SECTION 3. EARNINGS

ADJUSTMENT METHODS AND EXAMPLES

.01 Earnings Adjustment Methods . (1) In general. (a) Under section 6.02(4)(a) of this revenue procedure, whenever the appropriate correction method for an Operational Failure in a defined contribution plan includes a corrective contribution or allocation that increases one or more employees’ account balances (now or in the future), the contribution or allocation is adjusted for earnings and forfeitures. This section 3 provides earnings adjustment methods (but not forfeiture adjustment methods) that may be used by an employer to adjust a corrective contribution or allocation for earnings in a defined contribution plan. Consequently, these earnings adjustment methods may be used to determine the earnings adjustments for corrective contributions or allocations made under the correction methods in section 2 and under the VCS correction methods in Appendix A. If an earnings adjustment method in this section 3 is used to adjust a corrective contribution or allocation, that adjustment is treated as satisfying the earnings adjustment requirement of section 6.02(4)(a) of this revenue procedure. Other earnings adjustment methods, different from those illustrated in this section 3, may also be appropriate for adjusting corrective contributions or allocations to reflect earnings.

(b) Under the earnings adjustment methods of this section 3, a corrective contribution or allocation that increases an employee’s account balance is adjusted to reflect an “earnings amount” that is based on the earnings rate(s) (determined under section 3.01(3)) for the period of the failure (determined under section 3.01(2)). The earnings amount is allocated in accordance with section 3.01(4).

(c) The rule in section 6.02(5)(a) of this revenue procedure permitting reasonable estimates in certain circumstances applies for purposes of this section 3. For this purpose, a determination of earnings made in accordance with the rules of administrative convenience set forth in this section 3 is treated as a precise determination of earnings. Thus, if the probable difference between an approximate determination of earnings and a determination of earnings

Employer J corrects the failure under VCP using the contribution correction method by (1) amending the plan to increase the contribution percentage for all eligible employees (other than Employee W) for the 1998 plan year and (2) contributing an additional amount (adjusted for earnings) for those employees for that plan year. To determine the increase in the plan’s contribution percentage (and the additional amount contributed on behalf of each eligible employee), the improperly allocated amount ($4,800) is divided by the § 401(a)(17) limit for 1998 ($160,000). Accordingly, the plan is amended to increase the contribution percentage by 3 percentage points ($4,800/$160,000) from 8% to 11%. In addition, each eligible employee for the 1998 plan year (other than Employee W) receives an additional contribution of 3% multiplied by that employee’s plan compensation for 1998. This additional contribution is adjusted for earnings.

(3) Inclusion of Ineligible Employee Failure. (a) Plan Amendment Correction Method. The Operational Failure of including an ineligible employee in the plan who has not completed the plan’s minimum age or service requirements may be corrected under VCP and SCP by using the plan amendment correction method set forth in this paragraph. The plan is amended retroactively to change the eligibility provisions to provide for the inclusion of the ineligible employee to reflect the plan’s actual operations. This paragraph does not apply unless (i) the amendment satisfies § 401(a) at the time it is adopted, (ii) the amendment would have satisfied § 401(a) had the amendment been adopted at the earlier time when it is effective, and (iii) the employees affected by the amendment are predominantly nonhighly compensated employees.

1998, to provide a hardship distribution option that satisfies the rules applicable to hardship distributions in § 1.401(k)–1(d)(2). The amendment provides that the hardship distribution option is available to all employees. Thus, the amendment satisfies § 401(a), and the plan as amended in 2000 would have satisfied § 401(a) (including § 1.401(a)(4)–4 and the requirements applicable to hardship distributions under § 401(k)) if the amendment had been adopted in 1998.

(2) Hardship Distribution Failures. (a) Plan Amendment Correction Method. The Operational Failure of making hardship distributions to employees under a plan that does not provide for hardship distributions may be corrected under VCP and SCP using the plan amendment correction method set forth in this paragraph. The plan is amended retroactively to provide for the hardship distributions that were made available. This paragraph does not apply unless (i) the amendment satisfies § 401(a), and (ii) the plan as amended would have satisfied the qualification requirements of § 401(a) (including the requirements applicable to hardship distributions under § 401(k), if applicable) had the amendment been adopted when hardship distributions were first made available. (See Example 21.)

