Publications

March / April 2001

Compliance Audits Can Protect Plan Sponsors

By Sheldon M. Geller, Geller Group Ltd

EXECUTIVE SUMMARY

• Plan sponsors should periodically conduct self-audits to detect and correct plan defects before the Internal Revenue Service or Department of Labor finds the defect and fines the plan.

• A self-audit is a review of plan documents and operations that is used to determine the level of compliance and to find and correct any qualification failures under the Internal Revenue Code as well as fiduciary violations under the Employee Retirement Income Security Act.

• In addition to its self-correction programs, the Internal Revenue service has issued a digest of approved correction methods for 206 different violations.

CORRECTION PROGRAMS
The IRS and the DOL have established a comprehensive system of correction programs for plan sponsors to ensure that plans are operated in accordance with the tax qualification requirements of the Internal Revenue Code and the fiduciary responsibility provisions of the Employee Retirement Income Security Act (ERISA).¹ These programs permit plan sponsors² to correct qualification failures and violations of Title I of ERISA and therefore continue to provide their eligible employees with retirement benefits on a tax favored basis without penalties.
    Monetary sanctions and penalty taxes of substantial amounts may be imposed by the IRS and DOL even if the failures are unintentional administrative errors that result in no harm to plan participants.³ The IRS emphasized that sanctions will be imposed for failure to follow the terms of the governing plan document even if plan operation otherwise complies with the qualification requirements of the Code.⁴

SELF-CORRECTION PROCEDURES
A plan sponsor that has conducted a self-audit and has established a self-correction procedure may correct operational failures within a specified time period to avoid IRS fees and sanctions and ERISA fiduciary liability.⁵ A plan sponsor that has established compliance practices and procedures may, at any time, correct insignificant operational failures without paying any fee or sanction. Furthermore, if a qualified plan is the subject of a favorable IRS determination letter, the plan sponsor generally may correct even significant operational failures within a two-year period without paying any fee or sanction.

SELF-AUDITS
The IRS and DOL correction programs promote voluntary compliance, encourage plan sponsors to conduct self-audits and require the establishment of internal control procedures. A self-audit is a review of plan documents and operations that is used to determine the level of compliance and for the purpose of finding and correcting any qualification failures under the Code and any fiduciary violations of ERISA.
    The self-audit is distinguished from the financial audit that is required under ERISA for larger plans.⁶ The financial audit must be performed by an independent qualified public accountant and reviews the plan's financial statements as reported on IRS Form 5500 in accordance with standards established by the American Institute of Certified Public Accountants. On the other hand, a self-audit may be performed by the plan sponsor, ERISA fiduciaries, attorneys, accountants, plan consultants or other service providers.
    The correction of a qualification failure identified during an IRS audit and corrected with IRS approval may result in a significant monetary sanction. Further, if a fiduciary breach is voluntarily corrected, plan fiduciaries may avoid paying the 20 percent civil penalty⁷ that would have applied if the correction had been made due to DOL enforcement efforts.⁸
    Plan fiduciaries who breach their fiduciary duties may be held personally liable to restore any losses to the plan that occur as a result of their breaches. ERISA's fiduciary provisions are riot premised on nomenclature or official appointment, but rather fiduciary status is determined by functional terms of control and authority over plan officers and employees of the plan sponsor. Further, members of the board of directors and trustees who are fiduciaries may be held liable as co-fiduciaries.⁹
    Whereas, the correction of a qualification failure or document defect identified during a self-audit eliminates the employer's uncertainty regarding their potential tax liability and civil penalty, self-audits are encouraged by IRS and DOL¹⁰ and raise a number of important issues including the purpose and scope of the audit, types of plan defects, confidentiality, payment of the audit fee with plan assets and professional liability.

