IRS Enforcement Priorities for 2021

Audits

TE/GE has announced that they intend to pursue compliance on the following matters by examinations; in other words, audits. Plans are selected by the regional office of the IRS, and an on-site visit is scheduled in which the IRS agent assigned to the case will examine the employer's records to determine if their plan is in compliance.

Small Exempt Organizations that Sponsor Retirement Plans

Tax-exempt organizations can sponsor several types of retirement plans, including 401(k) plans and 403(b) plans. The IRS is specifically interested in making sure that the plan's investments are properly administered, and that there are no prohibited transactions involving any parties-in-interest.

One-Participant 401(k) Plans

A one-participant plan is a plan that covers only the owner(s) of a business and their spouse(s). It is also a plan that is eligible to file Form 5500-EZ. Most testing requirements, such as coverage, nondiscrimination, and top-heavy would not apply to a one-participant plan. The IRS is focusing on operational and plan document issues.

Worker Classification

Independent contractors are excluded from employee retirement plans. In the past, some employers have mis-classified employees as independent contractors and excluded them from their retirement plans. This can result in a failure of the coverage test if employees who should have been covered by the plan were not.

Required Minimum Distributions in Large Defined Benefit Plans

All qualified plans, regardless of size or type, are required to begin distributions to most participants starting at age 72 (or, pre-2020, age 70½). Failure to comply with this rule can lead to qualification problems for the plan, and a substantial excise tax on the participant. It is not clear why the IRS is choosing to focus its efforts in this area on large defined benefit plans, or how "large" is being defined for this purpose.

Earned Income for Self-Employed Plans

The IRS is specific that they are looking for businesses that file a Schedule C—in other words, sole proprietorships—that also file a Form 5500. Issues they will examine under audit include whether the pension deduction was taken properly on the owner's Form 1040, whether earned income was calculated correctly for plan purposes, whether correct allocations were made to plan participants, and whether nondiscrimination and annual contribution limit rules were correctly applied.

Participant Loans

Plans which allow participants to borrow against their retirement benefits have to ensure that the loans are not made in excess of certain limits, and that the loans are paid back timely. The IRS will be investigating plans where the loan balance remains constant or increases for more than one year.

Compliance Checks

For some issues, the IRS will contact a plan sponsor to request information about how they are administering their plan. This is known as a compliance check, and while it is less invasive than a full audit, it has the potential to turn into an audit if the plan sponsor does not comply with the request.

Plan Liabilities and Unrelated Business Income

The IRS is interested in plans which are engaging in outside business activity that generates taxable business income. Operating under the theory that these types of activities are likely to result in "large, unusual and questionable liabilities" they will be looking for plans that report unusual liabilities on their Form 5500.

Inflated Assets

Plans that are invested in assets which do not have a readily determinable market value are required to have those assets appraised annually. If the value of plan assets increases by more than a reasonable amount from year to year, it could indicate that the plan's assets are not being valued in a reasonable manner.

Partial Terminations

A plan that experiences a partial termination is required to provide 100% vesting to affected participants. The IRS will be reviewing plans  that had a significant decrease in plan participants to determine if a partial termination occurred and if the vesting requirements were satisfied. Note that limited relief from the partial termination rules for the 2020-2021 plan years was provided under the Consolidated Appropriations Act.

Voluntary Correction Program

The IRS notes that they will continue to process submissions under the Voluntary Correction Program (VCP) to allow sponsors to correct plan qualification failures before the IRS discovers them.

Look for more in-depth articles on many of these topics over the next several weeks.


Pension Relief under the American Rescue Plan Act

On Thursday, March 11, the president signed the American Rescue Plan Act (ARPA) into law. Sections 9701-9708 are grouped under a subtitle labeled "Pensions'' and anyone sponsoring a qualified defined benefit plan is going to be interested in what those sections have to say.

Multiemployer Plans

Multiemployer plans—plans sponsored by a union for its members, and funded by those members' employers—are subject to a different set of funding rules than single-employer plans. Multiemployer plan funding rules are the subject of sections 9701 through 9704 of ARPA, and will not be addressed further in this article.