(b) Example.

(b) Example.

Example 21 :

Employer K, a for-profit corporation, maintains a 401(k) plan. Although plan provisions in 1998 did not provide for hardship distributions, beginning in 1998 hardship distributions of amounts allowed to be distributed under § 401(k) were made currently and effectively available to all employees (within the meaning of § l.401(a)(4)–4). The standard used to determine hardship satisfied the deemed hardship distribution standards in § 1.401(k)–1(d)(2). Hardship distributions were made to a number of employees during the 1998 and 1999 plan years, creating an Operational Failure. The failure was discovered in 2000.

Correction :

Employer K corrects the failure under VCP by adopting a plan amendment, effective January 1,

Example 22 :

Employer L maintains a 401(k) plan applicable to all of its employees who have at least six months of service. The plan is a calendar year plan. The plan provides that Employer L will make matching contributions based upon an employee’s salary reduction contributions. In 2001, it is discovered that all four employees who were hired by Employer L in 2000 were permitted to make salary reduction contributions to the plan effective with the first weekly paycheck after they were employed. Three of the four employees are nonhighly compensated. Employer L matched these employees’ salary reduction contributions in accordance with the plan’s matching contribution formula. Employer L calculates the ADP and ACP tests for 2000 (taking into account the salary reduction and matching contributions that were made for these employees) and determines that the tests were satisfied.

Correction :

Employer L corrects the failure under SCP by adopting a plan amendment, effective for employees hired on or after January 1, 2000, to provide that there is no service eligibility requirement under the plan and submitting the amendment to the Service for a determination letter.

February 12, 2001 622 2001–7 I.R.B.

under this section 3 is insignificant and the administrative cost of a precise determination would significantly exceed the probable difference, reasonable estimates may be used in calculating the appropriate earnings.

(d) This section 3 does not apply to corrective distributions or corrective reductions in account balances. Thus, for example, while this section 3 applies in increasing the account balance of an improperly excluded employee to correct the exclusion of the employee under the reallocation correction method described in section 2.02(2)(a)(iii)(B), this section 3 does not apply in reducing the account balances of other employees under the reallocation correction method. (See section 2.02(2)(a)(iii)(C) for rules that apply to the earnings adjustments for such reductions.) In addition, this section 3 does not apply in determining earnings adjustments under the one-to-one correction method described in section 2.01(1)(b)(iii). (2) Period of the Failure. (a) General Rule. For purposes of this section 3, the “period of the failure” is the period from the date that the failure began through the date of correction. For example, in the case of an improper forfeiture of an employee’s account balance, the beginning of the period of the failure is the date as of which the account balance was improperly reduced.

(b) Rules for Beginning Date for Exclusion of Eligible Employees from Plan. (i) General Rule. In the case of an exclusion of an eligible employee from a plan contribution, the beginning of the period of the failure is the date on which contributions of the same type (e.g., elective deferrals, matching contributions, or discretionary nonelective employer contributions) were made for other employees for the year of the failure. In the case of an exclusion of an eligible employee from an allocation of a forfeiture, the beginning of the period of the failure is the date on which forfeitures were allocated to other employees for the year of the failure.

(ii) Exclusion from a 401(k) or (m) Plan. For administrative convenience, for purposes of calculating the earnings rate for corrective contributions for a plan year (or the portion of the plan year) during which an employee was improperly excluded from making period

ic elective deferrals or employee after-tax contributions, or from receiving periodic matching contributions, the employer may treat the date on which the contributions would have been made as the midpoint of the plan year (or the midpoint of the portion of the plan year) for which the failure occurred. Alternatively, in this case, the employer may treat the date on which the contributions would have been made as the first date of the plan year (or the portion of the plan year) during which an employee was excluded, provided that the earnings rate used is one half of the earnings rate applicable under section 3.01(3) for the plan year (or the portion of the plan year) for which the failure occurred.

(3) Earnings Rate. (a) General Rule. For purposes of this section 3, the earnings rate generally is based on the investment results that would have applied to the corrective contribution or allocation if the failure had not occurred.

