Audits of Section 401(k) Plans - Should Your Firm Make the Commitment?

Employee benefit plans are unique and complicated in so far as the tax and maze of rules and regulations that pertain to their operation and qualified status.

The IRS and Department of Labor Express New Concerns About Audits of Section 401(k) Plans


You’re a tax and accounting professional and you may have helped your client decide whether to have a Section 401(k) plan, a type of individual account plan. ((See Instructions to Form 5500 for 2015, page 44.))

You’ve worked through the details of costs and contribution limits and a maze of tax rules. You may well be the one to notify the client of new tax pronouncements and developments that affect the plan.

But helping the client decide whether to have a Section 401(k) plan and notifying the client of major pronouncements affecting 401(k) plans is quite different from the issue of the client’s decisions concerning management of the plan and your decision as to whether your firm is the one to audit the plan.

Our focus in this article is more on the differing responsibilities after the plan is in place, with an emphasis on the accounting firm’s decision as to whether to audit such plans. We hope to leave the accounting firm’s management with enough perspective to make an informed decision on the matter.

We also hope to provide a perspective to those plan administrators charged with hiring the auditing firm.

We try to provide some perspective but would also say up front that the complexities of such audits and their uniqueness are such that there is a significant threshold of commitment involved in doing such audits. That’s not to say that smaller firms can’t do audits of Section 401(k) plans but rather to say the topic is so unique and complex that the firm, regardless of its size, needs to plan on a rather significant threshold of commitment to this specialized particular environment.

The tax and audit and regulatory rules governing the Section 401(k) plan are subject to change. There is the on-going process of new regulatory issues and tax rules. The decision to work in the area is an on-going commitment to study.

The nature of the world we live in is such that even once the plan is in place and “perfect,” it is still necessary to obtain and review the plan document annually, and to perform a review as an integral part of planning.  ((See this explanation of Rev. Proc. 2007-44,

The IRS publishes a Cumulative List of Changes in Plan Qualification Requirements near each year end.

The complexities are such that the IRS has an Employee Plans Compliance Resolution System (EPCRS)  and web site devoted to the topic of fixing plan mistakes.  ((; Rev. Proc. 2013-12, 2013-4 I.R.B. 313; Rev. Proc. 2015-27 modifying Rev. Proc. 2013-12, and Rev. Proc. 2015-28 modifying Rev. Proc. 2013-12.))

Fixing mistakes comes with special forms and user fees.  ((See IRS Forms 8950 and 8951.))

The Basic Tax and Auditing Environment

The 401(k) assets are technically held by a trust, not just a “plan.” One of the audit steps of the IRS in examining a Section 401(k) or other employee benefit plan is to confirm plan assets are held in the name of the trust. ((Internal Revenue Manual Part, Examination Objectives and Development of Issues, No. 12, Review of the Trust.))

The terms are often used interchangeably but “plan” and “trust” distinctions sometimes arise. The Internal Revenue Manual suggests that in dealing with representatives of the taxpayer,  a power of attorney form may be needed for the plan and a separate power of attorney form may be needed for the trust. ((Internal Revenue Manual Part, “Power of Attorney (Form 2848) and Tax Information Authorization (Form 8821).)

The employer’s contributions to the trust for the benefit of the participant are generally not subject to income tax for the employee, hence the deferral nature of the Section 401(k) vehicle.

The 401(k) is a separate account type plan that generally lets tax-deferred earnings accumulate to an even larger amount until the time of distributions from the trust. It is possible for a Section 401(k) trust to allow Roth type arrangements whereby there is no deferral up front but the account accumulates tax-free  and distributions are tax-free.

There is the FICA tax on earnings going into the plan, whether a traditional 401(k) arrangement or the Roth account approach. FICA taxes do not apply to distributions out of the plan or to employer contributions to the plan, though they do apply to contributions for the employee whether the contribution is deferred for income tax purposes or the contribution is subject to immediate income tax under the Roth alternative (if the plan permits the Roth approach).

While the plan is exempt, there are nevertheless potential tax issues, both unrelated business income tax possibilities and sundry excise taxes. ((See IRS Form 990-T, Exempt Organization Business Income Tax Return and its instructions, and Form 5330, Return of Excise Taxes Related to Employee Benefit Plans, and its instructions.))

Many plans will get an opinion on their exempt status though it isn’t per se required.