Extended Amortization Period

Section 9705 of ARPA increases the period for amortizing funding shortfalls from 7 years (which was the period established under the Pension Protection Act (PPA) back in 2006) to 15 years going forward. This change is mandatory for all plans starting in 2022, but may be used for funding calculations as early as 2019 if the plan sponsor elects to do so. This change will generally have the effect of reducing employers' minimum required contributions.

In order to understand the impact of this change, it is important to first understand how the minimum required contribution is determined.The minimum required contribution is generally made up of two pieces: the Target Normal Cost and the Shortfall Amortization Charge. The Target Normal Cost represents the value of benefits earned during the current year. The Shortfall Amortization Charge only applies if plan assets are less than plan liabilities; the amount by which the liabilities exceed the assets is called the Funding Shortfall. Rather than having to pay the full amount of the Funding Shortfall all in one year, the amount is amortized into a number of equal installments, payable over a period of years. The Shortfall Amortization Charge for the current year is equal to the amortized installment of the current year’s Funding Shortfall, plus the amortized installments of any past years’ Funding Shortfalls. [Please note this paragraph is a vast simplification of the actual funding rules and there are many other factors which may affect a plan's minimum required contribution. However, the author believes it is sufficiently descriptive to help the reader understand the impact of the changes made by ARPA.]

For the 2022 plan year (or an earlier year if elected by the plan sponsor), if the plan is carrying any installments on prior years, those installments are reduced to zero. Any resulting Funding Shortfall after eliminating the 7-year installment payments is then amortized over 15 years, and the Shortfall Amortization Charge for that year will be equal to that single 15-year amortization installment. In the following year, any remaining Funding Shortfall will be amortized over 15 years from that date, and that amortization payment will be added to the first year's installment to get the Shortfall Amortization Charge for that year, and so on.

Because existing shortfall installments are being reduced to zero, and the Funding Shortfall is now being amortized over 15 years instead of 7, plan sponsors can expect smaller Shortfall Amortization Charges over the next several years. Eventually, however, multiple years' worth of amortization installments could be due in a single year and the total Shortfall Amortization Charge is likely to return to current levels.

Overall this change is likely to negatively impact plans' funded status. Under the original rule, a plan with a funding shortfall would be expected to become fully funded within 7 years, more or less. Now the horizon to reach full funding has been extended to 15 years, leaving plans in an underfunded and therefore riskier state for a longer period of time.

Funding Discount Rates

Section 9706 of ARPA adjusts the interest rates used to determine the minimum required contribution, as described in the previous section. The changes made by this section will result in higher discount rates, which translates into smaller Target Normal Costs and Funding Shortfalls. As a result, minimum required contributions will be smaller.

The interest rates in question are based on the yield on investment-grade corporate bonds. Those yields are grouped into three segments: the first segment is yields for a term of less than 5 years, the second segment is those with a term of at least 5 but less than 20 years, and the third segment is for those 20 years or more. A 24-month average is taken for the yields in each segment and those averages are our starting point.

Next, a 25-year average is calculated for each segment, and multiplied by an adjustment factor, which serves as a lower limit on the 24-month average. Prior to ARPA, the adjustment factor for 2020 was 90% and for 2021 was 85%. ARPA increased those to 95% for years 2020 through 2025, 90% for 2026, and reduces that by 5% each year thereafter until it reaches 70% in 2030.

Because bond yield rates have been very low for many years now, the 25 year average—which includes rates going back to the late 1990s when rates were significantly higher—will almost always be higher than the 24-month average, even after taking the adjustment factor into account. A higher discount rate means  smaller Target Normal Costs and Funding Shortfalls, which means smaller minimum required contributions for plan sponsors.

Section 9706 also adds a rule that if the 25-year average is ever below 5%, then 5% will be used instead of the actual 25-year average. In other words, for the years 2020 through 2025, the segment rates will never be lower than 95% of 5%, or 4.75%.

The changes made by this section are effective in 2020, but a plan sponsor may choose to delay taking them into account until 2021 or 2022, if they wish.

This change, while it reduces the funding obligations for plan sponsors, further distances the plan's funding requirements from reality. The original intention of the rule that discount rates be based on bond yield rates was that it could reasonably represent the actual investment returns available in a real pension fund. In reality, short- and medium-term bond yields have not approached anywhere near 4.75% in many years, so allowing plans to use that as a discount rate will not encourage the plan to be adequately funded. Ultimately the responsibility will lie on the plan sponsor and the enrolled actuary to determine a funding strategy that will ensure the plan remains adequately funded into the future.