SAFEGUARDING TAX BENEFITS
Retirement and 401(k) plans must comply with an array of legal requirements under the Internal Revenue Code to qualify for tax-exempt status.¹¹ Plan sponsors are required to establish and maintain an up-to-date, legally compliant written plan document that is communicated to employees and describes the specific terms and benefits provided under the plan.¹² Failure to maintain compliance with the qualification requirements may ultimately lead to the revocation of a plan's qualified status, including the loss of tax benefits.
    A recently issued report reviewed 1,802 retirement and 401 (k) plans with qualification failures during 1999, and advised that (i) 42 percent experienced plan document failures, (ii) 66 percent experienced operational failures and (iii) all types and sizes of plans were represented among those plans with qualification failures.¹³
    The report also determined that plan sponsors were assessed monetary sanctions that were 10 times greater on a field audit than the compliance fees that could have been assessed if the failures had been corrected as a result of a self-audit.¹⁴ Further, the IRS imposed higher compliance fees for plan document failures, particularly failures involving contribution and benefit provisions.¹⁵

ERISA FIDUCIARIES
Fiduciary responsibility under ERISA continues to evolve as federal courts interpret and apply the statutory language. A named fiduciary is the single most important fiduciary in administering a plan and the individual or entity most concerned with plan compliance. The act of appointing a named fiduciary is itself a fiduciary function. Accordingly, an employer's board of directors who generally designate the named fiduciary, either through its procedure set forth in plan documents or by approving the plan document that designates the named fiduciary, is an ERISA fiduciary of the plan with respect to the appointment process.
    Furthermore, members of the board of directors and officers of the corporation sponsoring the plan are ERISA fiduciaries to the extent that they perform fiduciary functions in selecting and retaining plan service providers.

PLAN DEFECTS
A qualification failure is any failure that adversely affects the qualification and thus the tax-favored treatment of a plan. There are three types of qualification failures:

• plan document failures,
• operational failures and
• demographic failures.

    A plan document failure is a plan provision that violates the qualification requirements of the Code. For example, the failure of a plan to be timely amended to reflect the Code's then-existing qualification requirements.
    An operational failure arises from the failure to follow the terms of the plan document, unless the plan may be amended (under an applicable remedial amendment) retroactively to conform to actual plan operation. For example, a failure to return excess 401(k) deferrals; follow the plan's definition of eligibility, entry dates, vesting or compensation; and the miscalculation of the plan's contribution provision, benefit formula or distributable amounts.
    A demographic failure is a failure to satisfy the general non-discrimination,¹⁶ minimum participation,¹⁷ or general coverage requirements¹⁸ of the Code (that is not an operational failure). The correction of a demographic failure generally requires a plan amendment adding more benefits or increasing existing benefits.
    If a plan contains disqualifying provisions or it is not timely amended to comply with new legislation or does not reflect actual plan operation and the remedial amendment period has expired, then the plan sponsor may not self-correct to avoid IRS sanctions and fiduciary liability. That is, the operational violations cannot be corrected by a plan amendment because the defect becomes a form (i.e., document) violation. Accordingly, it is imperative that plan sponsors conduct self-audits to identify and correct plan defects before the expiration of the remedial amendment period.
    There are no limitations on the number of years a plan sponsor may use the self-correction procedure. A self-audit establishes records that fully demonstrate how violations occurred, when they are discovered, what steps were taken to effectuate correction, and when correction was completed. If there is a subsequent IRS examination, the plan sponsor will have to establish that correction was proper and timely.¹⁹

PURPOSE
Although most plan documents are drafted and timely amended to comply with applicable law, plan sponsors rarely, if ever, audit actual plan operation for conformity with actual plan terms. Attorneys, accountants and other professional advisors seldom conduct operational audits to ensure compliance. The IRS will impose sanctions for a plan sponsor's failure to follow plan terms even if plan operation otherwise complies with the qualification requirements of the Code.
    The issues an IRS auditor identifies under examination²⁰ rarely constitute intentional or egregious violations of the qualification requirements of the Code. Most violations appear to occur in the administration of qualified plans and may be identified during self-audit. A plan sponsor may then correct an operational failure (even if significant) if the correction is completed (or substantially completed) by the last day of the second plan year following the plan year in which the failure occurred.
    Further, a plan sponsor may correct violations of the general non-discrimination, minimum participation and general coverage requirements by the 15th day of the 10th month after the close of the plan year in which any of these violations occurred by covering more lower paid employees or providing more benefits to lower paid employees. However, a plan is not eligible for self-correction if it has no administrative procedures designed and in place to ensure operational compliance.
    Self-audits permit correction that is in the control of the plan sponsor and its agents (i.e., lawyer and accountant) and before correction requires the participation of parties not within the control of the plan sponsor (i.e., plan participants, spouses and beneficiaries). Plan sponsors need to conduct annual self-audits to immediately effect the correction of operational violations to avoid the involvement of other parties. It may take substantial time to complete the correction process if the process requires participation by parties not within the plan sponsor's control.
    Accordingly, reasonable plan sponsors and ERISA fiduciaries are advised to conduct self-audits on an annual basis to ensure plan document and operational compliance to avoid IRS sanctions and fiduciary liability. Further, plan sponsors are advised to conduct compliance self-audits prior to the submission of an application to the IRS to effect a plan termination or if the plan sponsor has partial termination concerns.