There are myriad tax rules that the auditor must understand in auditing the plan, such as limits on employee compensation that can be taken into account when computing contributions, and vesting rules for the employee’s account, as well as the rules distinguishing between deferrals out of the employee’s earnings and contributions by the employer. The employee’s contributions must always be 100% vested but that is not true as to the employer’s contributions depending on the terms of the plan.

There are overall limits on contributions that apply to plans established by an employer and any related employer. Basically, the overall limit on additions to the employee’s account looks at the total of elective deferrals, employer matching contributions, employer nonelective contributions, and allocations of forfeitures. The annual additions to the participant’s account can’t exceed the lesser of 100% of the participant’s compensation or $53,000 ($59,000 with catch-up contributions for certain older employees). These are the limits for 2015 and 2016.

Audits of employee benefit plans and the accounting/tax rules governing such plans are quite unique. As an indication of the uniqueness of such audit engagements, consider this statement out of the Internal Revenue Manual that “Fair market value must be used to value depreciable assets.” ((Internal Revenue Manual,, No. 12.))

That’s not to say that there aren’t the  familiar issues of internal control, such as having two disinterested parties approve checks, but the auditor has to be committed to studying a body of rules that involve interplay and special considerations involving the myriad parties involved. ((See the IRS site, “Internal Controls Are Essential in Retirement Plans,”

  The Employer’s /Plan Administrator’s Perspective

There is, of course, the issue of the auditor’s fee, which is judged by the plan administrator and/or the employer. The employer will sometimes pay the fee out of general funds and will sometimes pay the fee out of plan assets.

The audit itself is one of the complexities and costs that should also go into the front-end weighing of factors affecting a decision to have such a plan. The auditor, of course, has to balance the need for doing a quality audit with the fee, the costs and time involved, and the problems associated with any major oversights in the audit process.

For the employer, the issues here are not only ones of contractual commitments and going forward in helping  the workers but the area is also fraught with penalties as well as cost issues.

For example, failure to make a timely deposit can not only trigger corrective measures but penalties. Failure to file the Form 5500 can result in penalties from both the IRS and the Department of Labor. Plan loans to disqualified persons can trigger penalties (excise tax). ((See Form 5330, Return of Excise Taxes Related to Employee Benefit Plans. See instructions to Form 5500,

It is possible for the plan administrator to incur penalties in excess of $50,000 in connection with Section 401(k) audit failures.

The 401(k) plan, to be qualified, needs not only be pursuant to a properly drafted plan but also has to operate in accordance with the plan and the strict regulatory environment.

The plan has to contain the appropriate language for qualification within the various choices available to employers adopting the plan and employees making choices within the limits of the drafted plan.

While a determination letter from the IRS on qualification isn’t mandatory, many employers choose to seek a formal letter from the IRS that the plan is qualified.

But there is also the operational aspect of the plan. Either category, drafting or operations, can create major problems. ((For a brief overview of the complexities, see IRS Pub. 4222, “401(k) Plans for Small Businesses,”

One of these operational aspects is described as follows by the IRS:

“In order to ensure that the plan satisfies these requirements, the employer must perform annual tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees.”  ((“401(k) Plan Overview,” IRS web site, Topics Retirement Plans))  There are safe harbor Section 401(k) plans with requirements such that the nondiscrimination tests applicable to traditional 401(k) plans do not apply.  ((See Section 401(k)(12).)) There are also Simple 401(k) plans, available in certain limited circumstances, which do not have to apply these nondiscrimination tests.

Some plans also offer loans. Whether to offer loans out of the plan is a decision made when the employer drafts or amends the plan. The terms of each plan vary, and it is the auditor’s job in opining on the financials to understand the details and particulars of this plan, including its loan provisions.

The employer’s responsibilities can sometimes be simplified by maximizing the use of outside help, often a financial institution. And while there are rules that mitigate the level of work when financial institutions are involved, the auditor still has to look over everyone’s shoulder so to speak; i.e.,  even when responsibilities are proliferated among other specialists who work with the administrator or specialize in investments there is still quite a lot of audit work involved. The auditor’s responsibilities involve all these parties in some aspects of completing the audit.

