Timing Differences Can Make a Difference
The number of participants as of the beginning of the year determines whether the plan’s financial statements must be audited. Starting in 2023, eligible participants who do not have an account balance on the first day of the plan year are no longer included in the participant count used to determine whether the plan must be audited. See our blog Counting What Counts, Counts the Auditors Out!. The literal application of this rule seems quite simple.
No Money, No Account, Right? Maybe Not!
Imagine the following situations:
- Plan Merger: In a plan merger effective January 1, 2023, the merged plan has title to the assets in the predecessor plan on January 1st, but the asset transfer does not happen until a later date.
- Trade Date vs. Settlement Date: Imagine a full asset transfer on December 31 that does not settle until January 2. The cash-basis recordkeeping system of the receiving plan does not report the assets or the participants as of January 1.
- Multiple Employer Plan (MEP) or Pooled Employer Plan (PEP) Spinoffs: A plan leaves a PEP or MEP effective 12/31/2022 or 1/1/2023. The spinoff plan is effective 1/1/2023 but the PEP or MEP does not transfer the account balances by 1/1/2023 and the plan does not receive any contributions until the first payroll deposit on the first Friday in January.
- Profit Sharing Contributions Funded After Year-End: A 2023 profit sharing contribution that is not funded until 2024 often includes contributions to newly eligible participants who entered the plan on 1/1/2023, but did not have an account balance yet.
In the above scenarios, on 1/1/2023, our example’s plan has title to assets in transit or contributions receivable that have not been funded.
The Form 5500 instructions indicate that both the cash method and the accrual method of accounting are acceptable, but:
- Do the cash and accrual methods apply both to the assets and to the participant count?
- Could a plan that reports the contribution receivable or the merged/spun-off assets to which the plan has title on the accrual basis also take the position that the accounts don’t exist until the reported contribution receivable is funded?
- Could the assets and the participants be double counted if an acquiring plan sponsor reports the pending asset transfer and its corresponding participants on the accrual basis, while the terminating merged plan’s recordkeeping system reports participant account balances and participant counts until the account balances are transferred?
Certainly, there is potential for assets and participants to be either double-counted or not counted at all, depending on what accounting method the plan sponsors involved are using and their interpretation of whether an account balance that has not been funded should be included in the participant count.
The Form 5500 Instructions State
“Line 6g. Enter in line 6g(1) the total number of participants included on line 5 (total participants at the beginning of the plan year) who have account balances at the beginning of the plan year. Enter in line 6g(2) the total number of participants included on line 6f (total participants at the end of the plan year) who have account balances at the end of the plan year.”
“For example, for a Code section 401(k) plan, the number entered on line 6g(2) should be the number of participants counted on line 6f who have made a contribution, or for whom a contribution has been made, to the plan for this plan year or any prior plan year.”
By “made”, did the DOL mean “deposited”, “remitted”, “funded”, “declared”, “allocated”…? To avoid this exact dilemma, our BLS plan auditors refrain from using the words “made” and “taken” on audit documentation, in favor of better verbs that describe the exact transaction that took place. We audit plans that segregate, remit, deposit, and allocate contributions as separate steps. Using the word “made” could describe any of those tasks, leaving the reviewer as confused as we are regarding what the 5500 instructions meant when they instructed us to count participants for which contributions had been “made for this plan year”.
Another Wrinkle: Initial Plan Years Could Show Beginning Asset Balances
Conceptually, spinoff plans are a continuation of the retirement plan that covered participants before the spinoff. Often, participants cannot choose to take a distribution or rollover to an IRA, and their account balances transfer to the new spun-off plan using the same source codes as the original plan, not a rollover source code. However, the spun-off assets and their respective account balances are not likely to transfer immediately.
Using the cash basis, spinoff plans rarely show the transferred assets on the plan’s effective date, even though the title to the participant account balances has been transferred. Undoubtedly, the DOL did not intend for all spinoff plans using the cash basis of accounting to avoid an audit requirement on their first year…and that’s the key, the first year.
Plans that break out from a MEP or PEP, and other spinoff plans, typically use a new EIN number and mark their Form 5500 as an initial plan year, meaning that they will use the number of account balances at the end of the year to determine if an audit is required. See our blog, Counting Participants in a First Year Plan, in which we explained that initial year plans must use the number of account balances on the last day of the initial plan year to determine whether there is an audit requirement.
Conversely, if the same spinoff plan filing as an initial year plan uses the accrual method of accounting, it will report all the assets to which the plan has title on the statement of net assets, and presumably the corresponding number of account balances immediately upon the plan’s inception. Counterintuitively, this would result in an initial plan filing with substantial assets and numerous account balances as of the first day of the plan year. Would we still look to the end of the plan year to determine if there is an audit requirement? I think so, it’s an initial year plan….an initial filing of a continuing plan!
Using the above logic, the initial filing of the continuing plan would be subject to an audit whether the cash basis or the accrual basis is used for the Form 5500 filing. The transferred assets would be subject to audit procedures, similar to beginning balance testing on a growing plan that needs an audit for the first time. If the original plan was audited, the testing would not be very involved.
Cash or Accrual: Audit or No Audit…that is the question!
If using the accrual basis would be the difference between a small plan or a large plan filing, the plan sponsor would just be postponing the inevitable. I do not underestimate the benefits of saving the costs and aggravation of an audit, if only just for twelve more months, but a self-audit or engaging an auditor to perform agreed-upon-procedures might be a wise consideration.
In the absence of specific guidance from the DOL as to whether contributions “made” include contributions receivable or in-transit, plan sponsors and their advisors are faced with the decision to audit or not to audit.
Stay tuned for more blogs involving cash vs. accrual basis conundrums….