PRACTITIONER RESPONSIBILITY
Given the complexity of the pension and tax laws, it is relatively easy for a business sponsor to inadvertently administer its plan in a manner that would constitute a qualification failure.
    Nevertheless, once the practitioner advising the plan is aware of an apparent qualification failure, the practitioner is responsible for providing the plan sponsor with advice on correcting the failure.²¹ A practitioner's advice needs to identify (i) possible corrective action, (ii) fees charged by IRS for approval and (iii) audit sanctions that could be assessed by the IRS if the plan sponsor does not either submit the corrections to the IRS for approval or self-correct the failures.
    It is, without qualification, in the best interests of plan sponsors and their practitioners to conduct periodic internal audits to ensure compliance; and if failures are discovered, for practitioners to advise as to the nature and extent of the failure or failures, and for plan sponsors to immediately correct those failures.

CONFIDENTIALITY
Although the IRS encourages voluntary compliance and believes that most plan sponsors attempt to administer their plans properly, the IRS understands that there will always be plan sponsors willing to play audit roulette. Nevertheless, each key district office of the IRS weighs whether the operational failures are insignificant and considers as an adverse factor the failure to correct a known violation prior to an audit. Plan sponsors are responsible for making their own initial determination whether there are operational violations. Further, any plan self-corrected may still be subject to later audit.
    Accordingly, it is advisable to have competent ERISA legal counsel conduct a self-audit to preserve a claim of attorney-client privilege or attorney work product. Nevertheless, plan fiduciaries generally may not claim a privilege between themselves and the participants and beneficiaries under the plan.²² Further, there is no privilege if the attorney represents the plan. Accordingly. legal counsel should represent only the plan sponsor and not the plan regarding certain issues. because no privilege exists regarding communications between attorneys who are retained by a plan and the plan fiduciaries who retain those attorneys on behalf of the plan. If the attorney is paid by the plan. then the attorney represents the plan. not the plan sponsor.
    Voluntary disclosures of otherwise confidential communications may waive the privilege (e.g.. if plan sponsor representatives discuss the results of a self-audit with those who are not directly involved with the self-audit process).
    If self-audits are documented. the documents may be discoverable by the DOL under ERISA Title I if the agency is investigating fiduciary breaches in the context of plan administration. Therefore, legal counsel should perform the compliance audit and prepare documentation to preserve a claim of attorney-client privilege or attorney work product, particularly because self-audit documentation will likely include the admission of an error or a qualifying plan defect.
    Accordingly, it is advisable for plan sponsors to retain ERISA counsel to identify and correct through a self-audit process prior to an IRS audit. The self-audit is an alternative to plan disqualification.²³ Disqualification may result in the imposition of monetary sanctions, litigation and misrepresentations to third-parties (i.e.. plan auditors, lenders, buyers). Plan sponsors may detect and self correct insignificant deviations and significant qualification failures within a specified time period without reporting the corrections to the IRS for approval, without having IRS supervision, and without paying a compliance fee or sanction.²⁴
    The IRS expects that self-audits will be confidential.²⁵ Employee plan specialists have been instructed not to request copies of a plan sponsor's compliance reports. Nevertheless, plan sponsors may use self-audit documentation defensively to demonstrate compliance. Plan sponsors need to properly structure the self-audit process to be protected by the attorney-client privilege.²⁶
    To maintain the privilege, fiduciaries who anticipate a lawsuit should take care to identify separately all their written attorney client communications relating to the matters in issue as prepared in anticipation of litigation. Once the interests of the fiduciary and the beneficiaries appear to diverge, ERISA fiduciaries and their counsel may have privileged communications in anticipation of litigation against ERISA plan fiduciaries.
    Because plan participants and beneficiaries are entitled to plan administration correspondence, advice relating to potential lawsuits should be strictly segregated from advice concerning general plan administration. Indeed, separate counsel for litigation issues may be necessary to preserve the privilege. Furthermore, communications are privileged regarding advice concerning an employer's non-fiduciary decisions such as whether to amend or terminate a plan. ERISA's fiduciary duties and the federal common law interpreting these duties have become major factors in plan governance.

