The Big Change to the IRS Determination Letter Program: Potential Consequences for Plan Sponsors
The Internal Revenue Service (IRS) has announced the end of the determination letter program as we know it. Beginning Jan. 1, 2017, the IRS will no longer accept determination letter applications based on the 5-year remedial amendment cycle (see IRS Announcement 2015-19
). Plan sponsors with EINs ending in 1 or 6 (and plans sponsors that made certain timely controlled group elections) will be able to submit an application in the upcoming “Cycle A” through Jan. 31, 2017.
As explained by the IRS, this monumental change was made “based on the need of the [IRS] to more efficiently direct its limited resources.” The IRS only averages about three hours per determination letter application, which is clearly not enough time to sufficiently perform a complete review of many plans. Going forward, individually designed plan sponsors may only apply for determination letters upon the initial qualification of a plan and upon plan termination. As a result, a plan sponsor that amends an individually designed plan cannot receive an IRS opinion letter that the changes made by the amendment do not affect the tax-qualified status of the plan. The consequences to plan sponsors of individually designed plans are potentially significant, and many plan sponsors are justifiably concerned about the end of the program.
One significant problem with the new policy is that determination letters are relied on in numerous contexts throughout the industry to demonstrate that a plan is tax-qualified in form: by auditors, in mergers and acquisitions, and, most importantly, by the IRS itself. The determination letter program put the burden on the IRS to rule on the qualification of plans, and this allocation of responsibility was fair because of the IRS is the entity that ultimately decides whether a plan is tax-qualified.
Now that the existing determination letter program is ending, plan sponsors will presumably have no reassurance that the IRS will not find qualification errors in their plan documents upon audit, and, importantly, no way to receive protection in the case the IRS does find an error. Furthermore, in the context of a merger, an acquiring company loses the ability to rely on a determination letter on a target company’s individually designed plan. This could significantly raise the due diligence costs associated with the merger, and ultimately result in greater uncertainties and potential barriers to closing a deal.
Another concern for plan sponsors is the loss of the current extension of the remedial amendment period under §401(b) to the end of the 5-year remedial amendment cycle. As a result, the amount of time that a plan sponsor has to amend for disqualifying provisions will be much shorter, which stings even more in light of the fact that the IRS will not be reviewing plans for compliance.
However, the IRS requested comments on the changes to the remedial amendment period that would otherwise apply, indicating a willingness to work with the industry on this issue. On Oct. 1, 2015, the American Retirement Association submitted a comment letter to the IRS
recommending that the general remedial amendment period be extended to two years from the date that period begins, which is consistent with the self-correction period for significant errors under the Employee Plans Compliance Resolution System (EPCRS). Furthermore, the American Retirement Association recommended that EPCRS be modified to expand the ability to self-correct plan document defects. Hopefully, the IRS will adopt these suggestions.
Another important problem is that without the ability to have the IRS review a plan, plan sponsors have no way to make sure that their plans meet the IRS’ strict standards and policies about plan document language. For example, the IRS is strict about the exact language that is required to comply with certain law changes. Furthermore, the IRS only allows certain statutory and regulatory provisions to be incorporated by reference into a plan document. To assuage these concerns, the IRS would need to liberalize their strict plan document language policies (in conjunction with an expansion of the ability to self-correct plan document defects under EPCRS), become more transparent in publishing their standards regarding the required contents of amendments, and work with industry practitioners to timely develop flexible and useful model amendments.
There have been a number of potential solutions to the problems caused by the IRS’ announcement floating around the industry. One idea, which the IRS has considered in the past, is to privatize the program under a “third party certification system.” Under this proposal, the IRS would certify practitioners who would follow IRS guidelines in issuing determination letters. The American Retirement Association voiced support for this suggestion in its Oct. 1, 2015 comment letter, and stated that it would be willing to work with the IRS in developing this such a system. Alternatively, plan sponsors could seek opinion letters from law firms or other entities on the tax qualification of a plan. However, it is unclear how anyone could guarantee that the IRS would agree with their opinion on the tax-qualification of a plan. In addition, obtaining an opinion letter could be prohibitively expensive for many plan sponsors given the amount of time and risk involved with issuing such an opinion letter.
On Jan. 4, 2016, the IRS announced in Notice 2016-03
that expiration dates on determination letters issued before Jan. 4, 2016, are no longer operative, and that future guidance “will clarify the extent to which an employer may rely on a determination letter after a subsequence change in law or plan amendment.” This announcement at least can give plan sponsors some comfort that their current determination letters will no longer expire, but we don’t currently know the extent that these existing determination letters can be relied upon once a plan has been amended.
The ultimate effect of the changes to the program on plan sponsors of individually designed plans will only become more clear once the IRS issues much-needed guidance. If the IRS does not issue favorable guidance, individually designed plan documents would become a riskier and less attractive option for many plan sponsors, and we may see a significant shift toward the use of pre-approved plan documents. Only time will tell.
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