(b) Multiple Investment Funds. If a plan permits employees to direct the investment of account balances into more than one investment fund, the earnings rate is based on the rate applicable to the employee’s investment choices for the period of the failure. For administrative convenience, if most of the employees for whom the corrective contribution or allocation is made are nonhighly compensated employees, the rate of return of the fund with the highest earnings rate under the plan for the period of the failure may be used to determine the earnings rate for all corrective contributions or allocations. If the employee had not made any applicable investment choices, the earnings rate may be based on the earnings rate under the plan as a whole (i.e., the average of the rates earned by all of the funds in the valuation periods during the period of the failure weighted by the portion of the plan assets invested in the various funds during the period of the failure).

(c) Other Simplifying Assumptions. For administrative convenience, the earnings rate applicable to the corrective contribution or allocation for a valuation period with respect to any investment fund may be assumed to be the actual earnings rate for the plan’s investments in that fund during that valuation period. For example, the earnings rate may be determined without regard to any special investment provisions that vary

according to the size of the fund. Further, the earnings rate applicable to the corrective contribution or allocation for a portion of a valuation period may be a pro rata portion of the earnings rate for the entire valuation period, unless the application of this rule would result in either a significant understatement or overstatement of the actual earnings during that portion of the valuation period.

(4) Allocation Methods. (a) In General. For purposes of this section 3, the earnings amount generally may be allocated in accordance with any of the methods set forth in this paragraph (4). The methods under paragraph (4)(c), (d), and (e) are intended to be particularly helpful where corrective contributions are made at dates between the plan’s valuation dates.

(b) Plan Allocation Method. Under the plan allocation method, the earnings amount is allocated to account balances under the plan in accordance with the plan’s method for allocating earnings as if the failure had not occurred. (See Example 23.)

(c) Specific Employee Allocation Method. Under the specific employee allocation method, the entire earnings amount is allocated solely to the account balance of the employee on whose behalf the corrective contribution or allocation is made (regardless of whether the plan’s allocation method would have allocated the earnings solely to that employee). In determining the allocation of plan earnings for the valuation period during which the corrective contribution or allocation is made, the corrective contribution or allocation (including the earnings amount) is treated in the same manner as any other contribution under the plan on behalf of the employee during that valuation period. Alternatively, where the plan’s allocation method does not allocate plan earnings for a valuation period to a contribution made during that valuation period, plan earnings for the valuation period during which the corrective contribution or allocation is made may be allocated as if that employee’s account balance had been increased as of the last day of the prior valuation period by the corrective contribution or allocation, including only that portion of the earnings amount attributable to earnings through the last day of the prior valuation period. The employee’s account balance is then

2001–7 I.R.B. 623 February 12, 2001

further increased as of the last day of the valuation period during which the corrective contribution or allocation is made by that portion of the earnings amount attributable to earnings after the last day of the prior valuation period. (See Example 24.) (d) Bifurcated Allocation Method. Under the bifurcated allocation method, the entire earnings amount for the valuation periods ending before the date the corrective contribution or allocation is made is allocated solely to the account balance of the employee on whose behalf the corrective contribution or allocation is made. The earnings amount for the valuation period during which the corrective contribution or allocation is made is allocated in accordance with the plan’s method for allocating other earnings for that valuation period in accordance with section 3.01(4)(b). (See Example 25.)

(e) Current Period Allocation Method. Under the current period allocation method, the portion of the earnings amount attributable to the valuation period during which the period of the failure begins (“first partial valuation period”) is allocated in the same manner as earnings for the valuation period during which the

corrective contribution or allocation is made in accordance section 3.01(4)(b). The earnings for the subsequent full valuation periods ending before the beginning of the valuation period during which the corrective contribution or allocation is made are allocated solely to the employee for whom the required contribution should have been made. The earnings amount for the valuation period during which the corrective contribution or allocation is made (“second partial valuation period”) is allocated in accordance with the plan’s method for allocating other earnings for that valuation period in accordance with section 3.01(4)(b). (See Example 26.)

.02 Examples.