FINANCIAL AUDITS
A self-audit compliance process enables the employer to make the required representations regarding plan compliance to the plan's auditors in connection with the annual financial audit for certain larger plans. Employers need to represent that:

• the plan document satisfies ERISA and IRS qualification requirements,
• the plan is being operated in accordance with the plan document and IRS qualification requirements, and
• the plan has not engaged in a "prohibited transaction" with a "party in interest."²⁷

    A prohibited transaction is a per se violation of ERISA subjecting the employer to a 15 percent annual excise tax, an additional 100 percent excise tax, and lawsuits by the DOL and plan participants. ERISA defines party in interest to generally include, among others, plan sponsors and anyone providing services to a plan.

PLAN TERMS
Plan documents need to be timely amended to comply with legislative changes and need to conform to actual plan operation. Thus, if loans were made to participants, but the plan document did not permit participant loans, the plan sponsor would need to correct this operational failure. The failure may be corrected by a plan amendment that conforms the terms of the plan to the plan's prior operations. For example, if the 401 (k) plan failed the AD p test and the employer made qualified non-elective contributions to avoid a return of excess 401 (k) deferrals to highly compensated employees, the plan may be amended to reflect operational correction.

MERGERS AND ACQUISITIONS
An employer involved in a merger or an acquisition needs to make representations on employee benefit plan compliance. These representations are made to the effect that plan documentation satisfies ERISA and IRS qualification requirements and that the plan is being operated in accordance with the plan document and IRS qualification requirements.
    If a company is sold or is intended to be merged with another company, failure to comply with applicable plan documentation requirements may nullify the traditional employee benefits-related representations in the acquisition or merger agreement, creating liability for the plan sponsor. In this event, the plan sponsor may either have to qualify his or her representations, disclose non-compliance or take the risk of incurring additional liability for breaching one or more of the representations it makes in connection with the corporate transaction.
    It is difficult to conduct an operational review and correct document and operational failures prior to the closing of a transaction. Accordingly, self -audits facilitate mergers and acquisitions and protect plan sponsors in connection with representations regarding plan documentation and actual plan operation.
    The compliance audit also enables a plan sponsor to identify and disclose document defects or operational failures and either negotiate 401 (k) and retirement issues or insure the related risks posed by the failures.

SERVICE PROVIDERS
Some service providers to a plan are "parties in interest," including accountants who audit the assets of a plan, attorneys who provide legal and fiduciary counseling for the plan, and banks that hold plan assets. Accountants, attorneys, banks and other service providers who are parties in interest that participate in a fiduciary's breach of fiduciary duties under ERISA or a prohibited transaction may be subject to liability under ERISA.
    The U.S. Supreme Court has determined that a non-fiduciary party in interest may be held liable under ERISA for participating in a prohibited transaction.²⁸ This recent ruling, while holding non-fiduciary parties in interest potentially liable for their involvement in prohibited transactions under ERISA, may have also established the possibility for non-fiduciary liability of entities that are not parties in interest.²⁹ Accordingly, it appears that any individual or entity who is a knowing participant in a fiduciary breach, whether or not they are parties in interest, would be subject to liability under ERISA.
    Accordingly, any entity providing services to a qualified plan will need to analyze transactions for potential liability exposure as well as consider the need for increased liability insurance.
    Service providers need to protect themselves when dealing with qualified plans through liability insurance and hold-harmless agreements. There is now increased liability exposure for plan service providers because plaintiffs seeking to hold a party to a plan transaction liable for a fiduciary's breach need only show that the party had knowledge of the breach. Even individuals or entities that do not pay fair value to a plan or that overcharge a plan for services rendered may be held liable as a result of this U.S. Supreme Court case ruling.