The employer’s fiduciary responsibilities should include confirming whether an attorney, accountant, or investment advisor has an up-to-date license and whether there are complaints pending against the service provider as part of their overall due diligence. ((

The DOL goes so far as to recommend that the administrator keep a written record of the process they followed in choosing service providers and the reasons for the selection of a particular provider. ((“Getting It Right, Know Your Fiduciary Responsibilities,”

The Regulatory Environment

The  accountant engaged in auditing the Sec. 401(k) plan has to be well versed in not only generally accepted accounting and auditing standards and the tax rules that play an important role, but also the Department of Labor regulations and policies governing such work.

An IRS web site titled “401(k) Resource Guide - Plan Sponsors - What if You are Audited?” describes the differing jurisdictions of  these federal agencies as follows:

“Authority and responsibilities of the Internal Revenue Service (IRS) and the Department of Labor (DOL). The Employment Retirement Security Act of 1974 (ERISA), as amended, provides the legal basis for the IRS Employee Plans (EP) compliance program. The jurisdiction over the rules for  401(k) plans is divided between the IRS and the DOL:

* The IRS has primary jurisdiction over the qualified status of 401(k) plans, which includes examining   plans and processing requests for determination letters.

* The DOL has primary jurisdiction over the fiduciary standards, reporting and disclosure requirements and other rules that do not affect the qualified status of 401(k) plans.”

The DOL is keenly interested in and even critical of the auditing process it sees with Section 401(k) plans and other employee benefit plans.

The DOL is so intent on the importance of the auditor in protecting employees and identifying problems that it produced a booklet, “Selecting an Auditor for Your Employee Benefit Plan.”  (( The publication goes so far as to warn:

“Because an incomplete, inadequate, or untimely audit report may result in penalties being assessed against you as the plan’s administrator, selection of an experienced and reliable auditor is very important…

The more training and experience that an auditor has with employee benefit plan audits, the more familiar the auditor will be with benefit plan practices and operations, as well as the special auditing standards and rules that apply to such plans.”

The Audit Required When Filing the Plan’s Form 5500

In the audit of a Section 401(k) plan, the accounting firm will wrestle with the law, regulations and rulings governing the plan itself, as well as the intricacies  and expertise it sometimes takes in dealing with the plan’s third party administrator and investment manager.

The overall current context is also one in which the governmental watchdogs have expressed significant dissatisfaction with the quality of audits of Section 401(k) plans. The environment is one of closer scrutiny than ever.

Over and above the complexities of  tax rules governing the plans, there is the issue of governmental oversight, especially the Labor Department’s scrutiny of the  accountant’s audit required of the plan. Technically, under ERISA, the auditor is engaged “on behalf of plan participants.” ((ERISA Section 103(a)(3)(A).))

A Section 401(k) plan has to file an annual Form 5500. The instructions to the 2015 Form 5500 are 82 pages,  whereas if the plan is that of a corporate employer, the instructions to the employer’s income tax return, Form 1120, are only 26 pages. This is some indication of the complexities, not to mention governmental zeal to  monitor the care that goes into managing the employees’ benefit plan.

Large plans have the further complication of  needing to have a certified audit of the plan attached to one of the tax schedules within the return. The instructions say that if the required accountant’s report is not attached to Form 5500, “it is subject to rejection as incomplete and penalties may be assessed.” ((Instructions to Form 5500, 2015, p. 37.))

“Large plans” that must be audited are generally defined as those having a hundred participants or more at the beginning of the plan year, but there are exceptions. There is also an “80-120 Participant Rule” which says if the plan has between 80 and 120 eligible participants at the beginning of the plan year, you can still file as a small plan if you so filed in the prior year. In this circumstance, no audit is required despite having a hundred or more participants. A key phrase is “eligible participants” which includes not only those in the plan but those who have met the eligibility requirements but have not yet opted into the plan. It also includes terminated participants that still have plan balances. Failing to accurately apply these rules can result in significant penalties from the Department of Labor. ((See also Instructions to Form 5500, Section 4.))