Example 23:

Employer L maintains a profit-sharing plan that provides only for nonelective contributions. The plan has a single investment fund. Under the plan, assets are valued annually (the last day of the plan year) and earnings for the year are allocated in proportion to account balances as of the last day of the prior year, after reduction for distributions during the current year but without regard to contributions received during the current year (the “prior year account balance”). Plan contributions for 1997 were made on March 31, 1998. On April 20, 2000, Employer L determines

that an operational failure occurred for 1997 because Employee X was improperly excluded from the plan. Employer L decides to correct the failure by using the VCS correction method for the exclusion of an eligible employee from nonelective contributions in a profit-sharing plan. Under this method, Employer L determines that this failure is corrected by making a contribution on behalf of Employee X of $5,000 (adjusted for earnings). The earnings rate under the plan for 1998 was +20%. The earnings rate under the plan for 1999 was +10%. On May 15, 2000, when Employer L determines that a contribution to correct for the failure will be made on June 1, 2000, a reasonable estimate of the earnings rate under the plan from January 1, 2000 to June 1, 2000 is +12%. Earnings Adjustment on the Corrective Contribution :

The $5,000 corrective contribution on behalf of Employee X is adjusted to reflect an earnings amount based on the earnings rates for the period of the failure (March 31, 1998 through June 1, 2000) and the earnings amount is allocated using the plan allocation method. Employer L determines that a pro rata simplifying assumption may be used to determine the earnings rate for the period from March 31, 1998, to December 31, 1998, because that rate does not significantly understate or overstate the actual earnings for that period. Accordingly, Employer L determines that the earnings rate for that period is 15% (9/12 of the plan’s 20% earnings rate for the year). Thus, applicable earnings rates under the plan during the period of the failure are:

Time Periods Earnings Rate

3/31/98 - 12/31/98 (First Partial Valuation Period) +15%

1/1/99 - 12/31/99 +10%

1/1/00 - 6/1/00 (Second Partial Valuation Period) +12%

If the $5,000 corrective contribution had been contributed for Employee X on March 31, 1998, (1) earnings for 1998 would have been increased by the amount of the earnings on the additional $5,000 contribution from March 31, 1998, through December 31, 1998, and would have been allocated as 1998 earnings in proportion to the prior year (December 31, 1997) account balances, (2) Employee X’s account balance as of December 31, 1998, would have been increased by the additional $5,000 contribution, (3) earnings for 1999 would have been increased by the 1999 earnings on the additional $5,000 contribution (including 1998 earnings thereon) allocated in proportion to the prior year (December 31, 1998) account balances along with other 1999 earnings, and (4) earnings for 2000 would have been increased by the earnings on the additional $5,000 (including 1998 and 1999 earnings thereon) from January 1 to June 1, 2000, and would be allocated in proportion to the

prior year (December 31, 1999) account balances along with other 2000 earnings. Accordingly, the $5,000 corrective contribution is adjusted to reflect an earnings amount of $2,084 ($5,000[(1.15)(1.10)(1.12)-1]) and the earnings amount is allocated to the account balances under the plan allocation method as follows: (a) Each account balance that shared in the allocation of earnings for 1998 is increased, as of December 31, 1998, by its appropriate share of the earnings amount for 1998, $750 ($5,000(.15)). (b) Employee X’s account balance is increased, as of December 31, 1998, by $5,000. (c) The resulting December 31, 1998 account balances will share in the 1999 earnings, including the $575 for 1999 earnings included in the corrective contribution ($5,750(.10)), to determine the account balances as of December 31, 1999. However, each account balance other than

Employee X’s account balance has already shared in the 1999 earnings, excluding the $575. Accordingly, Employee X’s account balance as of December 31, 1999 will include $500 of the 1999 portion of the earnings amount based on the $5,000 corrective contribution allocated to Employee X’s account balance as of December 31, 1998 ($5,000(.10)). Then each account balance that originally shared in the allocation of earnings for 1999 (i.e., excluding the $5,500 additions to Employee X’s account balance) is increased by its appropriate share of the remaining 1999 portion of the earnings amount, $75. (d) The resulting December 31, 1999, account balances (including the $5,500 additions to Employee X’s account balance) will share in the 2000 portion of the earnings amount based on the estimated January 1, 2000, to June 1, 2000, earnings included in the corrective contribution equal to $759 ($6,325(.12)). (See Table 1.)

February 12, 2001 624 2001–7 I.R.B.