ACCOUNTANTS AND ATTORNEYS
In another matter, the U.S. Supreme Court denied review of a case asking the court to decide whether ERISA's party in interest provisions completely preempt claims for state statutory violations of professional conduct brought against a pension plan's non-fiduciary.³⁰ A trustee and participant in a qualified plan brought an action in state court against a law firm, alleging that the firm overcharged the plan for legal services rendered between 1986 and 1988. Accordingly, the appellate ruling remained in effect holding that state law claims alleging the charging of excessive legal fees is precisely the type of prohibited transaction governed by ERISA. The court held that the law firm was not a fiduciary under ERISA and was not subject to a cause of action for a breach of fiduciary duties; therefore, the appellate court focused on the issue of non-fiduciary liability.
    Nevertheless, an accountant or attorney service provider may become a fiduciary if he or she engages in a fiduciary activity including, but not limited to, appointing other plan fiduciaries, delegating responsibility to or allocating duties among other plan fiduciaries, selecting and monitoring plan investment vehicles, giving investment advice to a plan for a fee, selecting and monitoring third-party service providers, negotiating the compensation of third-party service providers, interpreting plan provisions and denying or approving benefit claims.
    An attorney or accountant who renders legal or accounting services to a plan fiduciary will not be considered a fiduciary unless he or she exercises discretionary authority or discretionary control over plan management or the disposition of plan assets, or has any discretionary authority over plan administration.³¹
    Further, a fiduciary cannot comply with his or her duties under ERISA without a basic understanding of the fee structure for various services provided to the plan. The DOL, through the Pension and Welfare Benefits Administration (PWBA), enforces the provisions of Title I of ERISA and may conduct a service provider investigation.³² A significant portion of PWBA resources are directed at investigating plan service providers, with particular review of fee arrangements and the possibility of a prohibited transaction.
    Fees paid by a plan for the services provided by accountants and attorneys may violate ERISA's prohibited transaction rules. Since an entity or an individual who provides services to a plan is an ERISA party in interest, the fees are considered a transfer of property from the plan to a party in interest.³³
    ERISA allows only fees that (i) are "reasonable" in amount and (ii) have been paid for services that are "necessary for the establishment of the plan."³⁴ If the fees do not satisfy either of these requirements, the service provider may be required to return the fee to the plan and may be subject to an IRS excise tax -the results of having entered into a prohibited transaction under ERISA.
    An annual compliance audit is a cost-effective method for accountants and attorneys to avoid potential fiduciary breaches, prohibited transactions, and the financial consequences of non-compliance. Lack of clearly established plan documentation, including eligibility requirements, and actual plan operation consistent therewith, could result in successful benefit claims by participants, part-time employees and independent contractors, who are not intended to benefit under the plan. Given the complexity of ERISA's rules, accountants may need ERISA legal advice to help them avoid the risk of potential fiduciary breaches and prohibited transactions. An accountant may also consider procuring fiduciary insurance to cover negligent breaches of fiduciary duty. Accountants and attorneys need to avoid certain types of transactions and obtain plan sponsor assurances of operational compliance.

DISCRETIONARY AUTHORITY
The lack of unambiguous plan language as well as provisions granting the plan administrator the discretionary authority to interpret plan provisions and to construe plan terms relating to eligibility and other salient provisions, may subject the plan administrator as well as its professional advisors to the increased possibility of a successful claim against the plan. Ambiguous language and the lack of plan administrator discretion may subject the decisions of the plan administrator to de novo (i.e., full factual) review by a court, should the decisions of the plan administrator (i.e., plan sponsor) be challenged by a dissatisfied participant or former employee.

