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By James Redding, Senior Manager, Financial Audit

Electronic certification (“e-certification”) for loans and hardship withdrawals, without the retention of appropriate supporting documentation, is considered a QUALIFICATION FAILURE. The Code requires tax-exempt organizations to comply with Federal tax law to maintain its tax-exempt status.  In a recent IRS newsletter related to e-certification, we noted that the IRS indicated that it is not sufficient for plan participants to keep their own records for hardship and loan distributions because “Participants may leave employment or fail to keep copies of hardship documentation, making their records inaccessible in an IRS audit.”

Many plan administrators rely exclusively on e-certification to manage hardship and loan distributions for their retirement plans. Typically, a participant will self-certify that he or she meets the criteria to receive a hardship distribution. For example, the participant may self-certify that a hardship distribution is necessary to pay off steep medical expenses or an imminent foreclosure. In the past, the IRS guidance on what is necessary to support a hardship was unclear, and many practitioners and Third-Party Administrators (“TPA”) have felt that self-certification was sufficient.   

The IRS has issued guidance stating that electronic self-certification is not sufficient documentation of the nature of a participant’s hardship. Some TPAs allow participants to electronically self-certify that they satisfy the criteria to receive a hardship distribution. While self-certification is permitted to show that a distribution was the sole way to alleviate a hardship, it is not deemed adequate  to show the nature of a hardship [See Treasury Regulation Sections 1.401(k)-1(d)(3)(iv)(C) and (D)]. Even if the plan uses a TPA to handle participant transactions, the Plan is ultimately responsible for the proper administration, including record retention. Plan sponsors must request and retain additional documentation to show the nature of the hardship. Not retaining records for hardship and loan distributions, and not making them available for examination, is a QUALIFICATION FAILURE that should be corrected using the Employee Plan Compliance Resolution System (“EPCRS”).

In order to comply with the IRS guidance for record retention related to hardship withdrawals, the plan sponsor should obtain and retain the following:

1. Documentation of the hardship request, review, and approval
2. Financial information and documentation that substantiates the employee’s immediate and heavy financial need
3. Documentation to support that the hardship distribution was properly made in accordance with the applicable plan provisions and the Internal Revenue Code
4. Proof of the actual distribution made and related Forms 1099-R

A retirement plan may (but is not required to) allow participants to receive hardship distributions.  A hardship distribution from a participant’s elective deferral account can only be made if the distribution is due to an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need.

Under a “safe harbor” in IRS regulations, an employee is automatically considered to have an immediate and heavy financial need if the distribution is for one of the following:

• Medical care expenses for the employee, the employee’s spouse, dependents or beneficiary
• Costs directly related to the purchase of an employee’s principal residence (excluding mortgage payments)
• Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education for the employee or the employee’s spouse, children, dependents or beneficiary
• Payments necessary to prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence
• Funeral expenses for the employee, the employee’s spouse, children, dependents, or beneficiary
• Certain expenses to repair damage to the employee’s principal residence

The amount of a hardship distribution must be limited to the amount necessary to satisfy the need. This rule is satisfied if:

• The distribution is limited to the amount required to cover the immediate and heavy financial need.
• The employee could not reasonably obtain the funds from another source.

Unless the employer has actual knowledge to the contrary, the employer may rely on the employee’s written statement that the need cannot be relieved from other available resources, including:

• Insurance or other reimbursement
• Liquidation of the employee’s assets
• The employee’s pay, by discontinuing elective deferrals and after-tax employee contributions
• Plan loans or reasonable commercial loans

Hardship withdrawals are subject to income taxes and a 10% additional tax on early distributions. Employees who take hardship distributions cannot repay it to the plan.

Even though the newsletter constitutes informal guidance and does not have the effect of a regulation or IRS Notice, the newsletter is particularly troubling because it clearly shows how the IRS will act when auditing qualified plans. Under this guidance, plan sponsors will have to take much more of a hands-on role when it comes to hardship distributions. 

This new guidance contravenes the IRS’s published FAQs on hardship distributions, which can be found at http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Hardship-Distributions . In Question 3, the IRS specifically provides that, to the extent that it has no actual knowledge to the contrary, “an employer may generally rely on the employee's representation that he or she is experiencing an immediate and heavy financial need that cannot be relieved from other resources.”

Many TPAs are also e-certifying plan loans and failing to obtain and retain sufficient documentation for each plan loan granted to participants. It is indicated above that it is the plan sponsor that is ultimately responsible to obtain and retain supporting documentation for withdrawals.  A plan sponsor should retain the following for each plan loan granted to a participant:

1. Evidence of the loan application, review and approval process
2. An executed plan loan note
3. If applicable, documentation verifying that the loan proceeds were used to purchase or construct a primary residence
4. Evidence of loan repayments
5. Evidence of collection activities associated with loans in default and the related Forms 1099-R, if applicable

Note that if a participant requests a loan with a repayment period in excess of five years for the purpose of purchasing or constructing a primary residence, the plan sponsor must obtain documentation of the home purchase before the loan is approved. IRS audits have found that some plan administrators have impermissibly allowed participants to self-certify their eligibility for these loans.

If you are using a TPA to e-certify hardships and loans, it’s time to examine your process and determine if you are, in fact, obtaining and retaining the necessary supporting documentation to assure that a qualification failure does not occur.  

 

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