan sponsors called the Delinquent Filer Voluntary Correction Program. The program permits plan sponsors to file a delinquent Form 5500 and pay a reduced penalty, instead of the significant penalties (up to $1,100 per day, with no cap) previously discussed.

Small plans with fewer than 100 participants at the beginning of a plan year will pay a reduced penalty of $10 per day to file a delinquent Form 5500, up to a maximum of $750. If the plan sponsor is delinquent for two or more years, the penalty is capped at $1,500 per plan. Large plans that file a delinquent Form 5500 will pay a reduced penalty of $10 per day, up to a maximum of $2,000, or $4,000 for multiple delinquent filings. However, plan sponsors should note that if the DOL identifies the failure to file a Form 5500 and contacts the company in writing before the company has had a chance to correct the failure under DFVCP, the plan sponsor can no longer use DFVCP and is exposed to the full range of possible DOL penalties. Therefore, if a plan sponsor discovers that it has a delinquent 5500 filing that is eligible for correction under DFVCP, the plan sponsor should file as soon as possible.

VFCP .As discussed in Section 4 above, the DOL also sponsors a program that allows 401(k) plan sponsors to correct a variety of “prohibited transactions,” called the Voluntary Fiduciary Correction Program.

The program covers close to twenty categories of prohibited transactions, but one of the most common is the failure by a plan sponsor to timely remit participant salary deferral contributions (and sometimes participant loan repayments) to the trust established in connection with the 401(k) plan. The DOL has stated informally that failure to timely remit participant salary deferrals is the issue of greatest concern to the agency because for many employees, 401(k) deferrals are the only retirement savings they will ever have, other than Social Security. Correcting late salary deferral remittances under VFCP involves a filing with the DOL to utilize the program, as well as the use of an online calculator provided by the DOL on its website, to calculate the lost earnings that must be contributed to the plan on behalf of affected participants with respect to a late remittance transaction:

A plan sponsor who has not timely remitted participant salary deferral contributions to the 401(k) trust follows certain prescribed steps to correct the problem using the online calculator. The following is an example of how to correct a plan sponsor’s late salary deferral remittances, for a large plan that is not subject to the seven-day safe harbor previously mentioned.

Assume that the payroll with respect to which participant salary deferral withholdings were remitted late took place on Wednesday, January 15, 2014, and the total amount of late salary deferrals was $100K. Also assume that the earliest date by which salary deferrals could be remitted was the payroll date, which is the same date upon which participants also received their paychecks, and that deferrals were finally remitted to the trust on January 31, 2014. However, the company did not realize that it had made an error until a benefits consultant reviewing plan records identified the error on January 30, 2017.

Under the terms of the calculator, the “Principal Amount” is $100,000 and the loss date in January 15, 2014. The “Recovery Date” is the date the principal amount of $100,000 was restored or actually remitted to the 401(k) plan, or January 31, 2014. The “Final Payment Date” is the date on which a corrective contribution of lost earnings, computed using the calculator and calculated through the date of the final correction, is at last contributed to the plan. Assume that the company and its record keeper were able to coordinate their efforts, and by September 10, 2016 were confident the contribution could be made in advance, on or before October 10, 2016. The results from the online calculator would look like this:


Loss Date

Recovery Date

Final Payment Date

Amount Due






A total of $143.25 would have to be allocated among participants as on October 10, 2016. Note that because the corrective contribution must include interest through the date of correction, the date of the contribution must actually be scheduled a week or two in the future, to give the plan’s record keeper the needed time to make the required participant allocation.

EPCRS .The IRS also sponsors a program known as the Employee Plans Compliance Resolution System. If a 401(k) plan sponsor has made mistakes in operating its plan, it can use EPCRS to fix those mistakes and avoid possible plan disqualification by the IRS on audit.

EPCRS can be used to fix 401(k) plan operational errors, as well as certain errors that may have occurred when the plan document was drafted. In some cases, the plan sponsor is allowed to self-correct an error. If a document drafting error is involved, a written filing with the IRS is usually required to retroactively reform the plan document. If a plan operational error is involved, the employer has more choices. If the error is deemed insignificant, taking into account all the facts and circumstances, it can be self-corrected regardless of the number of plan years in which it occurred. If the error is significant, given all the facts and circumstances, it may be self-corrected, providing it is of short duration, as described in the Revenue Procedure. If not, a written filing with the IRS is required.

The latest version of EPCRS, Rev. Proc. 2016-51, runs over 150 pages of text and prescribes detailed procedures for correcting many different plan operational failures, document failures, and demographic failures, as defined in the Revenue Procedure. The following are examples of 401(k) plan corrections under EPCRS.

