Governmental Plans Initiative. The Internal Revenue Service recently has shown an increasing interest in governmental plans and their compliance (or lack thereof) with the Internal Revenue Code's tax qualification requirements. In April 2008, the Service's Employee Plans Compliance Unit launched the Governmental Plans Initiative. The Service's stated goal of the initiative was to provide plan sponsors of governmental plans with the tools, assistance, and programs needed for these plans to comply with the federal tax qualification requirements. As part of the initiative, the Service thus far has hosted a governmental plans roundtable to improve communications between the Service and plan sponsors and to increase their awareness of the need for governmental plans to comply with the Internal Revenue Code's qualification requirements and conducted a survey of governmental plans using questionnaires to learn more about these plans' unique compliance issues. Due to this Initiative, sponsors of governmental plans can expect increased scrutiny by the Service and a higher likelihood of a plan audit.
Compliance with Federal Tax Laws. While governmental plans generally are exempt from ERISA and many statutory requirements in the Internal Revenue Code that apply to other qualified plans, a governmental plan still must comply with multiple provisions in the Internal Revenue Code in order to ensure that the plan remains "qualified." In order for a governmental plan to be "qualified" under the Internal Revenue Code, the plan document generally must include certain provisions required by federal tax law and be timely amended to reflect changes in the law, and the plan itself must be operated in compliance with its written terms. While this sounds relatively simple, it is not always so. While many sponsors of governmental plans realize that their plan must comply with the state or local law that sets forth the terms of the plan, they often are not aware that the plan also must reflect and comply with federal tax laws. If a plan does not include certain required provisions and operate in accordance with federal tax law, the plan will not be qualified under the Internal Revenue Code. The primary consequences of a plan not being qualified are that: (i) its participants and beneficiaries will not be able to defer paying tax on certain benefits under the plan until retirement, which is the purpose of a qualified plan; instead, they will be taxed on their benefits to the extent the benefits are vested rather than when they are paid; and (ii) distributions from the plan will not be eligible for special tax treatment under the Internal Revenue Code, which generally allows distributions to be rolled over to other arrangements tax-free.
Common Problems with Governmental Plan Compliance. Based on our experience, is it is very common for a governmental plan to comply with its state laws or local acts, but not to comply with the applicable federal tax qualification requirements. Some of the more common qualification issues that we have encountered with governmental plans include the following:
- Failing to timely or properly amend to comply with changes in the federal tax law (commonly referred to as "TEFRA," "TRA '86," "UCA '92," "OBRA '93," and "GUST")
- Failing to adopt required interim plan amendments to reflect EGTRRA and guidance issued by the Service
- Failing to timely make required minimum distributions
- Allowing participants to make impermissible cash or deferred elections
- Failing to allow eligible rollover distributions (which includes after-tax contributions) to be paid to eligible retirement plans
- Providing benefits to participants based upon service and compensation that is not associated with the plan sponsor or any participating employer
- Improperly computing benefits using participant compensation in excess of statutory limits
- Failing to limit plan benefits contributed to and paid from a plan in accordance with statutory limits
- Failing to follow the plan's eligibility provisions by allowing ineligible employees to participate and excluding eligible employees
- Including more than a de-minimus number of non-governmental employees in a governmental plan
- Failing to hold plan assets in trust
The good news is that the Service offers programs that plan sponsors can use to generally ensure that their plans are qualified in both form and operation under the Internal Revenue Code: a determination letter program and a correction program for certain plan failures.
Determination Letter Program. Under the determination letter program, a plan sponsor can submit its plan to the Service for an advance determination as to the tax-qualified status of the plan. In the application, the plan sponsor requests that the Service make a determination that the plan complies in form with the requirements for tax qualification, and if the Service agrees, it issues a "determination letter" on the plan. (Of course, the plan sponsor also must administer the plan in accordance with the terms of the plan document in order for the plan to satisfy the qualification requirements.) Although a plan sponsor is not required to submit a plan for a determination letter, it is highly advisable (and is standard practice in the employee benefits community to apply for a determination letter) because the letter serves as somewhat of an insurance policy for a plan. For example, if the Service discovers improper or missing plan provisions during its review of a plan's determination letter application, the plan sponsor generally has additional time within which to correct the plan. Also, once the Service issues a determination letter on a plan, even if it is later determined that the plan included an improper provision or failed to include a required provision, the plan sponsor can rely on the determination letter and generally will not be subject to any penalties or plan disqualification.
The Service has established cycles in which certain plans can be submitted to the Service for a determination letter, and once a determination letter is issued, the letter then is effective generally for a period of five years. Plans are assigned to one of five annual cycles (Cycles A–E) based on the employer's employer identification number. However, all individually-designed governmental plans are assigned to Cycle C, which required applications for determination letters on these plans to be submitted between February 1, 2008 and January 31, 2009. While an application for a determination letter for a plan may be submitted in a cycle other than the cycle assigned by the Service (called an "off-cycle" application), the Service has stated that an off-cycle application will not be reviewed by the Service until all on-cycle and certain approved off-cycle applications are processed and any determination letter issued on the plan most likely will not consider all of the qualification requirements that an on-cycle application would cover. Additionally, the Service simply discourages off-cycle filings, and since when a plan sponsor submits an application for a determination letter, it is seeking the Service's opinion on the plan document, the plan sponsor certainly wants to follow the Service's procedure.
As a result of the Service's outreach to the governmental plans community, it learned that these plans have unique compliance issues and needed additional time within which to submit applications for determination letters. In an effort to assist and accommodate plan sponsors of these plans, the Service is allowing governmental plans to be submitted in Cycle E in addition to Cycle C. The time period within which an application must be submitted for Cycle E is between February 1, 2010 and January 31, 2011. (Note that if a plan sponsor elects to file a determination letter application in Cycle E rather than Cycle C, the plan's cycle will revert back to Cycle C. For example, if a plan sponsor submits an application in Cycle E ending on January 31, 2011, the determination letter that is issued for the plan will expire at the end of the next Cycle C (January 31, 2014) and not the end of the next Cycle E (January 31, 2016)). Not only has the Service extended the period within which a governmental plan can be submitted for a determination letter application, the Service has acknowledged that a governmental plan is eligible for a determination letter even if the plan has never received a determination letter or has an out-of-date determination letter.
Correction Program to Address Compliance Issues. Fortunately, the Service recognizes that even wellintentioned plan sponsors may fail to maintain a plan document that satisfies all of the necessary tax requirements or to consistently operate a plan in accordance with its terms. The Service offers a voluntary program, called the Employee Plans Compliance Resolution System ("EPCRS"), for plan sponsors to correct most plan failures. EPCRS allows a plan to voluntarily resolve certain documentary and operational failures and avoid stiff penalties and plan disqualification which could result if the Service discovered the same failures during an audit of a plan. EPCRS sets forth recommended correction methods for plan sponsors to follow to make a plan "whole." The general principle underlying EPCRS is that a plan should be restored to the position it would have been in had the failure not occurred. The benefit of correcting a plan failure in accordance with the applicable correction method under EPCRS is that the Service will not treat the plan as failing to meet the Internal Revenue Code's qualification requirements with respect to the failure.
Time to Act is Now. Given the Service's recent governmental plans initiative and focus on such plans' compliance with federal tax law, and with Cycle E open only through January 31, 2011, now is the time for governmental retirement plans to protect participants' and beneficiaries' benefits by taking the necessary steps to get their plans into compliance with federal tax law, and as needed, to consider EPCRS to correct any failures.
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