PSCA Executive Reports
March 03, 2017
IRS Issues Examination Guidance on Hardship Distribution Substantiation
The IRS recently modified the Internal Revenue Manual, IRM 4.72.2, regarding the information a plan should obtain, and retain in its records, to substantiate that a participant distribution was on account of a hardship, i.e., the distribution was necessary to meet an immediate and heavy financial need, for plans that rely on the regulatory “safe harbor” for hardship distributions. The modification is effective February 23, 2017 (including audits open as of such date). This new exam guidance provides that, rather than relying on and retaining “source documents” (e.g., for a hardship distribution to cover medical expenses, the actual medical bills) to support a hardship distribution, a plan may rely on and retain a participant’s summary of the source documents. To rely on this new guidance, the plan must provide a notice to a participant obtaining a hardship distribution, and the notice must include certain required information, including that he or she must retain the source documents.
Section 401(k) of the Internal Revenue Code (“Code”) restricts a plan’s ability to allow distributions of 401(k) deferrals and certain other amounts. Generally, such distributions are prohibited before a participant either terminates employment with the plan sponsor or reaches age 59 ?. However, a distribution is permitted before age 59 ? to a participant who incurs a financial hardship. A distribution is made on account of hardship only if the distribution meets two requirements: (i) it is made on account of an immediate and heavy financial need; and (ii) it is necessary to satisfy the financial need. Treas. Reg. sec. 1.401(k)-1(d)(3). IRS regulations include rules about how to satisfy these two tests, including a safe harbor rule for each test, so that if the safe harbor is met, the requirement will be deemed to be satisfied. The safe harbor for the first test provides generally that a distribution will be deemed to be on account of an immediate and heavy financial need if it is on account of (i) medical expenses, (ii) costs to purchase a home, (iii) tuition payments, (iv) payments to prevent eviction, (v) funeral expenses, or (vi) expenses for home repair. IRS rules do not, however, address the processes needed to support these determinations.
The new IRS guidelines address only the first test – whether a hardship distribution is on account of an immediate and heavy financial need – and only in the context of a plan that meets this requirement on a safe harbor basis. It seeks to addresses plan sponsors’ and recordkeepers’ long-standing concerns about the documentation that must be obtained, and retained in plan files, to support a hardship distribution. For example, “source” documents, i.e., the actual documents that reflect a participant’s hardship, can be lengthy and plan sponsors and administrators have been concerned about having to review and store these documents, which is necessary in case the IRS were to audit the plan and request documentary support for hardship distributions. This has been a particular concern for on-line electronic programs.
Significantly, the new guidance permits a plan to obtain from the participant, and retain in its records, a summary of the immediate and heavy financial need information – instead of actual source documents. The summary may be obtained via “paper, electronic format, or telephone records.” The new guidance includes a detailed Appendix that lists the information that must be included in the summary, and also lists what information must be provided to the employee prior to making a hardship distribution as part of the notification requirement. See https://www.irs.gov/pub/foia/ig/spder/tege-04-0217-0008.pdf. (These new guidelines should replace the existing IRS website link https://www.irs.gov/retirement-plans/hardship-distribution-tips-from-ep-exam.) Thus, for example, a plan sponsor or recordkeeper could require a participant requesting a hardship distribution to complete an on-line form (or other method) that includes all of the required information.
If, upon audit, an IRS agent reviews a summary and determines that it includes all required information, he or she can conclude that the hardship distribution was proper. In contrast, if an IRS auditor reviews the summary and determines that it does not include the required information (i.e., it is incomplete or inconsistent on its face), the auditor may request the source documents. An auditor (with managerial approval) may also request source documents if an employee has received more than two hardship distributions in a plan year, provided that there is not adequate explanation for the multiple distributions (e.g., adequate explanation includes follow-up medical or funeral expenses or tuition on a quarterly school calendar). Finally, the new guidance provides that, if a recordkeeper is responsible for obtaining the information necessary to complete the summary, the recordkeeper must provide the plan sponsor at least annually with information describing the hardship distributions made during the plan year, either via a report or by some other access to the data.