(a) A plan sponsor set up a new 401(k) plan several years ago, using a prototype plan and adoption agreement from a major provider in the 401(k) industry. The section of the adoption agreement dealing with the top-heavy rules included an unusual provision that the employer could check, if it wanted to make the required top-heavy contribution (generally 3% of compensation for all non-key employees) even in years when the plan was not top-heavy. Inadvertently, the plan sponsor checked the box when first establishing the plan – committing itself to making a 3% contribution on behalf of all non-key employees from the date the plan was first established. The employer never did so, however, and the drafting error was not discovered for a number of years. When it was discovered, one way to correct the error would have been to make a corrective contribution to the plan, so that every current and former non-key employee would receive a contribution equal to 3% of compensation (including earnings through the date of correction) for all years in which the provision had been elected in the adoption agreement. The cost of this corrective contribution to the employer would have been substantial.

The employer had never intended this result, and chose to make a filing with the IRS using a feature of EPCRS known as the Voluntary Correction Program. The employer asked the IRS to allow it to retroactively amend the plan adoption agreement to reflect the employer’s true intent when the adoption agreement was first executed. The employer pointed out to the IRS in its filing that a plan sponsor that wished to establish an employer contribution feature under the plan would be more likely to check other, more straightforward provisions in the adoption agreement, such as those clearly allowing it to make a discretionary or mandatory profit-sharing or matching contribution each year. The employer argued that it would make little sense for any plan sponsor to try to achieve this result by checking a relatively obscure box in the top-heavy section. Fortunately for the plan sponsor, the IRS found its argument to be reasonable and allowed the plan sponsor to make the retroactive amendment correcting the adoption agreement.

(b) A typical problem that plan sponsors encounter is the inadvertent exclusion from the plan of certain classes of employees that should have been permitted to participate, under the written terms of the plan. An entire group of employees, such as employees of a division or a subsidiary, may be inadvertently excluded. Or, in a different case, the employer may have erroneously classified individuals an independent contractors, when they really should have been classified as common-law employees under applicable law. A very common error is for an employer to inadvertently assume that it is permissible to exclude part-time and/or temporary employees from its plan, when in fact the plan document does not provide for their exclusion. In addition, it often happens that employers overlook the eligibility of a single individual or a few individuals, for a variety of possible reasons.

In such a case, the EPCRS correction program requires the company to make a corrective contribution to the 401(k) plan on behalf of employees who were impermissibly excluded from the plan – whether the plan sponsor is eligible to use the self-correction feature of EPCRS, or whether it is correcting a significant error of several years’ duration with a filing under the VCP feature. When an employee is wrongly excluded from the plan and does not have the opportunity to make salary deferrals, the correction is generally 50% of an amount based on the Actual Deferral Percentage of the compensation group to which the employee belongs (highly compensated or non-highly compensated), plus earnings determined under the rules of the Revenue Procedure though the date of correction. This amount is intended to approximate the employee’s lost tax deferral opportunity resulting from the exclusion. When an employee is also excluded from receiving an employer matching contribution, however, the contribution is an unreduced 100% of the match the employee would have received (based on the assumed salary deferrals previously calculated), with earnings through the date of correction.

If only a few eligible employees have been excluded for a short period of time, the cost of correction may not be large. However, the cost may be substantial, or even crippling, for a company that has retained the services of many “independent contractors” who later are determined to have been misclassified employees. In unusual circumstances, the direct and indirect costs of correction can exceed the costs that would be incurred if the IRS disqualified the plan. In a recent example, a failing company that had used hundreds of so-called contractors was required to correct its 401(k) plan error in connection with a merger in which it was the target. Not only did it find that it owed several hundred thousand dollars to plan participants in the form of corrective contributions, but the buyer refused to close the acquisition until the correction was accomplished. An extra month was required in order to complete the correction, in which time the company was forced to incur unexpected operating costs in excess of a million dollars. For this reason alone, an employer should make every attempt to ensure that it pays close attention to which employees are actually eligible to participate in its 401(k) plan – and that all employees are accurately classified.

Phase III: Terminating the Plan

For many companies who sponsor 401(k) plans, there comes a time when the decision is made to terminate the plan. A company may determine that the expense of maintaining the plan is too great. Or, if the company is acquired, the buyer may require that the target’s 401(k) plan be terminated before the closing. Many acquirers include a covenant in merger and acquisition agreements that the target must terminate its 401(k) plan. Unfortunately, a major reason that a plan sponsor may terminate its 401(k) plan is when the company is forced to cease business operations and wind down the company.

In such a case, the plan fiduciaries must be aware that in addition to formally and legally terminating the 401(k) plan, they have an ongoing duty to wind up the affairs of the plan that does not disappear when the company ceases business operations. The plan fiduciaries must ensure that distributions are made to all participants and beneficiaries with an account balance under the plan. In addition, final nondiscrimination testing must be performed and any necessary corrections made, and the plan must file its final Form 5500 annual report with the DOL and IRS with respect to its last plan year. If plan fiduciaries simply walk away from the 401(k) plan, the DOL may take required actions to force them to discharge their duties to the plan and its participants.

If the fiduciaries are simply unable to discharge their duties, an independent fiduciary can be retained to wind up the affairs of the plan. The DOL also has an “abandoned plan” or “orphan plan” program under which the Department appoints a fiduciary to carry out these duties.