A favorable determination letter is the IRS’s way of telling you that your plan complies as to form with current legal requirements. In other words, it is a type of “insurance policy” that says your plan is qualified.

We recently handled a matter for a client in which the process of seeking a favorable determination letter (or FDL) went terribly wrong. Fortunately, through diligence and a bit of creativity, we were able to turn the process around.

By way of background, to get a FDL, the employer must file an application that includes the plan document, prior amendments and various other items of information. In reviewing the application, the IRS will look to make sure that the plan and all required interim amendments were adopted on a timely basis. If not, the plan is considered to be under audit, and the IRS gives the employer a choice: retroactively correct the error under the audit Closing Agreement Program (CAP) or have the plan disqualified. Under CAP, the employer must pay a penalty, which is often tens of thousands of dollars, to avoid having the plan disqualified.

The matter we handled involved a profit sharing plan to which the employer was adding a 401(k) cash or deferred feature. The restated plan was submitted to the IRS for a FDL. The reviewing IRS agent asserted that the plan was subject to disqualification because participant deferrals had been permitted prior to the date the restated plan was signed, in violation of the tax regulations. The agent said that this was an operational failure that must be corrected under the audit CAP program. The employer and the third party administration firm that had submitted the application assumed the IRS was correct and engaged our firm to try to get the lowest possible audit CAP penalty.

Unfortunately, the signature date on the restatement was after the date the first elective deferrals were made. But in our mind, the question was whether the restatement had been adopted prior to the date deferrals began, regardless of when it was signed. We based this position on the following:

  • First, the tax regulations provide that “[a] qualified pension, profit sharing, or stock bonus plan is a definite written program and arrangement which is communicated to the employees and which is established by an employer.” There is nothing that mandates that the only way a definite written program can be established by an employer is by a dated signature block on the plan document. Having an executed and dated plan document is one way to prove that a definite written program has been established, but not the only way.
  • Second, we discovered documentation showing that, prior to the date deferrals commenced, the employer had taken all necessary steps to decide on the terms of the plan.
  • Third, we provided evidence that the establishment of the plan had been communicated to the employees and steps taken to implement prior to the first deferrals. We showed this through documents provided to and election forms obtained from the employees at an employee meeting on the date the restatement was to go into effect.
    Based on these facts, we argued that the employer had intended to adopt the plan before deferrals were to begin, had taken all steps needed to determine the terms of the plan and to communicate the plan to the employees and, therefore, had in fact established the plan on a timely basis. In the face of this information, the IRS reversed its earlier position and granted the FDL without the payment of any penalty.

We believe this case is important for two reasons. First, it serves as a reminder not to submit the plan for a favorable determination letter without being sure that there are no preexisting errors—and taking steps to correct the errors before the application is filed. Second, it emphasizes that resolution of a proposed CAP settlement involves more than just negotiation of the penalty amount and, instead, should be a creative process to see whether a penalty can be avoided altogether.