The main financial  portion of the DOL Form 5500 is Schedule I for a small plan, and Schedule H for large plans. ((

Common errors  encountered in auditing the plan include the following:

(1) not updating the plan;

(2) not expressly following the myriad particulars of the plan;

(3) failure to apply the plan’s definition of compensation correctly;

(4) employer matching contributions weren’t made to all appropriate employees;

(5) the plan failed the nondiscrimination tests;

(6) eligible employees were inadvertently excluded from the plan;

(7) elective deferrals weren’t limited to the right amounts and excess deferrals weren’t distributed;

(8) wage deferrals weren’t deposited in a timely manner;

(9) if permitted by the plan, employee loans didn’t conform to the terms of the plan and Section 72(p) of the Code;

(10) hardship distributions,  within “hardship” circumstances as reasonably detailed within the plan, were handled improperly;

(11) the plan was top-heavy and required minimum contributions weren’t made to the plan;

(12) and unfiled Forms 5500. ((See ))

Elements of operating the plan include participation, contributions, vesting (immediate or scheduled vesting is permissible), nondiscrimination rules, investing trust assets, fiduciary responsibilities, disclosures to participants, reporting to governmental agencies, and, yes, distributing plan benefits.

In focusing the efforts of IRS auditors working on employee benefit plans, the Internal Revenue Manual mentions seven particular areas to review for compliance, such as whether hardship distributions were made in accordance with the plan, whether the employer or trustee complied with filing Forms 1099-R, and whether spousal consent was obtained when required by the plan and the Code. ((Internal Revenue Manual,, No. 14, Distributions.))

Mr. Ian Dingwall,  Chief Accountant of the Office of the Chief Accountant,  speaking of their study in 2014, noted four characteristics of “deficient auditors”:

“*Inadequate technical training and knowledge.

*Lack of awareness of the unique nature of auditing employee benefit plans;

*Lack of quality control on audit processes; and

*A failure to understand the limited scope audit requirements.” ((

The limited scope concept relates to less stringent auditing rules for investments held by a bank or similar institution or insurance carrier. ((ERISA Section 103(a)(3)(C),

In general, the audited financial statements of the plan must include the opinion of the independent qualified public accountant. The IQPA report generally consists of the accountant’s opinion, financial statements,  notes to the financial statements and any supplemental schedules. ((Instructions to the 2015 Form 5500,  page 37.))

As with any audit, the auditor should plan on demonstrating the reasons for opining on the financials. This includes performing a detailed risk assessment of both the financial reporting and operations of the Plan, as well as performing detailed audit procedures. This is more than simply reconciling schedules to the financial statements, but rather involves reviewing documents supporting amounts and transactions shown in those schedules to ensure they were both properly recorded and are in accordance with Plan provisions and DOL and ERISA guidelines.

Part of the audience of the accountant’s opinion  is, of course, the IRS auditors, who are told to look for and review the report.

The Department of Labor’s definition of “independent” accountant is close to the general standard but may be even more restrictive than those of the AICPA. ((12 CFR 619.9270, See also this discussion of whether the auditor might be auditing his/her own work:  “Is Your CPA an ‘Independent Qualified Public Accountant,'”

It is possible that your plan, with its audit, will be further audited by the IRS.  If so, you’ll hear from a “specially trained agent…” ((The Employee Plans Examination Process - Internal Revenue Service - Tax Exempt and Government Entities (TE/GE) Division. The detailed description of that exam process outlines an appeals process, which is to say the issues can be difficult, complicated and controversial.

Section 401(k) plans may not be the most complicated type of employee benefit plan, but they are complicated and exist  in a complex environment that tries to balance the interests of the parties while primarily looking after the interests of the employees.

 The Scrutiny of the Auditor is Increasing

The understandable emphasis is to safeguard the employees who are to benefit from the Section 401(k) plan. The governmental concern about the work of auditors has been present for some time, but the concern is if anything growing. One would generally expect from the literature and actions of the regulators that scrutiny of auditors and possibility of penalties is going to increase.

In a 2014 study by the DOL released in 2015 of filings of Form 5500 for 2011, the DOL found “major deficiencies”  in 39%  of them, and a 76% deficiency rate among firms that did one or two of such audits. ((, page  1.))


The world of employee benefit plans is unique and complicated in so far as the tax and maze of other rules and regulations that pertain to their operation and qualified status.

The management of the auditing firm needs to examine closely its exposure and generally the level of commitment the firm must embrace to render quality audits of Section 401(k) plans, even if it audits only a few such plans. Those choosing the auditing firm have responsibilities beyond just measuring the fee.

The regulatory environment is one that suggests that in the future, there may be even closer scrutiny of the auditor and the audit process for such plans, and those charged with the responsibility of selecting the auditing firm.

About the Author

photo-bob-rojasRobert L. Rojas, CPA, MS Taxation, Los Angeles, Sacramento, Orange County,

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