TABLE 1 CALCULATION AND ALLOCATION OF THE CORRECTIVE AMOUNT ADJUSTED FOR EARNINGS

1$5,000 x 15%

2$5,750($5,000 +750) x 10%

3$6,325($5,000 +750 +575) x 12%

Example 25:

The facts are the same as in Example 23. Earnings Adjustment on the Corrective Contribution :

The earnings amount on the corrective contribution is the same as in Example 23, but the earnings

amount is allocated using the bifurcated allocation method. Thus, the earnings for the first partial valuation period (March 31, 1998 to December 31, 1998) and the earnings for 1999 are allocated to Employee X. Accordingly, Employer L makes a contribution on June 1, 2000 to the plan of $7,084 ($5,000(1.15)(1.10)(1.12)). Employee X’s account

balance as of December 31, 1999 is increased by $6,325 ($5,000(1.15)(1.10)); and the December 31, 1999 account balances of employees (including Employee X’s increased account balance) will share in estimated January 1, 2000 to June 1, 2000 earnings on the corrective contribution equal to $759 ($6,325(.12)). (See Table 3.)

2001–7 I.R.B. 625 February 12, 2001

TABLE 3 CALCULATION AND ALLOCATION OF THE CORRECTIVE AMOUNT ADJUSTED FOR EARNINGS

1$5,000 x 15% 2$5,750($5,000 +750) x 10% 3$6,325($5,000 +750 +575) x 12% 4 After reduction for distributions during the 2000 year but without regard to contributions received during the 2000 year .

the estimated January 1, 2000 to June 1, 2000, earnings on the corrective contribution equal to $759 ($6,325(.12)) are treated in the same manner as 2000 earnings by allocating these amounts to the December 31, 2000, account balances of employees in proportion to account balances as of December 31, 1999 (including Employee X’s increased account balance). (See Table 4.) Thus, Employee X is allocated the earnings for the full valuation period during the period of the failure.

Example 26:

The facts are the same as in Example 23. Earnings Adjustment on the Corrective Contribution:

The earnings amount on the corrective contribution is the same as in Example 23, but the earnings amount is allocated using the current period allocation method. Thus, the earnings for the first partial valuation period (March 31, 1998 to December 31, 1998) are allocated as 2000 earn

ings. Accordingly, Employer L makes a contribution on June 1, 2000 to the plan of $7,084 ($5,000 (1.15)(1.10)(1.12)). Employee X’s account balance as of December 31, 1999, is increased by the sum of $5,500 ($5,000(1.10)) and the remaining 1999 earnings on the corrective contribution equal to $75 ($5,000(.15)(.10)). Further, both (1) the estimated March 31, 1998 to December 31, 1998 earnings on the corrective contribution equal to $750 ($5,000(.15)) and (2)

TABLE 4 CALCULATION AND ALLOCATION OF THE CORRECTIVE AMOUNT ADJUSTED FOR EARNINGS

1$5,000 x 15% 2$5,750($5,000 +750) x 10% 3$6,325($5,000 +750 +575) x 12% 4 After reduction for distributions during the year for which earnings are being determined but without regard to contributions received during the year for which earnings are being determined.

February 12, 2001 626 2001–7 I.R.B.

APPENDIX C

VCP CHECKLIST IS YOUR SUBMISSION COMPLETE?

INSTRUCTIONS

The Service will be able to respond more quickly to your VCP request if it is carefully prepared and complete. To ensure that your request is in order, use this checklist. Answer each question in the checklist by inserting yes, no, or N/A, as appropriate, in the blank next to the item. Sign and date the checklist (as taxpayer or authorized representative) and place it on top of your request. You must submit a completed copy of this checklist with your request.

If a completed checklist is not submitted with your request, substantive consideration of your submission will be deferred until a completed checklist is received.

TAXPAYER’S NAME

TAXPAYER’S I.D. NO.

PLAN NAME & NO.

ATTORNEY/P.O.A.

The following items relate to all submissions:

1. Have you included a complete description of the failure(s) and the years in which the failure(s) occurred (including the years for which the statutory period has expired)? (See section 11.02(1) of Rev. Proc. 2001-17.) (Hereafter, all section references are to Rev. Proc. 2001-17.)

2. Have you included an explanation of how and why the failure(s) arose, including a description of the administrative procedures for the plan in effect at the time the failure(s) occurred? (See section 11.02(2) and (3).)

