On February 23, 2017, the IRS released a memorandum directed to its employees who conduct employee plan examinations about substantiation of hardship distributions. The memorandum describes the process IRS employees should follow in determining whether information provided by an employer is sufficient to substantiate that a distribution from a 401(k) plan satisfies the hardship safe-harbor. The memorandum provides a path for recordkeepers to avoid the necessity of gathering source documents; for example, contracts, bills and statements; to substantiate hardship distributions, but it could leave employers liable for qualification failures that result if a recordkeeper fails to follow precisely the requirements laid out in the memorandum.
Under 401(k) regulations, a 401(k) plan may permit a participant to take a hardship distribution, but only if the distribution is made on account of an immediate and heavy financial need. The regulations include a safe harbor that provides that a distribution is deemed to be on account of an immediate and heavy financial need if it is made to pay for certain types of expenses, e.g., expenses for medical care and costs of purchasing a principal residence. When an employer is relying on the safe harbor, substantiation is required to show that a hardship distribution is for one of these permitted expenses.
The memorandum describes the steps that a revenue agent should take during an examination to determine whether the information offered by an employer is sufficient to substantiate that the safe harbor requirements are satisfied. The memorandum suggests that an employer may substantiate a hardship distribution by obtaining from the participant either source documents or a summary of information contained in source documents. If the summary is used, then the memorandum requires that the employer must provide certain notifications to the participant. One of the required notifications is that “the recipient agrees to preserve source documents and to make them available at any time, upon request, to the employer.” Presumably, the reference to the “recipient” means the participant receiving the hardship distribution.
If an employer is using a summary of source documents to substantiate hardship distributions, rather than the source documents themselves, there are four circumstances in which an agent examining the plan may request copies of the source documents:
If the employer fails to provide the notifications that are required to the participant, then the agent may request source documents.
The agent may also request source documents if the information contained in the summary is either incomplete or inconsistent on its face.
If a participant receives more than two hardship distributions in a plan year, and there is inadequate explanation for the multiple distributions, then, after obtaining managerial approval, the agent may request source documents.
One of the steps required in the memorandum that applies if a third party administrator is using a summary to substantiate a hardship distribution is that the third party administrator must provide a report or other access to data to the employer on an annual basis describing the hardship distributions made during the plan year. Presumably, the IRS intends that the employer will review the report to determine whether there are any summaries where the information included in the summary is either incomplete or inconsistent.
If all of the steps outlined in the memorandum are satisfied, then the memorandum provides that the plan should be treated as satisfying the substantiation requirement for hardship distributions. If an employer elects to use a summary as substantiation for hardship distributions and not all of the applicable steps for use of a summary are satisfied, then the agent may require the employer to produce source documents to substantiate hardship distributions made from the plan.
The catch is that if a recordkeeper fails to follow all of the requirements for use of a summary, and the agent examining the plan requires the employer to produce source documents, the employer may be forced to go back to the participant who received the hardship distribution and obtain the source documents from the participant. That could be difficult if the participant is no longer employed by the employer maintaining the plan. If the participant cannot be found or he or she cannot produce the source documents, the agent could take the position that there is no substantiation for the hardship withdrawal and that the plan has suffered an operational qualification failure. Any such operational defect identified during an examination of the plan could mean that the employer will be required to enter into a closing agreement with the Service to re-qualify the plan and pay a significant sanction amount as part of the agreement.
For this reason, employers may want to think twice about permitting a recordkeeper to use summaries to substantiate hardship distributions. If an employer decides that the cost savings is worth the potential risk involved, the employer should attempt to limit the risk by taking the following actions:
Confirm that the recordkeeper is taking all of the steps outlined in the memorandum required to substantiate hardships by a summary including making the required notifications to the participant, ensuring that there are no summaries that are incomplete or inconsistent, and providing to the employer a report or other access to data on an annual basis describing the hardship distributions made during the plan year.
Review the report or data on an annual basis, and if the report or data reveal that any summary is incomplete or inconsistent, take steps to obtain the source documents from the participant. If the participant is unable to provide the source documents, then consider treating the distribution as an impermissible distribution and take appropriate steps to complete a correction.
Consider limiting hardship distributions to no more than one in any plan year.
Amend the service agreement with the recordkeeper to provide that the recordkeeper agrees to take all the steps in the memorandum applicable for substantiating hardship distributions by way of a summary. Employers might also want to consider obtaining indemnification from the recordkeeper in the event of a failure of the recordkeeper to follow the required steps for substantiation.
For more information, see, “10 Questions to Ask Before Signing that New Service Agreement”, Benefits News, October 2016).
Please feel free to contact us if you need advice for any questions you might have regarding this new guidance.
© Boutwell Fay LLP 2017, All Rights Reserved. This handout is for information purposes only, and may constitute attorney advertising. It should not be construed as legal advice and does not create an attorney-client relationship. If you have questions or would like our advice with respect to any of this information, please contact us. The information contained in this article is effective as of March 31, 2017.