The Internal Revenue Service ("IRS") has modified procedures governing favorable determination letters for individually designed qualified retirement plans, including 401(k), profit sharing, defined benefit, and cash balance pension plans. The IRS will now issue determination letters for individually designed plans only upon initial plan adoption and termination, and it has eliminated the five-year cyclical determination letter and remedial amendment program.1
Under the prior staggered remedial amendment program, plan sponsors were eligible to receive IRS approval of individually designed qualified retirement plan language at regularly scheduled five-year intervals. Sponsors could submit applications for determination letters once every five years, staggered cyclically according to the last digit of the sponsoring employer's identification number ("EIN"). Upon IRS issuance of a favorable determination letter, sponsors had up to 91 days to adopt the proposed plan or any amendments. Finally, to preserve reliance on a letter past the five-year cyclical period, sponsors could apply for a new letter within the last 12 months of their plan's remedial amendment cycle. Determination letters expired in five years.
The New IRS Determination Letter Program
However, the IRS how now eliminated the five-year cyclical remedial amendment system. Now, plan sponsors of individually designed plans may instead submit their plans for determination letters only upon initial plan qualification, qualification upon plan termination, and in other special circumstances pursuant to forthcoming IRS guidance. However, Cycle A filers (including any plan sponsor whose EIN ends in 1 or 6) are still permitted to submit determination letter applications on or before January 31, 2017.
When May a Determination Letter Application Be Submitted?
Under the new procedures, plan sponsors may apply for a favorable determination letter in only three instances. First, in the case of initial plan qualification, a sponsor may apply if the plan has never received a favorable determination letter. Second, where a plan is terminating, sponsors may apply on or before the later of (i) one year from the effective date of the termination, or (ii) one year from the date on which the action terminating the plan was taken, but in either case, no later than one year after the distribution of substantially all plan assets in connection with the termination. Finally, the IRS may make special exceptions for applications, based on additional circumstances and factors, such as program capacity. The IRS has stipulated, however, that no such additional circumstances apply for 2017 applications.
Does a Favorable Determination Letter Expire?
Under the new system, favorable determination letters no longer expire, and expiration dates previously applicable to letters issued before January 4, 2016, are no longer valid. As a result, plan sponsors may continue to rely upon any previously issued letters as well as initial letters issued to newly adopted plans—to the extent that no design changes have been made, and the plan is not affected by a change in law.
Change to Remedial Amendment Periods
In connection with changes to the determination letter program, the Department of the Treasury and the IRS will publish an annual Required Amendments List containing obligatory plan amendments, the implementation of which is necessary to preserve qualified plan status. To facilitate compliance, remedial amendment periods (during which required changes may be made) have also been changed in some circumstances.
The IRS has extended the remedial amendment period for plan qualification to the end of the second calendar year following the publication year of the Required Amendments List giving rise to the change. With respect to plan qualification provisions of new non-governmental retirement plans, the remedial amendment period has been extended to the later of (i) the fifteenth day of the tenth calendar month following the end of the initial plan year, or (ii) the date determined by the plan sponsor's income tax filing deadline. Finally, for qualification provisions affecting preexisting non-governmental plans, the remedial amendment period has been extended to the end of the second calendar year following the plan's adoption or effective date (whichever is later). Notably, the termination of a plan shortens the remedial amendment period, which will expire upon the plan termination.
Consequences of Determination Letter Program Changes for Employers
A number of important consequences are foreseeable for plan sponsors as a result of the new IRS ruling.
Consequences during corporate transactions
Favorable determination letters are heavily relied upon by potential acquirors for due diligence purposes in connection with corporate transactions. Without the ability to seek favorable determination letters to ensure qualification of individually designed plans, costs and associated liabilities related to conducting due diligence and acquiring such plans will increase. As a result, transacting parties may seek to limit plan liabilities through obtaining opinion letters from law firms, and, in connection with a merger or acquisition, acquirors may prefer to terminate and liquidate retirement plans and distribute assets to participants rather than merge such plans into the acquiror's existing plans.
Consequences for plan investments
Financial institutions rely upon exemption allowances from registration requirements when offering investment funds to qualified retirement plans. In order to use such exemptions, a favorable determination letter proving qualification is required. Under the new system, lack of an updated letter may inhibit a plan's ability to partake in certain investments. As a result, financial institutions may reduce investment offerings or pass increased costs on to sponsors or participants.