3. Have you included a detailed description of the method for correcting the failure(s) identified in your submission? This description must include, for example, the number of employees affected and the expected cost of correction (both of which may be approximated if the exact number cannot be determined at the time of the request), the years involved, and calculations or assumptions the Plan Sponsor used to determine the amounts needed for correction. In lieu of providing correction calculations with respect to each employee affected by a failure, you may submit calculations with respect to a representative sample of affected employees. However, the representative sample calculations must be sufficient to demonstrate each aspect of the correction method proposed. Note that each step of the correction method must be described in narrative form. (See section 11.02(4).)

4. Have you described the earnings or interest methodology (indicating computation period and basis for determining earnings or interest rates) that will be used to calculate earnings or interest on any corrective contributions or distributions? (As a general rule, the interest rate (or rates) earned by the plan during the applicable period(s) should be used in determining the earnings for corrective contributions or distributions.) (See section 11.02(5).)

If you inserted “N/A” for item 4, enter explanation:

5. Have you submitted specific calculations for each affected employee or a representative sample of affected employees? (See section 11.02(6).)

6. Have you described the method that will be used to locate and notify former employees or, if there are no former employees affected by the failure(s) or the correction(s), provided an affirmative statement to that effect? (See section 11.02(7).)

7. Have you provided a description of the administrative measures that have been or will be implemented to ensure that the same failure(s) do not recur? (See section 11.02(8).)

8. Have you included a statement that, to the best of the Plan Sponsor’s knowledge, the plan is not currently under an Employee Plans examination? (See section 11.02(9).)

2001–7 I.R.B. 627 February 12, 2001

9. Have you included a statement that, to the best of the Plan Sponsor’s knowledge, the Plan Sponsor is not under an Exempt Organizations examination? (See section 11.02(9).)

10. Have you included a copy of the portions of the plan document (and adoption agreement, if applicable) relevant to the failure(s) and method(s) of correction? (See section 11.04(2).)

11. Have you included a copy of the plan’s most recent Favorable Letter and/or the required applicable document(s)? (See section 11.04(4).)

12. Have you included the appropriate voluntary compliance fee due with the submission? (See section 11.06.)

13. Have you included the original signature of the sponsor or the sponsor’s authorized representative? (See section 11.07.)

14. Have you included a Power of Attorney (Form 2848)? Note: representation under VCP is limited to attorneys, certified public accountants, enrolled agents, and enrolled actuaries; unenrolled return preparers are not eligible to act as representatives under VCP. (See section 11.08.)

15. Have you included a Penalty of Perjury Statement signed (original signature only) and dated by the Plan Sponsor? (See section 11.09.)

16. Have you designated your submission as a VCP, VCO, VCS, VCT, VCSEP, VCGroup, or Anonymous Submission Procedure, as appropriate? (See section 11.11.)

The following items relate only to submissions under VCO (including VCS):

17. If the plan is currently being considered in a determination letter application on a Form 5310, have you included a statement to that effect? (See section 11.03(10).)

18. Have you included a copy of the first page, the page containing employee census information (currently line 7f of the 1999 Form 5500), and the information relating to plan assets (currently line 31f of the 1999 Form 5500) of the most recently filed Form 5500 series return? Note: If a Form 5500 is not applicable, insert N/A and furnish the name of the plan, and the census information required of Form 5500 series filers. (See section 11.04(1)(b).)

19. Have you proposed a time period of correction that is limited to 150 days (240 days for VCGroup) from the date the compliance statement is issued? (See sections 10.06(8) and 10.14(3)(b).)

The following items relate only to submissions under VCS:

20. Are each of the failures you have identified eligible for correction under VCS? (See Appendix A and Appendix B.)

21. Have you identified no more than two VCS failures? (If more than two failures were identified, VCS is not available, but you may make a submission under VCO.) (See section 10.11(3).)

22. Have you proposed to correct the failure(s) identified in your request using the permitted correction method(s) set forth in Appendix A or Appendix B? (See Appendix A and Appendix B.)

The following items relates only to submissions under the general procedures of VCP:

24. Have you included a copy of the most recently filed Form 5500? (See section 11.04(1)(b).)

25. Have you submitted an application for a determination letter? (See section 11.05.)

Signature Date

Title or Authority

Typed or printed name of person signing checklist

February 12, 2001 628 2001–7 I.R.B.