Other provisions

Section 9707 provides special funding rules for community newspaper plans. Section 9708 affects the rules determining excessive remuneration for certain employees of publicly-held corporations. Neither of these sections is likely to have an impact on sponsors of small defined benefit plans.

Overall impact of the ARPA

All of the changes made by ARPA with respect to single-employer plans have the effect of reducing minimum contribution requirements. While many plan sponsors will appreciate the flexibility this offers them, minimum contribution requirements alone do not tell the whole story. Plans which are covered by the PBGC are still required to pay a variable-rate premium which is based on the plan’s funded status and calculated using spot discount rates. PBGC premiums are expected to rise over the next several years due to the low interest rate environment, and unlike the rates used for minimum funding, the rates used for PBGC have not been adjusted or capped. Plan sponsors who take advantage of the lower minimum contribution requirements may find themselves subject to higher PBGC premiums if their plans are not well-funded.

It is important for plan sponsors to understand that merely satisfying the minimum contribution requirements is not sufficient to ensure that their plans are sufficiently funded to meet all benefit obligations. Discussing your funding objectives with an enrolled actuary or plan consultant is essential to developing a sound contribution strategy for your plan. Please don’t hesitate to contact us to talk about funding your plan.


Form 5500-EZ Updates for 2021

Most qualified retirement plans are required to file an annual return with the IRS. For plans subject to Title I of ERISA, this requirement is satisfied by filing Form 5500 or Form 5500-SF with the DOL. Other plans may file an abbreviated form known as Form 5500-EZ. For 2020, Form 5500-EZ received some important updates.

Electronic Filing Now Available

Since 2009, plans that file Form 5500 or Form 5500-SF have been required to file electronically through the DOL’s EFAST website. One-participant plans had the option to file electronically through EFAST as well, by using a special option to file a Form 5500-SF as a one-participant plan. However if the plan administrator wanted to file Form 5500-EZ, they would have had to do so on paper.

Starting with any forms filed for plan years beginning on or after January 1, 2020, Form 5500-EZ may be filed electronically through EFAST. As a result, Form 5500-SF may no longer be used for a one-participant plan. Form 5500-EZ may continue to be filed on paper for the time being, although we would encourage all filers to migrate towards the electronic system.

Expanded Eligibility to File

The term “one-participant plan” has been mentioned a few times already in this article, without having been clearly defined. A one-participant plan is a plan that is eligible to file Form 5500-EZ. A one-participant plan includes any plan that covers only the 100% owner of a business and his or her spouse, or a plan that covers only partners in a partnership and their spouses.  As long as the plan provides no benefits to anyone other than those, it is considered to be a one-participant plan. Note that the name is misleading, since a one-participant plan can cover more than one participant. Likewise, not every plan that covers only one participant would be a one-participant plan.

Starting with the 2020 Form 5500-EZ, the IRS expanded (or perhaps merely clarified) the definition of one-participant plan to provide that a 2% shareholder in an S-corporation is considered a partner. This is helpful, since it resolves the ambiguity about whether an S-corporation is treated as a partnership, where the plan can cover any number of partners, or a corporation, where the plan would be considered a one-participant plan only if it covered the 100% owner.

However, the real news is that the IRS specified that the term “2% shareholder” is defined under IRC sec. 1372(b), which means that family attribution applies in determining who is a 2% shareholder. Prior to 2020, a plan which covered the 100% owner of an S-corporation, their spouse, and their child would not have been considered a one-participant plan and would have been required to file Form 5500-SF. Under the new rules, the child is also considered a partner, and therefore the plan is considered a one-participant plan, and is therefore eligible to file Form 5500-EZ. However, this only applies in the case of an S-corporation - if the company were a sole proprietorship, partnership or C-corporation, Form 5500-SF would still be needed.

Finally, a 2% shareholder in an S corporation is defined as someone who, after the above family attribution rules are applied, owns more than 2% of the company’s stock or voting power at any time during the year. Ironically, a person who owns exactly 2% is not considered a 2% shareholder.

The changes to Form 5500-EZ for 2020 are expected to streamline the filing process for many plans. If you have any questions about how these changes could impact your plan, please contact us.