In late 2011, the IRS announced significant changes to its “determination letter” program, which for over two decades has allowed sponsors of Section 401(a) qualified plans (including 401(k) plans, profit sharing plans, ESOPs and defined benefit plans) to obtain written assurance from the IRS that the form of their plan document, and certain aspects of the plan’s operation, satisfy the applicable requirements of the Tax Code.
Although plans with favorable determination letters must still be operated in accordance with the terms of the Code (and the terms of the plan document), a favorable determination letter provides assurance that, if the IRS were ever to audit the plan, it could not “disqualify” the plan solely because the plan document has some minor error or omission. This in turn provides assurance that, so long as the plan is operated properly, (i) the employer will be able to deduct its contributions to the plan, (ii) both employer and employee contributions (other than designated Roth contributions) will not be currently includible in the employee’s gross income, (iii) the earnings on the plan’s assets will not be taxed each year, and (iv) distributions from the plan will qualify for tax-free rollover to an IRA or another employer plan.
Current Rules for Obtaining Determination Letters
Under existing procedures, employers that have “individually designed” plan documents may seek a determination letter on those documents during a 12-month period that occurs once every five years, with a given employer’s “filing cycle” determined by the last digit of the employer’s federal tax identification number (“EIN”). Cycle A (for sponsors with EINs that end with 1 or 5) just ended on January 31, 2012. Cycle B (for plan sponsors with EINs that end with 2 or 7) began on February 1, 2012, and will end on January 31, 2013. There are special rules for determining the proper cycle for multiple employer plans, multiemployer (union) plans, governmental plans, and plans maintained by multiple members of a controlled group.
Generally, plans must be restated to comply with all recent law changes when they are submitted for a new determination letter. The IRS publishes a list (referred to as the “Cumulative List”) each fall detailing the law changes that must be reflected in plans that are filing in the next cycle. For example, plans currently filing under Cycle B (which began on February 1, 2012) must comply with the 2011 Cumulative List, while plans that filed under Cycle A (which began on February 1, 2011, and ended on January 31, 2012) had to comply only with the 2010 Cumulative List.
Pre-approved plans (including prototype plans and volume submitter plans) are subject to a different procedure. Employers that adopt pre-approved plans may either (i) rely on the IRS opinion letter issued to the sponsor of the pre-approved plan, so long as the employer does not make any significant change to the pre-approved document, or (ii) file for an individual determination letter on their plan (regardless of whether they make any changes to the pre-approved plan). Once every six years, there is a 24-month period during which an employer may adopt the latest version of the sponsor’s prototype plan and submit that plan to the IRS for the employer’s own determination letter.
Although employers that do not make any modifications to a pre-approved plan (other than to check existing boxes or select among pre-approved options) may technically rely on the IRS opinion letter issued to the sponsor of the pre-approved document, many employers (at the advice of counsel and/or recommendations by third-party consultants and service providers) elect to pay the relatively small ($300) user fee and apply for their own individual determination letter (using Form 5307). As a result, even as more employers adopt pre-approved plans, and even though employers may file for determination letters only every five or six years (depending on whether the plan is an individually designed plan or a pre-approved plan), the IRS is still receiving more determination letter applications than it can handle.
As first announced in IRS Announcement 2011-82 (and as now set forth in the 2012 version of the annual revenue procedure describing the IRS’ procedures for issuing determination letters and other rulings), the IRS has made several important changes to the determination letter program. In the IRS’ own words, these changes were designed to (i) eliminate features of the program that are of limited utility to plan sponsors in comparison to the burdens they impose on the IRS, and (ii) improve the efficiency of the program by reducing the time it takes to process applications. However, under the modified procedures, some employers will no longer be able to apply for (or receive) determination letters with respect to their plans.
The most significant change is that, effective May 1, 2012, the only adopters of pre-approved plans that may request a determination letter on a Form 5307 will be adopters of “volume submitter” plans that modify the terms of the pre-approved specimen plan. This assumes that the modifications are not so extensive as to cause the plan to be treated as an “individually designed” plan – which must then be filed on the longer, and more expensive, Form 5300. Thus, employers that adopt a prototype plan, and employers that adopt a volume submitter plan without modification, will no longer have the option of applying for or receiving a determination letter on their plans.