PLAN DOCUMENTATION
The failure to include provisions authorizing affiliated employers to adopt the plan may also result in inadvertent state corporate law or other applicable law violations. Furthermore, a well drafted summary plan description and a review of an employer's employee handbook or other employee communication material may be binding upon the employer by a court of law, even if inconsistent with the governing plan document. Professional advisors need to make certain that employers maintain an up-to-date and fully executed written plan document to avoid:

• substantial penalties,
• vulnerability to successful claims and challenges,
• a constraint upon the employer's ability to modify the plan,
  and
• issues in a proposed merger or other corporate transaction.

FIDUCIARY STANDARDS
A fiduciary is required to diversify the investments of the plan so as to minimize the risk of large losses (unless under the circumstances it is clearly prudent not to do so).³⁵ Thus, ERISA adopts the portfolio theory of investment, and the standard of prudence applies to each investment as a part of the total portfolio.³⁶ The self-audit should include a review of the composition of the plan portfolio with regard to the diversification of risk and the adherence to specific investment guidelines of the plan.

QDRO PROCEDURES
Written plan documentation includes the maintenance of qualified domestic relations order (QDRO) procedures to permit plan administrators to administer the submission of a QDRO. Although there has been a longstanding requirement to have a QDRO procedure in place, there has been no record of sanctions against a plan administrator for failing to provide a procedure. Nevertheless, the DOL is increasing its enforcement actions against plan administrators, which may now include the review of QDRO procedures. Most attorneys are not familiar with the Code or ERISA and the requirements to qualify a domestic relations order for a transfer of plan assets from a qualified plan, without jeopardizing the tax-exempt status associated therewith. As a result, the domestic relations orders submitted to plan administrators by counsel are generally deficient and not in conformity with the Code's requirements for QDROs.
    Plan administrators are receiving a significantly increasing number of domestic relations orders, which require a review as to the qualifying nature thereof, and then the timely processing of the order. Plan administrators need to avoid a delay in any benefit payments to participants or alternate payees under a QDRO, to avoid additional claims by beneficiaries of the QDRO.
    A DOL Advisory Opinion has made it clear that plans may not charge a fee to individual plan participants to process a QDRO.³⁷ The opinion does not however prohibit charging the costs of administering the review of a domestic relations order to the trust as a general administration expense. This expense would therefore be spread among all plan participants, rather than the participant directly affected by the QDRO.

LIABILITY INSURANCE
Insurance carriers favorably consider compliance audits when underwriting the risk and thus determining the premium payable for fiduciary liability insurance. Fiduciary liability insurance has provided coverage for operational failures and ERISA violations committed by plan sponsors.
    A 401 (k) plan sponsor was indemnified for failing to inform employees when they switched guaranteed income contract carriers and misled participants by continuing to use the old carrier's enrollment forms. A plan sponsor was also indemnified for releasing a spouse's retirement funds to the participant in the absence of spousal consent.
    A 401 (k) plan sponsor and its investment committee were indemnified and defense costs paid for imprudently investing plan assets ill an Insurance carriers guaranteed income contract because of the carrier's extensive bond holdings. A pension plan sponsor was indemnified for taking more than 45 days and thus failing to timely value plan assets in response to an employee's request in writing for a pension calculation. There was a substantial drop in the stock market that adversely affected the value of the employee's retirement funds.
    A pension plan sponsor was indemnified and its defense costs paid for failing to account for maternity leave in determining service for pension benefits.³⁸
    In addition to fiduciary liability coverage, a plan sponsor may qualify for an insurance program providing indemnification against IRS monetary sanctions. These sanctions are not covered by traditional fiduciary liability policies.
    401 (k) and retirement plan trustees need to consider all of the relevant factors and circumstances and their responsibilities as fiduciaries in determining whether to use plan assets to pay for fiduciary liability coverage.³⁹ To this end, ERISA expressly allows, but does not require, a plan to purchase insurance for its fiduciaries or for itself to cover liability or losses occurring by reason of the act or omission of a fiduciary, provided that such insurance permits recourse by the insurer against the fiduciary in the case of a breach of a fiduciary obligation under ERISA by the fiduciary.⁴⁰
    Accordingly, plan trustees need to consider whether and to what extent the purchase of insurance with plan assets is primarily for the benefit of the plan, the ERISA fiduciaries in their official capacities, the ERISA fiduciaries in their personal capacities or the employer, by taking into account all relevant facts and circumstances and the particular responsibilities of the fiduciaries. ERISA 's exclusive benefit rule requires that ERISA fiduciaries need to act prudently and solely in the interest of participants and beneficiaries when using plan assets to pay expenses.⁴¹

