Receiving a notice that your defined benefit plan is being audited can be a stressful experience. However, with the right preparation and understanding of what’s expected, you can navigate the process smoothly.
The audit process requires a close examination of your plan’s compliance and reporting accuracy, which the IRS evaluates for discrepancies or potential errors.
Below are some key steps to help you prepare effectively if your defined benefit or cash balance plan is being audited. Let’s jump in.
Understand the Statute of Limitations for Tax Returns
The IRS audit process includes a statute of limitations, which restricts the number of prior years the IRS can examine. Typically, the IRS has three years from the date you file a tax return to initiate an audit. This three-year rule is based on standard cases without significant reporting discrepancies.
However, if a return contains a substantial understatement of income—defined by the IRS as omitting more than 25% of gross income—the statute of limitations can extend to six years. Additionally, if fraudulent activity is suspected or a tax return was never filed, the IRS has no limitation period and can audit indefinitely.
Understanding the statute of limitations can help you prepare, as it gives you a clear view of the years that may be reviewed. This understanding helps determine which years’ documents to gather. Knowing the timeframe allows you to focus on preparing specific documents, especially if the audit notice specifies certain tax years.
The IRS will typically audit you for one specific year. But if they find discrepancies, they will usually open up the audit to multiple years that are still within the statute. So, you want to do everything you can to resolve the year under audit with no changes. In this situation, they will likely not expand the audit into other years.
But if the IRS finds that you are having difficulty supporting specific items in your tax return, they will likely open up the audit to the other years. This is why accurately pulling information for the year under audit is so critical.
Gather Your Plan Documents
Once you know which years are under review, the next step is to gather all relevant plan documents. This includes the setup documents, such as the original plan document, adoption agreements, trust agreements, and any other documents created when establishing the defined pension plan. The IRS will want to see these documents to confirm the plan was set up in accordance with regulatory requirements and any amendments have been appropriately documented.
Alongside the initial setup documents, it’s crucial to have the annual reports for each year under audit. These reports may include Form 5500 filings, actuarial reports, and participant statements. Form 5500 is an annual filing required by the IRS to report the plan’s financial condition and ensure it meets ERISA (Employee Retirement Income Security Act) requirements.
Actuarial reports, prepared by the plan’s actuary, show funding calculations and assumptions used to determine the plan’s funding needs, while participant statements indicate each individual’s benefits. Gathering these documents in advance allows you to have all the necessary materials at hand when the IRS initiates the audit.
Review Your Tax Return for Accurate Recording
It’s essential to review your tax return to ensure the Defined Benefit Plan’s contributions and deductions were reported correctly. Accurate reporting is especially important since the IRS will be looking for discrepancies between the tax return, Form 5500 filings, and actuarial reports. Verify that the numbers provided by the actuary align with what was recorded on your tax return.
For example, contributions to the Defined Benefit Plan should be reported on Schedule C of Form 1040 or on the appropriate line in corporate returns. Check that the amounts on the tax return match the actuarial reports and participant data for the relevant years.
Errors in recording contributions or misstatements in deductions may draw additional scrutiny from the IRS and extend the audit process. Having accurate, consistent reporting across your tax return and plan documents reassures the IRS that the Defined Benefit Plan is compliant.
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Pro Tip: We have found that often CPAs and other tax preparers input the defined benefit plan numbers incorrectly. They sometimes don’t even input the correct amount. Ensure you review the contributions with your CPA and make sure they tie out to the annual documents to the tax return.
During this review, ensure that the information on Form 5500 matches the amounts on the tax return. Form 5500 contains critical details about the plan’s funding, investment, and participant data, so these amounts should align with the financial details on your tax return. Ensuring that contributions, deductions, and participant data were all recorded accurately and that they match the actuary’s reports will prepare you for questions the IRS might raise.
Reconcile Any Differences in Reporting
Finally, it’s important to reconcile any discrepancies between your tax return and plan documents. During the audit, the IRS will focus on any inconsistencies in your reporting. Carefully review each report to make sure the contributions, benefits, and funding amounts reported are the same across all filings. For example, if your tax return shows a deduction of $50,000 for plan contributions but Form 5500 or the actuarial report shows a different amount, this discrepancy needs immediate attention.
To reconcile differences, review the actuarial reports, participant records, and financial statements related to the plan. If there are differences due to timing issues, such as a late contribution or an adjustment to benefits, prepare a clear explanation for the IRS.
It’s often helpful to create a reconciliation sheet that clearly identifies any discrepancies and provides the reasoning behind them. This reconciliation sheet can serve as a roadmap during the audit, making it easier for the IRS auditor to understand the plan’s reporting without added questions.
Reconciling differences ahead of time demonstrates your commitment to maintaining accurate records. By showing the IRS that discrepancies are fully explained and corrected where necessary, you’re more likely to achieve a favorable audit outcome.
This proactive approach also allows you to catch potential errors that could otherwise result in penalties, helping to keep the audit process efficient and straightforward.
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Final Thoughts
Preparing for an IRS audit of your Defined Benefit Plan can seem daunting, but with thorough preparation, you can navigate it effectively. Understanding the statute of limitations clarifies the years under review, helping you focus your efforts. Gathering all plan documents, reviewing your tax return, and reconciling any discrepancies will ensure your records are accurate and complete.
Maintaining organized and compliant records reassures the IRS of your plan’s legitimacy and saves time during the audit process. By following these steps, you can approach the audit with confidence, knowing that your Defined Benefit Plan meets the necessary standards.
