The Internal Revenue Service ("IRS") has implemented a new voluntary compliance policy, called the Administrative Policy Regarding Self-Correction ("APRSC"), which generally allows plan sponsors to avoid the loss of tax qualification by correcting any error by the close of the plan year following the year in which the error occurred. The new policy also permits IRS agents to disregard "insignificant" qualification violations discovered on audit provided the errors are (or have already been) fully corrected. The policy is applicable to the following types of plans:

• tax-qualified retirement and savings plans, including so-called section 401(k) plans, and
• tax-sheltered annuity ("TSAs") arrangements.

In general, it is the position of the IRS that upon the occurrence of an operational error under the qualification rules, the plan (be it a tax-qualified arrangement or TSA) ceases to be tax qualified until the errors are corrected. The new policy, however, allows plan sponsors to retroactively restore a plan’s qualification, without the need for IRS involvement, by fully correcting any errors upon discovery. The new policy is intended to work in tandem with the IRS’ other voluntary relief programs – the Voluntary Compliance Resolution Program, the Walk-in Closing Agreement Program and the Tax Sheltered Annuity Voluntary Correction Program (all of which require a formal application to be submitted to and approved by the IRS) – to provide an array of programs for retroactively correcting operational errors, either with or without IRS involvement.

Only operational violations of the qualification rules for tax-qualified plans and TSAs are eligible for relief under APRSC. Thus, defects in the content of the plan document, as well as deduction and other tax issues that do not affect a plan’s continued tax qualification, are not covered by the

policy. For example, violations of the exclusion allowance limit for TSAs are not eligible as such a violation does not affect the continued tax qualification of the TSA involved. On the other hand, in the case of tax-qualified plans, a failure to follow the plan’s terms would be covered by APRSC as the IRS generally views such errors to be disqualifying operational defects.

The policy also contains several general limitations as to eligibility: First, the plan must have generally established practices and procedures (be it formal or informal) for qualification compliance which are routinely followed. The policy makes clear that the plan document alone is not sufficient for this purpose. Second, as is the case under the agency’s other relief programs, violations of the exclusive benefit rule (which involve the misuse or diversion of assets) are not eligible for APRSC relief.

To qualify for relief under the policy, the defects involved must be corrected both retroactively and prospectively. In general, this means, among other things, that the plan and any affected participants must be put into the position they would have been in had the errors not occurred. For example, for an employee who was improperly excluded from participating in a 401(k) plan, the required correction would involve the following:

• Allowing the employee to enter the plan immediately;
• A "make-up" contribution by the employer for any missed contributions (which, in the view of the IRS, would include elective contributions the employee would have made and any corresponding matching contributions); and
• An additional "make-up" contribution for "lost" earnings on the missed contributions.

In addition, presumably any defective plan procedures or practices also would have to be corrected to the extent necessary to avoid repetition of the error.

The self-correction procedure described above applies to all eligible violations (whether or not they are insignificant) which are corrected within the required timeframe. In addition, there is no limit on the number of violations or number of years for which the procedure can be used. However, to qualify under the procedure, the IRS apparently requires that the violation be completely corrected by the close of the plan year following the year in which the error occurred.

To be eligible to use this self-correction procedure, a plan must also:

• in the case of tax-qualified plans, have an up-to-date IRS determination (or equivalent) letter for the plan,(fn1) and
  
• not be under audit or have notice of an impending audit.

Any eligible violation not handled under the self-correction procedure which is insignificant may be disregarded by an IRS agent on audit, so long as the error is properly corrected. According to the IRS, the determination of whether a violation is "insignificant" turns on the facts and circumstances involved, including such factors as:

• The number of violations that occurred during the period involved – however, a violation which affects more than one participant is treated as a single error
• The number of years in which a violation occurred
• Relative number and percentage of affected participants
• Whether correction occurred prior to audit
• Why the violation occurred

At the same time, the policy directs that no one factor is to be determinative and that a violation should not be considered significant solely because it occurred in more than one year.

In general, the aim of APRSC is to increase voluntary compliance by encouraging plan sponsors to review periodically internal compliance and to correct fully any errors upon discovery. The APRSC automatic self-correction procedure provides an unparalleled opportunity for plan sponsors to protect a plan’s continued tax qualification by promptly detecting and correcting most operational errors without the need for IRS involvement. The exception for insignificant violations is also useful as it effectively allows plan sponsor to avoid – or, at least, significantly minimize the chances of – disqualification (should such an error be discovered in a later audit) by fully correcting such errors upon discovery.

The new policy comes at a time when the IRS has significantly expanded its enforcement efforts with respect to both tax-qualified plans and TSAs. As a consequence, plan sponsors should generally be taking greater care to monitor their plans’ continued compliance with the qualification requirements. To take advantage of the relief provided by APRSC, plan sponsors may want to establish practices and procedures for periodically monitoring a plan’s continued compliance with the qualification requirements, particularly for those areas where the plan may have had compliance problems in the past. Sponsors also may want to undertake from time to time a comprehensive review of plan administration to detect any new or unforeseen problems.

(fn1) This limitation is not applicable to TSAs.