AUDIT FEE
Plan audits are not inexpensive, and may be paid by the plan or the plan sponsor. The DOL has approved payment of a self-audit with plan assets provided the following requirements are met:⁴²

• the plan document permits the use of plan assets to pay for the compliance audit,
• the plan fiduciaries determine that a compliance audit is a prudent means of operating the plan,
• the amount paid for the audit is reasonable (taking into account the benefit received by the plan as well as by the plan sponsor), and
• any amounts paid may not include the payment of sanctions or penalties for non-compliance.

      Accordingly, plan sponsors would not violate the fiduciary provisions of ERISA if they used plan assets to pay for compliance audits. The compliance audit can include, but is not limited to, an examination of the administrative aspects of a plan's routine operation, including the plan's collection of contributions, payment of benefits and investment of assets, as well as compliance with the qualification provisions of the Code. The compliance audit generally relates solely to the management of a tax qualified plan and to decisions relating to the establishment, design or termination thereof.
    It is the DOL's view that reasonable expenses of administering a plan include direct expenses properly and actually incurred in the performance of a fiduciary's duties to the plan. Thus, if the plan trustees were to determine that periodic compliance audits were a helpful and prudent means of carrying out their fiduciary duties, including the duty to operate the plan in accordance with its terms,⁴³ then the use of plan assets to procure compliance audit services would not, in and of itself, violate ERISA.⁴⁴
    In choosing among potential service providers, as well as the monitoring and retention of a service provider, the trustees must objectively review the qualifications of the service provider, the quality of the work product and the reasonableness of the fees charged in light of the services provided. This is an important trustee function to the extent that compliance audits may confer a benefit on the employer; therefore, trustees have a duty to ensure that the plan's payment for the compliance audit is reasonable in light of the benefits conferred on the plan.
    Moreover, to the extent that the compliance audit involves services for which a plan sponsor or other entity could reasonably be expected to bear the cost of in the normal course of the entity's business, the use of plan assets to make such payments would not be a reasonable expense of administering the plan.⁴⁵
    If a plan disqualifying defect was not caused by a breach of fiduciary duty, the plan may only pay for any resulting sanctions and penalties to the extent that such payment would constitute a reasonable expense of the plan.⁴⁶
    The DOL has expressed its view that ERISA fiduciaries may not use plan assets for the payment of sanctions or penalties in connection with the settlement of disqualification matters with the IRS. These penalties do not constitute a reasonable expense of administering the plan for the purpose of ERISA, to the extent that there is personal liability for someone or some entity other than the plan.⁴⁷

