IRS Examinations and Compliance Checks for Employee Benefit Plans

The Internal Revenue Service (IRS) continues to focus on areas of potential noncompliance, particularly in the area of employee benefit plans (EBPs). In its most recent compliance program and priorities update, the IRS’ Tax Exempt and Government Entities Division (TE/GE) released new initiatives for examinations and compliance checks as they related to EBPs. Examinations generally involve an in-depth review of an organization’s books and records and may result in the determination of tax liability, while compliance checks are on a lesser scale. They typically focus on whether an organization is adhering to recordkeeping and information-reporting requirements, as well as whether the organization’s activities are consistent with its tax-exempt purpose.

Following are the EBP strategies introduced in 2021 that will be handled by the IRS via the examination process:

Small Exempt Organizations that Sponsor Retirement Plans – The focus of this strategy is to review retirement plans of small exempt organizations to determine whether the plan investments are properly administered, whether there are any party-in-interest transactions in the plan trust, and whether any participant loans violate Internal Revenue Code (IRC) Section 72(p). Improper transactions between the plan and its participants can result in prohibited transactions under IRC Section 4975, deeming distributions as taxable income, or result in IRC Section 72(t) early distribution penalties.

Worker Classification – The focus of this strategy is to review retirement plans of employers that were determined to have misclassified employees as independent contractors. The IRS will determine if coverage requirements of the Internal Revenue Code are satisfied.

Required Minimum Distributions in Large Defined Benefit Plans – This strategy is to ensure that retirement plan sponsors comply with IRC Section 401(a)(9) to begin distribution of benefits by April 1 following the calendar year an employee turns 70 ½. Failure to make these distributions could cause plan disqualification as well as a 50% excise tax on amounts not distributed.

Participant Loans – This strategy is to ensure that participant loans comply with IRC Section 72(p) rules on maximum loan balances and IRC Section 72(t) re-payment rules for early distributions before age 59 ½. The IRS will verify whether participant loans of retirement plans that hold a high percentage of participant loans to total assets of the trust are being repaid timely if the loan balance remains consistent or increases for more than one year. Noncompliance may result in deemed distributions under IRC Section 72(p) and/or prohibited transaction excise taxes under IRC Section 4975.

Earned Income for Self-Employed Plans – This strategy addresses businesses that file Schedule C, Profit or Loss From Business (Sole Proprietorship), and a Form 5500-series return. The IRS will examine whether these businesses have:

• Correctly taken the self-employed deduction on the Form 1040, Individual Income Tax, Schedule 1, Additional Income and Adjustments, rather than on Schedule C,
• Properly calculated the owner-employee’s earned income,
• Made correct allocations to plan participants, and
• Complied with the nondiscrimination requirements and IRC 415 contribution limits.

One-Participant 401(k) Plans – The focus of this strategy is to review one-participant 401(k) plans to determine if there are operational or qualification failures, income and excise tax adjustments, or plan document violations.

As mentioned above, compliance checks are less daunting than examinations. Below are the newly identified EBP initiatives for compliance checks in 2021. These items address potential noncompliance and would most likely result in educational letters to limit costs and taxpayer burden.

Plan Liabilities and Unrelated Business Income – With this strategy, the IRS will determine if plan sponsors who reported plan liabilities on their Form 5500-series return are engaging in activities that result in taxable unrelated business income. Large, unusual, and questionable liabilities may result from prohibited transactions, unrelated business income, or failure to value assets properly. The unrelated business income tax provisions of the IRC ensure that exempt organizations are taxed on income earned from activities that are unrelated to the purpose for which they were granted exempt status.

Inflated Assets – This initiative determines if plan sponsors are completing financial information on Form 5500-series returns with complete and accurate information. The focus will be on plans whose assets have increased beyond reasonable amounts from the beginning of the year to the end of the year.

Partial Termination/Partial Vesting – This initiative will identify employers whose Form 5500 indicates that their plan has had a significant decrease in plan participants. The IRS will review these plans to determine compliance with IRC Section 411(d)(3) vesting requirements and accuracy of other information on their Form 5500.

The IRS reminds plan sponsors that the plan sponsor is ultimately responsible and will be held accountable for any noncompliance even if such services have been outsourced to third-parties. The Employee Plans Compliance Resolution System (EPCRS) is available to plan sponsors to correct any compliance issues. If you receive correspondence from a regulator, always respond timely.

If you have questions about the information outlined above, our seasoned and experienced employee benefit plan professionals are here to help. You can learn more about our Employee Benefit Plan services by visiting our website and don’t hesitate to contact Dan Sturm, Partner & Director of ERISA Services at dsturm@macpas.com.

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