Those employers may, however, rely on the IRS opinion letter issued to the prototype sponsor. According to the IRS, this “reliance” will provide the same level of protection as an individual determination letter. Whether that turns out to be true (i.e., whether the letter will actually protect the plan sponsor from a subsequent IRS auditor’s threat to disqualify the plan, or from a court that allows a participant’s rollover to be included in – rather than exempt from – the participant’s bankruptcy estate under the theory that the distribution was not from a “qualified” retirement plan, solely because the plan document was deficient in some minor way) remains to be seen.
The second important (but less significant) change is that, for applications filed after the date(s) described below, the IRS will no longer provide a determination (as part of the review process) as to whether the plan satisfies the minimum coverage requirement of Code Section 410(b), the nondiscrimination requirements of Code Section 401(a)(4), or the minimum participation requirement of Code Section 401(a)(26) (which applies solely to defined benefit plans). Currently, employers filing for determination letters have the option to complete Schedule Q and the accompanying demonstrations and thereby request a ruling, based on those demonstrations, that the plan satisfies the applicable coverage and/or nondiscrimination requirements of the Code. In our experience, however, most employers do not complete Schedule Q (and pay the higher user fee) to obtain these rulings, primarily because the ruling is good only so long as the employer’s demographics do not change (i.e., the plan must still demonstrate, each plan year, that it covers a sufficient percentage of the employer’s non-highly compensated workforce, and that contributions or benefits under the plan do not discriminate in favor of the highly compensated employees). According to the IRS, the need for this subsequent testing reduces the value of these optional determinations, so it no longer intends to offer this service. This change is effective for determination letter applications filed on or after February 1, 2012 (in the case of individually designed plans other than terminating plans), and for applications filed on or after May 1, 2012 (in the case of pre-approved plans and terminating plans).
The third change is that there are two new situations in which an employer that has adopted a pre-approved plan may be required to file a Form 5300 – the form that is generally filed by sponsors of individually designed plans, and that requires a substantial ($2500) user fee. Under current procedures, an adopter of a pre-approved plan must file the longer, more expensive Form 5300 if the plan is a multiple employer plan, or if the application also requests a determination regarding “affiliated service group” or “leased employee” status or a determination as to whether there has been a “partial plan termination.” Effective May 1, 2012, an employer seeking a determination letter for a pre-approved plan must also file Form 5300 (rather than Form 5307) if either:
the employer has added language to a pre-approved plan to satisfy the requirements of Code Section 415 (the limit on annual additions) or Code Section 416 (the “top-heavy” rules) because of the required aggregation of plans (i.e., to set forth which plan will address excess annual additions, or which plan will satisfy the top-heavy minimum); or
the plan provides for a “normal retirement age” that is earlier than age 62.
Impact of the Changes
As indicated above, the IRS hopes that these changes will both reduce the number of determination letter applications it receives and simplify its review of the applications it does receive. However, it remains to be seen whether employers that have historically sought and obtained their own individual determination letters will be content to rely on the opinion letter issued to the sponsor of the preapproved plan, or whether they will opt for a volume submitter plan (in lieu of a prototype plan), in order that they can modify the document just enough that it will qualify for filing on Form 5307. Care would need to be taken in those situations to make sure that the changes are not so significant as to cause the plan to be treated as an individually designed plan, since those plans require the more expensive Form 5300 filing, and must be filed during the appropriate 12-month period to be considered an “on-cycle” filing.
In addition, because we are still early in the current 6-year cycle for pre-approved defined contribution plans (the period for sponsors to submit those plans to the IRS for new opinion letters does not close until April 2, 2012, and it will take the IRS a year or more to review those applications and issue new opinion letters), it will still be two to three years before the next “window” of time for employers to adopt and file applications for pre-approved plans. It is possible that there could be further changes to the determination letter procedures by that date.