401 (K) PLAN REPORT
    The IRS examined and compiled data on 472 401 (k) plans from 1995 through 1997 and has issued a report advising of the results of its 401 (k) audit program.⁴⁸ The primary purpose of the survey was to identify areas in which 401 (k) plans failed to comply with the Code and to obtain information on the sizes of the plans containing these violations. These violations were not limited to qualification requirements, but also included prohibited transactions, deemed distributions and reporting failures.
    The IRS conducted this 401 (k) audit program to assist plan sponsors, employers and practitioners who have an interest in maintaining the tax qualified status of their own 401 (k) plans by identifying where violations are more likely to occur. The IRS reported that there were many violations relating to eligible rollover distributions, special non-discrimination tests, and compliance testing.
    401 (k) plans may not make any other benefits contingent on the employee making deferrals. There were many violations by plan sponsors who made 401 (k) plan participation contingent upon the employee meeting non-plan specific conditions. Many plans also violated the hardship distribution criteria, the top heavy requirements and the limitation on annual additions.
    Plan sponsors had entered into prohibited transactions by failing to timely deposit 401 (k) salary deferrals from the employer's payroll and operating account into the 401 (k) plan's trust. Although the maximum period has been reduced to the 1Sth business day following the month of the deferral, the general rule is and has been that the funds must be segregated from the general assets of the employer as soon as reasonably practicable.
    Partnership plan sponsors permitted partners to elect in and out of profit sharing features and thus caused their profit sharing features to be treated as 401 (k) features. A plan that allows partners to elect in and out of a non-401 (k) feature will have violated the Code by not including the proper 401 (k) plan language in the profit sharing feature, as well as exceeding the annual $10,500, as indexed, limit on 401 (k) elective deferrals. That is, if profit sharing contribution allocations to partners are treated as 401(k) deferrals, the annual dollar limitation on 401(k) deferrals will likely have been exceeded under the plan.
    The survey is useful in identifying areas to be reviewed in a self-audit. We understand that the IRS has again targeted 401 (k) plans in its 2001 work plan in an effort to gain greater insight into the areas of non-compliance.

IRS-APPROVED CORRECTIONS
    A digest of IRS-approved corrections of Code violations has been prepared to include 206 different violations under 81 retirement plans through April 2000.⁴⁹ In one case, the IRS cited a plan sponsor for violating the definition of compensation in calculating 401 (k) deferrals and employer matching contributions. The IRS permitted the plan sponsor to retroactively amend the plan to adjust the definition of compensation to exclude taxable special allowances and imposed a monetary sanction of $50,000.
    The IRS cited another plan sponsor for administering a plan in accordance with a three-year cliff vesting schedule, whereas the plan document had a four-year graded vesting schedule. The employer drafted, but failed to execute, the amendments to effect the three-year cliff vesting schedule. The IRS permitted the plan sponsor to retroactively amend the plan to provide for a three-year cliff vesting schedule and imposed a monetary sanction of $50,000.
    The IRS cited another plan sponsor for permitting participation as of the date of hire, rather than on an entry date following satisfaction of an age and service requirement set forth in the plan document. The IRS permitted the plan sponsor to execute a retroactive amendment to allow immediate participation and imposed a monetary sanction of $50,000.

• AUDIT ENGAGEMENT
  The plan sponsor and legal counsel need to determine:
• whether the compliance audit will follow a traditional accountancy model and thus examine randomly selected transactions to determine compliance or a screening method to review documents and interview key personnel,
• the cost of the audit and who pays for the audit and
• whether the audit report is reduced to writing, including any discovered defects, and the resolution of those defects, as prepared by legal counsel. If an individual other than legal counsel performs the compliance audit, then only an oral report of plan defects and the correction thereof should be made to plan trustees.

    The results of a compliance audit need to be transmitted to the trustees of the trust established as a part of the qualified plan. The engagement letter for the self-audit process may include a disclaimer that a self-audit cannot guarantee that all issues will be found or that additional defects will not later be discovered by the IRS or DOL upon examination. Further, the engagement letter may include a statement that the auditor is relying on the plan administrator (i.e., plan sponsor representative) to provide the data necessary to conduct the audit and that the results of the audit depend on the accuracy of the data provided.
    Further, the auditor may negotiate a hold-harmless agreement if Title I of ERISA or other litigation results and the auditor is required to testify as a defendant.⁵⁰

BEST PRACTICES
    Employee benefit plan advisors who want to correct qualification failures and ERISA violations pursuant to established IRS and DOL policies and programs may want to conduct annual self-audits. However, voluntary compliance is a relatively new and rapidly changing area of the law.
    Even the most carefully administered plan may experience a potentially disqualifying defect that may be timely discovered by the implementation of self-correction procedures and the conduct of an annual self-audit. The sanctions associated with disqualification disproportionately penalize the plan sponsor for inadvertent and unintended infractions of the very complex rules under the Code and ERISA. Plan sponsors should rely on the availability of self-correction to maintain the qualified status of their plans and to avoid fiduciary liability.