The Employee Plans Compliance Resolution System ("EPCRS") requires a current favorable determination letter in order for plan sponsors to self-correct for significant failures, including by retroactive amendment. The IRS has not yet issued guidance regarding how this rule can be complied with under the new program.
A current favorable determination letter is required for plan-to-plan rollovers and plan-to-IRA rollovers by plan auditors, for both deductibility purposes as well as S-8 registrations. It is unclear how this requirement can be met for plans that can no longer rely upon favorable determination letters.
In addition, individual debtors with tax-exempt retirement accounts are protected from the assets held in such accounts being included in a bankruptcy estate. However, in order to be protected, accounts must provide evidence that the account is tax-qualified or in substantial compliance with the qualification rules.
Finally, IRS audits may become more extensive and devoted to the language of the plan document, increasing legal expenses related to IRS audits.
Going Forward—Potential Solutions
An Alternative to Individually Designed Plans: Master & Prototype Plans
The IRS is encouraging the use of preapproved Master and Prototype ("M&P") plans2 as an alternative to individually designed plans; M&P plans carry reduced risk and low up-front and compliance costs, and therefore present a safe and cost-effective alternative to individually designed plans. However, M&P plans are necessarily restrictive in content and thus subject employers to important limitations. For instance, employers are restricted to the elective provisions provided for in the adoption agreement, which may entail higher employer contribution costs than would the alternative in an individually designed plan. Furthermore, M&P plans are designed to protect the interests of the plan documents provider and record-keeper, rather than the employer, and as a result, they may entail higher management and recordkeeping fees, as well as unnecessarily restrict plan sponsors' conduct. Finally, whenever a change in vendors occurs, M&P plans require a new plan document or amendment.
Law Firm Opinion Letters
Plan sponsors and other parties may continue to rely on existing determination letters, as well as initial letters issued to newly adopted plans—to the extent that no design changes have been made or any changes in law apply. However, in the event of a plan design change or legal change to plan qualification requirements, such reliance ends. Going forward, plan sponsors unable to rely upon determination letters may instead seek opinion letters from law firms, which confirm that a plan is qualified for purposes of acquisitions, rollovers, plan audits, tax deductibility purposes, S-8 registrations, and financings. Potential buyers in merger and acquisition transactions will likely request that sellers provide such law firm opinion letters on qualified plans, to provide reasonable reliance on the form of the plan document and limit unanticipated liabilities.
Alternatively, if significant plan design changes are anticipated, plan sponsors may be advised to terminate the existing plan and adopt a new plan implementing the new design; in this way, sponsors may obtain a final determination letter for the prior plan's termination, in addition to a favorable initial determination letter for the new plan. Notably, the IRS seeks to discourage plans from being adopted with the intent of discontinuation, stating that the termination of a plan for any reason other than business necessity, within a few years after it has been adopted, will indicate that the plan was never intended to be permanent. Indeed, according to the IRS, the definition of a "plan" implies "a permanent as distinguished from a temporary program."3 However, the IRS exception for changing business circumstances may provide sufficient cause and justification for a plan sponsor to change or discontinue a plan in order to implement a major design change.
Importantly, complications may arise depending on whether or not the plan in question includes participant elective deferrals. For instance, a defined contribution plan including participant elective deferrals cannot be terminated and the assets distributed if a new plan covering more than two percent of previous employees is established within one year of the prior plan's termination. In that case, plan sponsors may instead be advised to freeze the prior plan or transfer assets to a new plan, thereby enabling the new design to be implemented and issuance of a favorable determination letter for that new plan. However, if assets are transferred from a terminated or frozen plan to a new plan, certain participant options must be preserved from the prior plan in the new plan. In contrast, defined benefit, cash balance, and defined contribution plans lacking employee elective deferrals (such as profit sharing only plans) may be terminated and assets distributed to participants, thereby enabling reliance upon both termination and initial determination letters.
Ultimately, plan sponsors and employers must assess whether individually designed qualified retirement plans should be maintained, or whether they should be replaced with M&P plans. If individually designed plans are retained, plan sponsors and other parties that previously relied upon IRS-issued determination letters must assess how to obtain adequate assurances that retirement plans continue to remain qualified.
1 Revenue Procedure 2016-37.
2 IRS-issued opinion letters for pre-approved M&P plans will continue on a six-year cycle, although the current cycle is delayed to start on August 1, 2017.
3 Treas. Reg. Section 1.401-1(b)(2).
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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